Corporate Bankruptcy: A Guide for Directors and Officers

When the economy is stressed, corporations and their directors and officers must brace for a prolonged downturn. Unfortunately for some companies, filing for bankruptcy will be inevitable.

Directors and officers will want to plan for how they will fulfill their responsibilities and duties when insolvency is on the horizon. This includes considering potential alternatives, as well as being thoughtful about how to protect themselves against personal liability.

Finding Alternatives to Bankruptcy

Before deciding to file for bankruptcy, consider other financial solutions. Some alternatives to bankruptcy that could be discussed with outside counsel include:

• Corporate dissolution
• Out-of-court restructuring
• A merger or acquisition
• State-law sanctioned liquidation (without court oversight)
• Recapitalization
• Assignment for the benefit of creditors

Let's take a closer look at the last two bulleted ideas.

Recapitalization

Recapitalization is especially common among venture-backed private companies in Silicon Valley and other venture-capital hot spots. If you are opting for recapitalization, the board should consider which investors will take the biggest financial loss.

Working with a trusted corporate attorney will give you insight into:

• How to conduct a clean “down round”—a round of financing where investors purchase shares at a lower valuation than the previous round of financing. This often leads to washing out the equity position of investors in earlier rounds of financing.
• The necessary disclosures that must be given to equity holders, creditors, and others. Complete and forthright disclosures are your watchwords in this type of situation.

Assignment for the Benefit of Creditors (ABC)

Another, perhaps lesser-known alternative to bankruptcy is an ABC, or an assignment for the benefit of creditors. This is an alternative provided under most states’ business laws. It typically requires the approval of a majority of the shareholders and the cooperation of all parties, including all creditors.

An ABC is a state law mechanism. (As a reminder, bankruptcy is a function of federal law). ABCs allow corporations to operate without court oversight. In an ABC, a company transfers its assets to an assignee, who becomes a fiduciary for the creditors’ benefit.

An ABC might be especially attractive for directors and officers concerned that a hostile bankruptcy trustee might like to bring a fiduciary duty suit against them as a way to fund the bankruptcy estate.

It will be important to speak to local counsel about this option since not all states’ rules will make the ABC process favorable to every business.

Companies often prefer this option to bankruptcy when it's possible because:

• It’s less costly
• There may be less media attention
• It often moves faster than federal bankruptcy
• Since it is negotiated and cooperative in nature, directors and officers are unlikely to be sued

There are a couple of things you should know about this option:

1. The assignee works to maximize proceeds for the company’s creditors, including selecting key employees to wind down operations, marketing the business to potential buyers, and obtaining the highest price for liquidated assets.
2. While board members resign in an ABC, this resignation does not void any liability from conduct before their resignations. The assignee takes on the financial decisions from that point forward and assumes fiduciary duties.

When Bankruptcy Is the Only Option

When all else fails, bankruptcy may be the only course for a struggling corporation. It’s useful to understand how the different types of bankruptcies create different options for companies and their directors and officers.

Types of Bankruptcy

Most corporations will attempt to pursue one of two types of bankruptcies:

• Chapter 7 bankruptcy. In Chapter 7, a company closes its doors and a court designates a trustee to control and liquidate the company’s assets for the creditors.
• Chapter 11 bankruptcy. In Chapter 11, the bankruptcy court allows a company to continue operations. The company’s current management team often stays in place as the “debtor-in-possession,” at least pending a recapitalization or other resolution under the oversight of a court.

Chapter 11 often allows a company to retain its employees and keep the business running, and so is usually the preferred option. The viability of a Chapter 11 bankruptcy depends on the strength of the company going into the process, a strong reason for a board to consider filing for bankruptcy sooner rather than later.

Remember: Abandoning Ship Is Not Always the Best Move

If the ship is going down, it may be tempting for directors and officers to bail out. Unfortunately, resignation does not separate directors and officers from liability tied to their position before quitting.

Steering the company through tough times is one of the reasons the experienced businesspeople who sit on the board were placed there.

