A Guide to Weathering Corporate Bankruptcy for Directors and Officers

The markets are getting squirrely… and for the first time in a long time I'm actively talking to clients about bankruptcy. Even if your company is wildly successful, it's worth knowing something about bankruptcy, if only on a "just in case" basis. Part of being a prepared director or officer is having a clear view of the responsibilities and duties of Ds and Os when bankruptcy is on the horizon.

If the ship is going down, it may be tempting to bail. Unfortunately, resignation does not separate any director or officer from liability tied to their position prior to quitting.

In this post, we’ll discuss the options directors and officers have to weigh when facing a bankruptcy. In Part 2 of this series, we look at what you’ll want in your get D&O insurance policies if you are, in fact, faced with a bankruptcy situation.

Abandoning Ship Is Not Always the Best Move

When faced with the financial woes of a sinking company, abandoning ship is very tempting. Remember, however, that resignation won’t:

• Void a director’s history of service on the board
• Protect a director from being investigated
• Necessarily permit directors to omit mentioning tenure at the bankrupt company in future public filings with the Securities and Exchange Commission

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

• Creditors or bankruptcy trustees for breach of fiduciary duty
• Shareholders for breach of fiduciary duty
• The SEC and other government regulators

A resignation might provide immediate relief 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 notwithstanding that you’ll be sailing in some especially rocky shoals.

Finding Alternatives to Bankruptcy

One reason to refrain from resigning might be to help a company find some creative solutions to its financial woes. In consultation with outside counsel, some alternatives to bankruptcy could be:

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

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

Recapitalization

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

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.
• What are the necessary disclosures 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, which is legal under most states’ business law and typically requires the majority of shareholder approval 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). It allows corporations to operate without court oversight. In an ABC, a company transfers its assets to an assignee, which becomes a fiduciary for the creditors’ benefit.

For Ds and Os who are concerned about a hostile bankruptcy trustee who might like to purse Ds and Os for breaching their fiduciary duty, an ABC might be especially attractive. Not all states' rules will make the ABC process favorable to every business.

However, when possible, companies often prefer this option to bankruptcy because:

• It’s less costly;
• There can be less media attention;
• It often moves faster than federal bankruptcy; and
• It is negotiated and cooperative in nature, Ds and Os are unlikely to be sued

A couple things you should know about this option:

• 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.
• While board members resign in an ABC, this resignation does not void any liability from conduct before resignation. The assignee takes on the financial decisions from that point forward and assumes fiduciary duties.

Types of Bankruptcy

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 Ds and Os. Most corporations will attempt to pursue one of two types of bankruptcies:

1. 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.
2. 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 some option like recapitalization or other resolution under the oversight of a court.

When a company is facing financial woes, directors and officers must explore all options for an exit strategy. Bankruptcy is not always the best choice, but in some cases it absolutely is.

For more information about how to best protect Ds and Os whose companies may be facing a corporate bankruptcy, read this companion article.

The views expressed in this blog are solely those of the author. This blog should not be taken as insurance or legal advice for your particular situation. Questions? Comments? Concerns? Email: phuskins@woodruffsawyer.com.