Navigating Financial Distress: Protecting Yourself as an Officer, Director, or In-House Counsel

When a company faces financial distress, the landscape becomes complex and fraught with risk. Officers, directors, and in-house counsel play crucial roles in guiding the company through these turbulent times, but their efforts can expose them to personal liability. This article discusses how their roles change with respect to shareholders, how the business judgment rule functions as a shield, and how officers, directors, and in-house counsel can protect themselves from liability.

Entering the “Zone of Insolvency: A Shift in Responsibilities

For a company entering the “zone of insolvency,” the primary beneficiaries of any increase in its value shift from shareholders to creditors. Officers and directors are no longer solely responsible for maximizing shareholder returns but must now prioritize the interests of creditors.

The Business Judgment Rule: A Shield, Not a Guarantee

The business judgment rule is a legal principle that provides a presumption in favor of the decisions made by the directors of a corporation. It is based on the understanding that directors, in making business decisions, act on an informed basis in good faith, and with the honest belief that their actions are in the best interests of the company. This rule shields corporate decision-makers from judicial second-guessing — especially by a bankruptcy trustee or a creditors’ committee — provided certain elements are present, such as a business decision made by disinterested directors who have exercised due care and acted in good faith.

Lessons from the Toys “R” Us Case: A Cautionary Tale

The Toys “R” Us bankruptcy case serves as a stark reminder of the potential repercussions for officers and directors who fail to uphold their fiduciary duties during financial distress. In this case, officers and directors were accused of:

• Prioritizing their own interests: Excessive compensation, conflicts of interest, and favoritism
• Mismanagement and negligence: Actions or inaction contributing to financial distress
• Misrepresentation of financial information: Providing inaccurate or misleading information to stakeholders
• Improper asset transfers and preferential treatment: Benefiting specific parties over others
• Failure to adapt to changing trends: Ignoring market shifts and e-commerce rise
• Poor financial decisions: Taking on excessive debt and exacerbating financial struggles
• Ineffective cost-cutting measures: Negatively impacting inventory levels and customer service

Protecting Yourself: Essential Actions for Officers and Directors

If bankruptcy has been filed under Chapter 11, officers and directors can be the subject of a forensic investigation. To protect themselves, officers and directors need to ensure that they perform the following:

• Actively review financial statements and key metrics
• Participate in regular board meetings and engage with management.
• Document discussions and inquiries in board minutes
• Seek expert advice from insolvency professionals
• Balance the interests of all stakeholders
• Ensure transparency in decision-making
• Verify the scope and availability of officer and director insurance coverage.. 
• Not take advantage of financial distress to gain a personal benefit or increased control of the company

In a situation of financial instability or near insolvency, directors should prevent the company from embarking on a plan that an honest and intelligent director of the company could not have reasonably believed was in the interests of the company.

Protecting Yourself: Essential Actions for In-House Counsel

In the Lehman Brothers bankruptcy, in-house counsel faced lawsuits alleging that they breached their fiduciary duty by failing to adequately advise the company on risk management and by approving questionable transactions. General Motors’ in-house counsel confronted lawsuits that included allegations that they failed to properly disclose known defects in the company’s vehicles.

In-house counsel at WorldCom were accused of breaching their fiduciary duty by being aware of or participating in the fraudulent accounting practices. Finally, in Washington Mutual’s bankruptcy case, in-house counsel was alleged to have failed to provide appropriate legal advice regarding the risks associated with the company’s mortgage lending practices.

Besides officers and directors, in-house counsel can be the subject of a forensic investigation in Chapter 11 cases.  In-house counsel need to ensure they do the following:

• Advise the board and officers on legal and regulatory obligations
• Implement enhanced internal controls and fraud detection mechanisms.
• Monitor financial indicators for early warning signs
• Provide guidance on restructuring strategies and negotiations.
• Stay involved in the restructuring process
• Ensure compliance with environmental, tax, and other regulations
• Maintain open communication with management and the board

By proactively managing risk, exercising due care, and seeking expert advice, officers, directors, and in-house counsel can navigate financial distress while protecting themselves from personal liability. Remember, diligence, transparency, and a commitment to protecting the interests of all stakeholders are key to weathering storms and emerging stronger.