Remember, too, that resignation won’t:

• Void an officer’s or director’s history of service on the board
• Protect officers or directors from being investigated
• Help officers or directors avoid disclosing their association with a bankrupt company in future proxies filed with the Securities and Exchange Commission (SEC) if they were an officer of a company within two years of that company’s filing for bankruptcy

A resignation might provide a director or officer with immediate relief from a stressful and likely time-consuming situation in the short term. However, looking at the big picture, many directors and officers would be better off staying involved so that they can steer the company in as good a direction as possible.

Next: Start Planning for Insolvency Sooner Rather Than Later

It can be tough to start planning for insolvency in part because no one wants to “give up” too soon. However, a common mistake boards make is failing to realize how much money—which is to say cash—is required to get through a bankruptcy proceeding well.

To be sure, bankruptcy usually means creditors will not be fully paid, but be aware that bankruptcy counsel will not engage with you if you do not have enough cash to pay them up front. Other needed advisors may have similar policies.

If nothing else, a board should consider hiring experienced bankruptcy counsel to consult on the cost and timeline of a potential bankruptcy well in advance of making the decision to file for bankruptcy. This attorney can also provide the board with important clarifications about fiduciary duty issues.

Discussions about the zone of insolvency will be particularly important given the amount of misinformation there is out there on this topic. Understanding these issues sooner rather than later can be the difference between having a derivative suit filed against a board by creditors or not.

Remember, too, that if a board is proactive, the bankruptcy might be a restructuring that allows the company to keep operating with its employees, as opposed to a complete liquidation.

Different Levels of Protection

As directors and officers consider the timing of when to start winding down the company, it may be worth thinking about the different levels of protection that various board members and officers may have.

For example, some board members may be investors who are indemnified by the private equity or venture capital firms they represent. These board members likely have extra-company indemnification arrangements from their firms, arrangements that may shield these directors from personal liability for WARN Act issues and unpaid employment taxes, as I will discuss later.

Letting a failing company continue to operate in the hope that things will turn around is a lot more comfortable for a director who has extra-company indemnification than for the officers and directors who do not.

If you are a corporate officer or an independent director without an indemnification arrangement from a private equity (PE) or venture capital (VC) firm, you will want to understand how much runway you have and the company’s shut-down costs. Otherwise, you may be looking at some tricky situations, including personal liability for unpaid compensation.

In some (albeit unusual) cases, these same PE and VC firms have been known to indemnify a key employee or two to incentivize them to stay on board and help wind down a company.

Finally, Document Everything

The board should be especially vigilant about taking good meeting minutes. Often, boards meet much more frequently—as much as daily—when a company is sinking.

The frequency and urgency of these meetings can generate the feeling that, with everything going on, it is too much of a hassle to create official board meeting minutes for relatively short conference calls. This is a mistake.

Bankruptcy is a vulnerable time for a company’s directors and officers. It provides a stay on litigation against the bankrupt company; however, directors and officers may be sued by:

• Creditors or the bankruptcy trustee
• Shareholders
• The SEC and other government regulators

Consider this situation: A bankruptcy trustee is curious as to whether a board considered its fiduciary duties to the company’s creditors as it approached insolvency. If the board fails to minute the numerous meetings it had, there is no documentary evidence of the board’s diligence.

Having minutes that evidence the board’s diligence and concern for its creditors will go a long way to deflect a bankruptcy trustee’s interest in bringing a derivative breach of fiduciary duty suit against the board.

Personal Liability for Directors and Officers During Bankruptcy

A well-brokered D&O policy can cover many liabilities such as the cost to defend and settle breach of fiduciary duty suit claims. Unfortunately, there are things that may not be covered by D&O insurance.

Unpaid employee wages and unpaid employment taxes head the list of items that are not covered by a D&O insurance policy, something that is unlikely to change in a fundamental way anytime soon.

