Managing Through Financial Distress: The Board’s Oversight Role and Protecting Against Litigation

When a public company faces significant financial challenges and uncertainty, the pressure on management teams and boards of directors to make the “right” decisions intensifies. If those financial challenges are not successfully managed and the company is forced to consider strategic alternatives that could negatively impact stakeholders, this pressure can evolve into scrutiny—often in the form of litigation.

Unfortunately for directors in these situations, shareholders, creditors, employees, and other stakeholders may second-guess your decisions and claim that you breached your fiduciary duties. These claims can expose directors to personal liability, further elevating the stakes.

This article will:

• Provide a refresher on directors’ fiduciary duties.
• Discuss indicators of financial distress.
• Explore two common strategic alternatives—mergers and acquisitions (M&A) and bankruptcy—and how directors can fulfill their fiduciary obligations in these scenarios.
• Explain the importance of indemnification agreements and directors and officers (D&O) insurance, emphasizing provisions that ensure adequate protection.

This discussion is framed in the context of Delaware corporate law since this is where most US public companies are incorporated.

Director Fiduciary Duties: A Refresher

The Duties of Care and Loyalty

Directors are required to uphold certain fiduciary duties to a corporation and its shareholders. The two primary fiduciary duties directors should be mindful of in the context of a company managing through financial distress are:

• Duty of Care, which requires directors to act with the same care that a reasonably prudent person would in similar circumstances, including making informed decisions based on sufficient due diligence.
• Duty of Loyalty, which requires directors to act independently, prioritize the company’s interests over their own or competing interests, and avoid conflicts that could compromise their objectivity.

The Perils of Conflicts of Interest: Erosion of the Business Judgment Rule

Conflicts of interest are a key focus in litigation involving companies navigating financial distress.

Shareholder litigation often arises after a significant board decision—such as one involving M&A or other strategic alternative—leads to a sharp drop in the company’s stock price, with claims alleging breaches of the directors’ fiduciary duty of loyalty.

Delaware courts generally defer to board decisions under the “business judgment rule,” but this deference diminishes when there’s the appearance of conflict. The mere appearance of a director-level conflict of interest may call into question director independence and whether a decision was fair to the corporation. This is just the opening a plaintiffs' attorney is looking for to make a Section 220 books and records request, which is typically a precursor to litigation. Avoiding these costly and time-consuming plaintiff actions gives directors even more reason to disclose any potential conflicts that could call their impartiality or independence into question.

See our prior article for a deeper dive into director conflicts.

Signs of Financial Distress

The road from a company working through economic headwinds to full-blown financial distress isn’t typically a short one, and directors must generally rely on information they receive from management. This is not to say that management will be looking to hide the ball; rather, it may be that the team is not in the best position to properly assess and/or communicate the risk. This might be especially true if the issues relate to or are worsened by strategies management initiated.

With that in mind, directors must be able to recognize the early warning signs of financial distress so they can ask the appropriate questions and help mitigate risks.

Here are a few areas that directors may want to keep in mind when looking to predict and/or identify financial distress before the company is in the thick of it:

• Declining Financial Metrics: Persistent cash flow challenges, eroding profit margins, continued growth of off-balance sheet/contingent liabilities, decrease in cash reserves, or breaches of financial covenants.
• Operational Challenges: Supply chain disruptions, declining market share, high senior staff turnover, or deteriorating customer relationships.
• Credit Concerns: Difficulty securing financing, declining credit ratings, or significant creditor pressure.
• Regulatory or Legal Issues: Pending lawsuits, compliance violations, or investigations that could result in large financial impacts to the company.

It may not be practical or relevant to update the board on these factors, depending on the nature of the company’s business. So, what’s the solution?

Discussions about financial distress can be sensitive, especially when a company is still a long way from insolvency. Instead of explicitly discussing “distress,” boards might focus on broader questions, like how management assesses financial health and benchmarks the organization against industry peers. 

This approach fosters transparency while minimizing unnecessary alarm.

Ultimately, a critical review of these metrics by the board may help to refine existing models, lead to future management updates that include information that is more relevant to the board, and more importantly, reveal the possibility of financial distress early.

A Focus on Two Common Strategic Alternatives: M&A and Bankruptcy

Consider the situation where a company sees all the signs of imminent financial distress. The company will undoubtedly need to consider strategic alternatives. While turnarounds and financings may be explored to keep the company afloat, if circumstances don’t improve, companies may need to consider an exit in the form of M&A or a restructuring through bankruptcy.

