How to Prevent Personal Liability for In-House Counsel During Financial Distress

Whenever a company enters financial distress, there is a risk of personal liability for in-house counsel. Corporate counsel face significant challenges as they guide their organization through complex legal proceedings and manage potential personal liability.

Engaging in Wrongful Conduct

Personal liability for in-house counsel can arise if in-house counsel engages in wrongful conduct, even if such actions are within their professional duties. They may be held accountable:

• If they are perceived as the “guiding spirit” behind such actions.
• If they oversee actions that violate the law.
• If they fail to take appropriate action in response to efforts by management to violate the law or breach contracts. 

These actions can occur when a corporate officer (or in-house counsel) directs a corporate agent to engage in wrongful conduct, even if the officer or counsel does not personally engage in the conduct. The corporate shield, which typically protects officers from personal liability for actions taken on behalf of the corporation, does not apply when the officer personally engages in wrongful conduct or fails to take appropriate action when aware of wrongful conduct.

Several real-world cases illustrate these risks. For instance, attorneys for Toys “R” Us were sued for allegedly failing to disclose the company’s financial issues. In-house counsel at WorldCom faced repercussions for their involvement in the accounting fraud that led to bankruptcy. In W.R. Grace & Co., the bankruptcy trustee sued in-house counsel for not disclosing asbestos liabilities, and former counsel for Washington Mutual, Inc. was sued for failing to inform the board about potential liabilities.

Avoiding Negligence Claims

During financial distress, the duty of care and loyalty of in-house counsel becomes critical. Decisions can significantly affect the organization’s future, and failure to demonstrate due diligence and reasonable oversight can lead to negligence claims. Counsel must stay informed about relevant laws, management actions, and management inaction. They may need to decline or oppose executive requests if they conflict with the company’s best interests or expose them to personal liability.

The role and responsibilities of in-house counsel increase in times of financial distress. Counsel must be vigilant against actions associated with preference payments, fraudulent conveyances, misleading information provided to stakeholders, or failure to provide information to stakeholders who need to make credit decisions. Given their proximity to corporate governance, in-house counsel may face personal liability under securities laws if they fail to ensure accurate disclosures or become involved in misleading investors. For example, negligence in ensuring compliance with SEC regulations can expose them to liability.

Acute awareness of management’s actions or inaction, both financial and operational, is essential to mitigate potential liabilities. In-house counsel must have a holistic understanding of everything that is happening in the company (not just in the legal department), an understanding of why it is or is not occurring, and an understanding of how creditors are likely to view actions or inaction with 20/20 insight.

The Role of the Creditors’ Committee

In a Chapter 11 bankruptcy case, a US Trustee appoints a creditors’ committee. The committee aims to maximize the recovery for unsecured creditors, conducting forensic investigations to identify claims against third parties. Increasingly, when the creditors’ recovery is below reasonable expectations or when creditors are suspicious of pre-bankruptcy actions by the debtor, the committee looks to recover from officer and director liability insurance. 

The committee may target C-suite executives, including in-house counsel, to obtain bargaining leverage regarding a reorganization plan and recovery of Directors and Officers (D&O) insurance proceeds. Often, the tradeoff is a larger recovery for creditors in exchange for granting releases under the reorganization plan. The foregoing emphasizes the need for counsel to understand actions that could trigger personal liability during and outside bankruptcy proceedings.

Exercising Oversight 

External experts (bankruptcy or restructuring counsel, financial advisors, investment bankers, and chief restructuring officers) may be brought in to assist and guide the company to a successful refinancing, reorganization, or restructuring.

• In-house counsel must retain oversight of their work. The board should mandate this oversight and require in-house counsel’s attendance at internal strategy meetings with senior management, meetings with external advisors, and meetings with creditor constituencies.
• In-house counsel also should review all communications with external parties, particularly lenders, bondholders, and vendors.
• In-house counsel must closely monitor the creditors’ committee’s investigation so they know where an investigation is headed, and how to protect the parties being investigated and preempt the assertion of claims. 

Negotiating Releases 

Determining who receives a release from liability under an out-of-court restructuring or Chapter 11 reorganization plan is a pivotal aspect of the negotiation process. In-house counsel should be included in the company’s executive group that is being released. This message should be sent to senior management and external professionals guiding the plan negotiations.

The creditors’ committee may deny releases to in-house counsel unless it is shown that such releases are necessary and beneficial. Therefore, the in-house counsel should demonstrate that they are integral to success. This is best achieved by in-house counsel’s full involvement in the restructuring or reorganization process.

Conclusion

In-house counsel play a vital role in navigating financial distress and bankruptcy challenges. They must balance legal responsibilities with the risks of personal liability while ensuring the company’s interests are protected throughout the process. By staying informed, exercising due diligence, and effectively communicating with all parties involved, they can help guide their organization toward a successful resolution.