Unpaid Wages

WARN Act

It is important to pay attention to the federal WARN Act (Worker Adjustment and Retraining Notification Act of 1988) and its state law equivalents. Violations can potentially result in personal liability for directors and officers.

The WARN Act is a federal law that requires most employers with 100 or more employees to give a 60-day notice in advance of mass layoffs or plant closings.

State Law Versions: The WARN Act also has state law versions. Some state law versions have provisions that can be more serious than the ones found in the federal version.

For example, the California version of the WARN Act allows employees to sue for up to 60 days of unpaid pay and benefits. This webpage at the California Employment Development Department expands on the differences between federal and California state law.

Stanziale v. MILK072011, LLC, a 2015 bankruptcy case filed in Delaware against a dairy and milk processing facility in Wisconsin, is a cautionary tale. In this case, the company in question abruptly ceased operations and filed for bankruptcy three days later.

Former employees alleged that officers of the company had violated the Wisconsin version of the WARN Act and breached their fiduciary duties. Counsel for the officers attempted to end the matter through a motion to dismiss, which the court denied.

From a summary provided by the American Bar Association:

The managers argued that the company was already insolvent at the time when they might have given the WARN notice . . . . The court ultimately concluded that the trustee’s complaint alleged facts which, if established at trial, would support a finding that the defendants had breached their fiduciary duties to Golden Guernsey.

Importantly, although the WARN Act only provides for recourse directly against the “employer,” the Chapter 7 trustee sought to hold the officers personally liable for the violation based on the alleged breach of fiduciary duty claims.

Former Exceptions: During the height of the pandemic, there were exceptions to the notice requirements. Both the federal government and some state governments, such as California, clarified that the pandemic would trigger the exceptions.

However, one of those exceptions was challenged in court, and in June 2022, the Fifth Circuit Court of Appeals concluded that COVID-19 was not considered a natural disaster exception under the WARN Act.

Investors and Lenders: Investors and lenders could be liable under the WARN Act as well. In Guippone v. BH S&B Holdings LLC, former employees of Steve & Barry’s stated they did not receive proper notice under the WARN Act when they were laid off.

The plaintiffs had included a parent entity composed of the investors in the now-bankrupt company in their suit. Whether the parent entity could be held liable depended on whether related entities are single employers under the WARN Act.

In reviewing the case, the Second Circuit Court of Appeals noted the applicability of the US Department of Labor (DOL) to this question.

Cooley LLP summarizes here:

The test under DOL regulations determines the portfolio company’s degree of independence from the respective investor based on the following factors:

• Common ownership
• Common directors and/or officers
• De facto exercise of control
• Unity of personnel policies emanating from a common source
• Dependency of operations

The court held that a jury could reasonably find that the investor exercised control over Steve & Barry’s and was therefore liable under the WARN Act, highlighting that exercise of control alone could be sufficient to justify liability for the investor.

The Cooley article also points to decisions where the lenders of a company could be held liable under the WARN Act:

The Second Circuit has held that a lender is liable under the WARN Act for its borrower’s missteps when it “becomes so entangled with its borrower that it has assumed responsibility for the overall management of the borrower’s business.” Coppola v. Bear Stearns & Co. 499 F.3d 144, 150 (2d Cir. 2007)

Other courts have looked at this liability question as well, as Cooley points out:

The Eighth and the Ninth Circuits have also looked at investor and lender liability and, like the Second Circuit, apply the DOL regulations test for investors, but apply a similar, more lenient, standard for lenders. The Third and Fifth Circuits, on the other hand, apply the DOL regulations test for both lenders and investors. The trend in recent case law appears to favor the more stringent DOL regulations test for both investors and lenders.

Fair Labor Standards Act

Remember, too, that other sources of potential personal liability exist for officers (and perhaps directors) related to unpaid wages beyond the WARN act and its state law equivalents. For example, the Fair Labor Standards Act of 1938 (FLSA) is one such law that could impose personal liability for unpaid wages.

