Bankruptcy in the Time of COVID-19: A Guide for Directors and Officers

This blog post can also be found on our Coronavirus Resource Center.

The economic impact of the COVID-19 pandemic has become devastating for some companies, particularly retailers among others. It has also been very difficult for startups.

Corporations are being forced to make tough decisions right now, including if they should file for bankruptcy. In order to better prepare, directors and officers will want to pay attention to their responsibilities and duties when insolvency 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, I will discuss some factors directors and officers will want to consider when confronted with the possibility of corporate bankruptcy, including issues of potential personal liability for directors and officers. I will also discuss how D&O insurance comes into play.

Immediately Abandoning Ship Is Not Always the Best Move

Even the best-managed company may find itself facing insolvency in an environment like the one caused by COVID-19.

Steering the company through tough times is one of the reasons the experienced businesspeople who sit on the board were placed there. When faced with the financial woes of a sinking company, abandoning ship is very tempting.

Remember, however, that resignation won't:

• Void officers 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 SEC if they were an officer of a company within two years of that company’s filing for bankruptcy

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 will be sailing in some especially rocky shoals.

During these times, there are two main ways a board can help both the company and itself.

1. Start Planning for Insolvency Sooner Rather than Later

First, start planning for insolvency sooner than later. It can be tough to get this process started 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 with on the cost and timeline of a potential 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 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.

As directors and officers consider the timing of when to start winding down the company, it may be worth thinking about the different incentives 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 extra-company indemnification arrangements may shield these directors from personal liability for WARN Act issues and unpaid employment taxes, as I will discuss below.

Letting a failing company continue to operate in the hope that things will turn around is a lot more comfortable for a director that 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 PE or VC firm, you will want to understand how much runway you have and the company's shut-down costs, or 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 in order to incentivize them to stay on board and help wind down a company.

2. Document Everything

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

There can be a feeling that with everything going on, it is too much of a hassle to minute relatively short conference calls as official board meetings. That 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, Ds and Os 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 its 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.

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:

• Financial assistance through the CARES Act
• 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 us take a closer look at the last two bulleted ideas.

Recapitalization

If you are opting for recapitalization, the 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, or an Assignment for the Benefit of Creditors. This 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). 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 directors and officers who are concerned about a hostile bankruptcy trustee who might like to bring a fiduciary duty suit against them as a way to fund the bankruptcy estate, an ABC might be especially attractive.

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.

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
• 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 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 often the preferred option. This outcome is more likely the stronger a company is going into the bankruptcy process, a strong reason for a board to consider filing for bankruptcy sooner than later.

Note: A lot of legal rules and regulations are in flux due to governmental intervention in light of the COVID-19 pandemic. You will want to consult with bankruptcy counsel to see if any changes will be relevant to your filing.

Personal Liability for Ds and Os 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 this list, something that is unlikely to change in a fundamental way anytime soon––even with all the rules and regulations that congress is changing due to the current pandemic.

Unpaid Wages

One area where employers are being given a break due to the pandemic is the federal WARN Act (Worker Adjustment and Retraining Notification Act of 1988) and its state-law equivalents. It is important to pay attention to the various WARN acts because 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.

The 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. As I have discussed in an earlier post, investors and lenders could be liable under the WARN Act as well.

However, there are exceptions to the notice requirements, and both the federal government and some state governments, such as California, have clarified that the current pandemic will trigger the exceptions.

In short, the full 60-day notice period may not be required due to "unforeseen business circumstances"—but remember that there is no case law interpreting these recent rule changes. In its excellent update on this topic, the law firm Sullivan and Cromwell notes that:

[T]he extraordinary circumstances of the Coronavirus outbreak may excuse employers from the full statutory notice obligations; however, the statutory exclusions of the federal . . . WARN Act . . . and state-law analogues may nevertheless require some notice and record-keeping and, thus, it is worth keeping in mind the obligations imposed by those statutes. In addition, employers should also bear in mind other relevant state and local laws as well as employment contracts or collective bargaining agreements in taking any such actions.

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, as I discussed in an earlier post (linked above), the Fair Labor Standards Act of 1938 (FLSA) is one such law that could impose personal liability for unpaid wages.

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 that's not an issue in the future.

It is worth noting that the CARES Act in response to COVID-19 currently allows employers to defer their share of Social Security Payroll taxes in 2020.

That provides some temporary relief from the IRS code that outlines 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.

This deferral is, of course, to help companies with their cash flow. The deferral will not be available if a company has enjoyed loan forgiveness under the Paycheck Protection Program.

This is awkward because it is unclear when companies will know for certain if their loans were forgiven. However, the IRS did issue some clarifying guidance on this point, which the law firm Cooley summarizes here.

In any case, deferrals are not forgiveness. Directors and officers will want to be sure that the company will ultimately be able to make its required tax payments.

As with other rules and regulations related to the pandemic, tax rules may be subject to further changes. Be sure to consult with your tax advisor for the most up-to-date advice.

In the best case, you would want to wind down a company at a time when there is still enough money in the bank to meet all of the company's obligations, including to its employees and tax collectors.

How D&O Insurance Would Respond in a Bankruptcy

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.

Indeed, in the current economic environment caused by COVID-19, 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 at all.

Directors and officers in possession of a well-brokered D&O insurance policy are people who have significant protection in bankruptcy. 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.

The sorrow of the pandemic is not limited to sickness and death; companies are failing as well. Directors and officers can avoid compounding the problem by incurring additional personal liability. They can do this by taking a clear look at the situation, understanding their various obligations, and in some cases electing to wind down or restructure the company sooner than later.