When boards evaluate strategic alternatives in the face of imminent financial distress, directors must keep their fiduciary duties front and center. 

In that spirit, what follows are notable considerations for directors to keep in mind when evaluating M&A and bankruptcy.

M&A: Conflicts of Interest Remain a Central Concern

M&A-related litigation involving public companies is common and typically involves shareholders of the target company objecting to an announced M&A deal. A common claim is that the company agreed to a purchase price that was too low. The play here for plaintiffs’ lawyers is to stake the claim, create a speedbump for the companies to getting the deal done quickly, get the company to enhance certain disclosures related to the deal, and then ride off into the sunset with hundreds of thousands of dollars in awarded fees.

This type of traditional M&A-related litigation was vanishing, only to have plaintiffs’ attorneys use their creativity to pursue other avenues, most recently in the form of mootness fee suits. However, this type of litigation has also generally fallen out of favor due to the fees that Delaware courts now consider reasonable. We are talking in the range of $75,000 to $125,000, which is a far cry from the amounts previously garnered by public company M&A-related litigation.

M&A-related litigation may be trending downwards since the financial incentives aren’t as attractive as they used to be. Additionally, companies seem to have improved their disclosures, addressing many of the issues that previously attracted scrutiny from plaintiffs’ attorneys.

What’s left for plaintiffs’ attorneys to take issue with?

Directors’ fiduciary duties continue to be an area of focus and in Delaware courts, that focus—whether in the context of M&A or otherwise—is on director conflicts. In M&A, a perceived conflict of interest is all a plaintiffs’ attorney needs to move towards making a Section 220 books and records request.  Board minutes may be fair game, as well as texts, emails, and instant messages in some cases.

We have previously written about the importance of effectively managing conflicts of interest and outlined strategies in how best to do so. For high-stakes decisions, especially M&A-related decisions when facing financial distress, companies should consider engaging outside counsel early to identify potential conflicts and structure a process to manage those conflicts, including forming special committees.

That theme of engaging outside counsel early carries over to the next strategic alternative: bankruptcy.

Bankruptcy: A Last Resort that Shouldn’t Be Considered Last

Bankruptcy is often viewed as a last resort, but delays in preparing for it can worsen outcomes for the company and its directors. Directors would be well-advised to remain engaged and proactive in exploring this option, even when other strategic alternatives are still on the table.

With that in mind, here are a few important considerations for directors:

• Fiduciary Duties When Approaching Potential Insolvency: The board continues to owe a duty to the company (extending to shareholders).
• Fiduciary Duties When Actually Insolvent: The board continues to owe a duty to the company (now extending to shareholders and creditors).
• Importance of Engaging Outside Counsel: In litigation, courts will consider whether the corporation was solvent in hindsight by looking at cash flow, balance sheet, and capital position. As a result, it’s important to obtain the advice of counsel at key junctures on the solvency/insolvency analysis and relevant duties to shareholders and/or creditors.

See this discussion from Sullivan & Cromwell for more information regarding director fiduciary duties when facing potential insolvency.

Importantly, while bankruptcy shields the company from litigation, it does not necessarily protect directors, who may face claims from shareholders or creditors. This underscores the importance of indemnification agreements and D&O insurance.

Protections for Directors: Indemnification Agreements and D&O Insurance

Even the most diligent directors can face lawsuits during periods of financial distress. Robust indemnification agreements and comprehensive D&O insurance are essential safeguards.

Indemnification Agreements

Public company directors know they should secure an indemnification agreement from a company before agreeing to be on a board.

As time passes from when these agreements are first signed, there is a risk that the director protections may no longer align with market standards or be as robust as directors may have envisioned. For instance, if a company is contemplating putting itself up for sale, it would be a good idea to confirm that the indemnification agreement provides for specified protections in the case that the company undergoes a change in control. Surprisingly, there are still a number of public company indemnification agreements that do not address how these agreements are intended to respond in the case of a change in control.

It’s generally a good idea for directors to request that companies revisit their indemnification agreements every few years as a housekeeping item.

D&O Insurance

D&O insurance provides a vital safety net for directors, particularly in high-stakes scenarios. As directors are approaching potential financial distress, they should consider confirming:

• The Company Maintains Adequate Side A DIC Coverage: Under a typical D&O insurance policy, the personal asset protection for the directors and officers (Side A) and the corporate balance sheet protection (Sides B and C) share the same single policy limit. This means in bankruptcy, there is a risk that insurance proceeds may be exhausted by the company before the policy steps in to protect directors and officers.
  
  This is where 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 D&O insurance policy 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.