In Boucher v. Shaw (2009) the Ninth Circuit Court of Appeals found that managers of the Castaways Hotel, Casino and Bowling Center would be liable under FLSA for unpaid wages after bankruptcy.

A Fair Day’s Pay Act

Finally, in California, A Fair Day’s Pay Act can hold a company's owners, directors, and officers personally liable for wage and hour violations.

Atempa v. Pedrazzani found that the owner (also a director) of an Italian restaurant was liable for failing to pay overtime wages, minimum and regular wages, and other claims. The court ruled that Paolo Pedrazzani was personally liable for more than $30,000 in civil penalties and an additional $300,000 in attorney fees.

Taxes

Another area of potential personal liability for directors and officers of a failing company is employment taxes. As a director or officer, you want to be sure that payroll taxes are being properly withheld and remitted during a company wind-down so it's not an issue in the future.

See this IRS code for more on the liability of third parties for unpaid employment taxes:

"Any person required to collect, truthfully account for, and pay over any tax imposed by this title who willfully fails to collect such tax, or truthfully account for and pay over such tax, or willfully attempts in any manner to evade or defeat any such tax on the payment thereof, shall, in addition to other penalties provided by law, be liable to a penalty equal to the total amount of the tax evaded, or not collected, or not accounted for and paid over. No penalty shall be imposed under section 6653 or part II of subchapter A of chapter 68 for any offense to which this section is applicable."

Insurance Protection for Directors and Officers During Corporate Bankruptcy

While a corporation will find relief from litigation when it enters bankruptcy, its directors and officers may remain on edge because they can be sued individually or collectively—and the company is no longer able to indemnify them.

Thus, when a company goes into bankruptcy, its directors and officers are in an especially vulnerable position. Enter the D&O insurance policy. A well-brokered D&O policy that has the right terms and was placed with a good insurance carrier is designed to protect directors and officers in exactly this situation.

It is vital for directors and officers to have a well-negotiated D&O policy before their company’s finances start to deteriorate. If this was not the case before, it is unlikely that terms will improve as a company gets closer to bankruptcy.

Unfortunately, you can only purchase D&O insurance on terms offered by a willing counterparty. Indeed, in the current economic environment, we are seeing incumbent carriers sometimes impose bankruptcy-specific exclusions on policies they are renewing.

New carriers are often unwilling to provide a quote for D&O insurance for a distressed company. Insurance carriers often want to see 12 to 18 months of working capital before they are willing to issue a D&O insurance quote.

Let’s take a closer look at four critical issues to consider if you want a D&O policy that will protect directors and officers in bankruptcy.

1. A Specialized Broker and Policy Negotiator

Unlike some other lines of insurance, D&O insurance requires a specialist. Ideally, you will work with a broker that has helped many companies before yours through bankruptcies. This is an area where experience matters.

Consider the vital timing and technical issues surrounding policies. An experienced broker can walk you through the issues. Remember, too, that insurers are more willing to embrace broad bankruptcy terms the further away from bankruptcy your company is.

An experienced broker knows this and will often make a point of negotiating broad bankruptcy policy coverage well before anyone else might think this sort of negotiation is important.

2. A Financially Solid, Dependable Insurance Carrier

It may be tempting to select your insurance coverage based on price, but there are other things to consider when evaluating a carrier. A critical issue for the directors and officers of a company facing bankruptcy is the financial health of the insurance carrier. Another important consideration is the carrier’s track record of paying claims.

Insurance carriers that are unable or unwilling to pay legal bills timely are carriers that are leaving directors and officers in a lurch.

3. The “Side A” Insuring Agreement

“Side A” is the common term for the insuring agreement in a D&O policy that responds when a director or officer is sued and the corporation is unable to respond, including due to bankruptcy. This insuring agreement should require no payment of a self-insured retention (like a deductible) before the policy will begin to respond.

Most public companies and many private companies purchase Side A as part of a broader insurance policy, and also purchase Side A insurance on a standalone basis. When the Side A policy is part of a broader policy that also includes coverage for the corporate entity, the policy is often referred to as an “ABC policy.”

