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Directors of Financially Troubled Companies Beware

By William Gehrke, Senior Partner, Hale and Dorr LLP

As a result of the prolonged downturn in technology spending and today's difficult economic environment, many technology companies, including public and private enterprise software companies, are continuing to encounter financial and liquidity problems. Directors of financially troubled companies are often surprised to learn that their fiduciary duties may extend not just to the company and its stockholders, but also to the company's creditors. Directors and officers of financially troubled enterprise software and other companies need to be aware of the risk of personal liability as a result of their own acts or omissions or as a result of the failure of the company to satisfy its obligations.

Fiduciary Duties

Directors of a corporation owe a duty of care and a duty of loyalty to the corporation and to the corporation's stockholders.

The duty of care obligates a director to act on an informed basis, in good faith and in a manner he or she reasonably believes to be in the best interests of the corporation. The duty of loyalty obligates each director to put the interests of the corporation ahead of his or her personal interests.

Absent unusual circumstances, these duties generally are not extended to others. For example, absent the special circumstances discussed below, directors do not owe fiduciary duties to the creditors of a corporation.

When Does a Fiduciary Duty to Creditors Arise?


When a corporation becomes insolvent -- either because it is unable to pay its debts as they become due or because its liabilities exceed the fair value of its assets -- the directors must generally put the interests of the creditors ahead of the interests of the stockholders. This shift occurs principally because the creditors of an insolvent company, and not the stockholders, bear the risk of further erosion of the value of the corporation.

At the point of insolvency, the interests of the stockholders and creditors can be quite different. While stockholders may be inclined to have the corporation use any remaining cash in risky transactions which represent the stockholders" only chance to create value for their stock, from the creditors" perspective the so called "Hail Mary pass" may represent an improper squandering of assets, and thus a breach of the board's duties to creditors. For example, the decision of the board of an enterprise software company to devote all of the company's remaining cash to a highly speculative product development program in the hope that it will achieve an unexpected breakthrough that increases the company's value, might be a breach of the board's duties to creditors.

The Vicinity of Insolvency

Some courts have suggested that the duties of directors may shift away from the stockholders to include creditors when a corporation is not insolvent but is operating in the "vicinity" or "brink" of insolvency.

When a corporation is in the vicinity of insolvency, the prudent course is for the directors to consider the interests of the corporate enterprise as a whole, taking into account the interests of creditors, employees and customers as well as stockholders.

Will Board Decisions Be Protected by the Business Judgment Rule?

If a board action is challenged in court by stockholders, the directors are generally entitled to the benefits of the "business judgment rule." This rule establishes a presumption that in making a decision, the directors acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the corporation. The purpose of the business judgment rule is to prevent judicial second-guessing of directors" decisions, except in clear cases of abuse.

It is uncertain whether decisions made by directors of corporations that are insolvent or in the vicinity of insolvency would be afforded the protection of the business judgment rule. In light of this uncertainty, boards should understand that the record of their deliberations and actions would be subject to great scrutiny. It is advisable to keep minutes demonstrating the board's careful consideration of all relevant facts and circumstances and the interests of all relevant constituencies.

Personal Liability

For Breach of Fiduciary Duties

If the board of directors has breached its fiduciary duties, can a director be held personally liable?

Most states allow corporations to include in their charters provisions that limit a director's personal liability for negligence, which would generally include a breach of a director's duty of care. However, these provisions typically do not protect directors in suits brought by creditors or for duty-of-loyalty claims. In addition, these provisions apply only to directors acting in their capacities as directors and do not protect directors from liability for actions taken in any other capacity, such as active management of the company.


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