This evolution of the D&O insurance program structure—companies purchasing Side A both within an ABC policy and also on a standalone basis—happened due to a concern about bankruptcy.

The worry is that, in bankruptcy, a trustee may attempt to assert that the ABC policy is an asset of the corporation since it includes corporate entity balance protection. If the trustee is successful in seizing the ABC policy and there is no separate standalone Side A policy, directors and officers will be left with no coverage.

A side note on additional coverage: Directors and officers might consider a separate wealth security policy, which is an extra safeguard of personal wealth. This is a backup plan for when a company’s D&O insurance falls short or becomes unavailable.

Remember that your normal personal insurance policies (such as your personal umbrella policy) almost always exclude coverage for service on a for-profit company board.

4. Custom Contractual Terms

Terms specific to bankruptcy should be carefully crafted in the D&O policy. You’ll want to consider the following:

• Zero self-insured retentions. As mentioned previously, the policy should not require any payments by a corporation or its directors or officers before the Side A insuring agreement responds to a claim.
• Specific triggers. Triggers can vary for Side A coverage, but at a minimum, filing for bankruptcy or the designation of a trustee should be a trigger.
• Drop-down coverage. If, for some reason, your primary insurer doesn’t respond, a standalone Side A policy with drop-down coverage may be very helpful. In some cases, it’s possible to purchase a more lenient standalone Side A as a backup plan to step in for things like insolvency, a situation in which some companies will not honor their indemnification obligations to their directors and officers even though they are not yet in bankruptcy.
• Waiver of the “automatic stay.” When a company files for bankruptcy, the bankruptcy court imposes an “automatic stay,” which halts creditors from collecting debt as well as litigation. You want your policy to specify that all parties to the D&O policy have agreed to waive the automatic stay imposed by bankruptcy. This provision is designed to persuade the bankruptcy court not to hold up payments by the D&O policy.
• Insured versus insured. Look for a carve-back to the insured versus insured exclusion. In its classic form, this exclusion states insured parties under the same policy aren’t covered when one sues the other. The specific carve-back you are looking for from this exclusion (or a similarly worded one known as the entity versus insured exclusion) provides for coverage even if a bankruptcy trustee standing in the shoes of the company attempts to sue directors and officers.
• Debtor-in-possession as an insured. If your company is looking at a Chapter 11 reorganization, it may well be the case that the current management team will remain in place during the bankruptcy. In such cases, the company becomes the “debtor in possession.” Consistent with this outcome, you want the debtor in possession to be covered by the terms of the D&O policy.
• Order of payment. This language specifies who should be paid first under the policy—the directors and officers or the corporation. Directors and officers will want to ensure the former.
• Run-off. Most policies will not respond to claims that arise out of activities that took place after a change of control. Instead, the policy is said to go into “run-off.” Ideally, you want language in your policy clarifying that your carrier does not view bankruptcy as a trigger for your policy to go into run-off policy. Instead, you want the policy to remain in place (and responsive to the evolving situation to support directors and officers who are staying on to help right the ship).
• Non-cancellation. Confirm with the carrier that the policy cannot be canceled for any reason except non-payment of premium—even if it’s the insured who is trying to cancel the policy. This helps to guard against a bankruptcy trustee who might attempt to cancel the policy to recover the policy premium for the benefit of the bankruptcy estate.
• Tail coverage. Purchasing a tail policy will allow the coverage to continue after the policy has expired for a specified period (usually up to six years).

A properly brokered D&O insurance policy is a director or officer’s best line of protection during a bankruptcy situation. For example, a good D&O policy should respond to pay the legal bills if a creditor or bankruptcy trustee were to bring a derivative suit against directors and officers for breaching their fiduciary duties.

One hopes that the policy will never need to respond. However, it’s prudent to ensure well before the threat of a possible bankruptcy that the D&O policy could respond on behalf of directors and officers.