When Chapter 11 Strikes, D&O Claims May Bring Down Unsecured Director | Lowenstein Sandler LLP

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Corporate Compliance Insights – November 9, 2021

Actions against directors and officers common after sales of Chapter 11 bulk assets leave nothing to recover

In Chapter 11 bankruptcy, creditors often seek to recover funds by individually targeting directors or officers (via D&O claims). Those with a history of poor judgment, lack of addiction, or inability to see impending problems could find themselves on the hook.

As measured by collections from unsecured creditors, the success rate in Chapter 11 bankruptcy cases is relatively low. Driven by the decreasing patience and willingness of secured lenders to fund time-consuming reorganizations, corporate Wisconsin Bankruptcy cases increasingly result in accelerated bulk asset sales that leave no significant assets after the secured debt has been paid. .

As a result, unsecured creditors committees often look to other sources of collection, such as legal claims against directors and officers (commonly referred to as A&D complaints). For such people, unless the defense costs are paid by the insurance companies or the company, the burden of litigation can be prohibitive and extremely painful, even if such a lawsuit is without merit.

Let’s take a look at some of the things unsecured creditors committees look for in assessing whether there are viable D&O claims and the safeguards directors and officers can take to meet their fiduciary obligations.

The role of the Commission in Chapter 11 and A&D complaints

The business judgment rule is the foundation of corporate governance and is the primary legal protection available to directors under Delaware law. When assessing potential claims against a board member, it is considered whether the board and its members have functioned properly and exercised reasonable business judgment. There may be a responsibility for making decisions without being fully informed, especially when approaching insolvency.

Written board presentations, board minutes, and interviews with board members will reveal whether the board made reasonably informed decisions in a timely manner. If a director or officer objects to a particular decision or action plan, they must express their disagreement and have this objection recorded in the minutes. Any conflict of interest or potential personal gain for a director or officer related to an action contemplated by the board must also be disclosed and recorded in the minutes and that person must abstain from voting on these matters. Of course, confirm that the dossier reflects a sufficiently deliberative process.

It is critically important to know whether the board has provided the required guidance and leadership on its part. Directors should seek out and rely on the information provided by those who manage key aspects of day-to-day operations. And when certain business decisions inevitably go beyond the area of ​​expertise of an administrator, do not refrain from consulting legal advisers, financial advisers or experts for reports or opinions that are necessary to be adequately informed.

A board of directors is supposed to provide management with a perspective that enables them to better increase shareholder value. To do this, the board must be made up of people who have the required knowledge and expertise. Therefore, a creditors committee reviews the qualifications and experience of each member.

Advice that works well

As the body responsible for overseeing and guiding senior management, the board must be free from undue influence by management. Directors who are family or friends of the CEO or company founder, and therefore unlikely to stand up to the CEO or founder, are likely targets for an unsecured creditors committee. This concern is particularly accentuated with regard to the members of the board committees responsible for investigating the actions of management.

The committee will determine which of the members of the board are independent. In doing so, the committee will ask who appointed the board member, whether the board member is a creditor or a shareholder, whether the company has had any related party transactions with the board member, and whether the board member is likely to ” being so loyal to the person who appointed them that it exceeds their fiduciary obligations to the company.

The independence of a director is most often examined when he or she is indebted to a person or entity with a discernible interest in an action submitted for the review of the board. A director may be considered indebted or liable if there is evidence to suggest that a director cannot act in the best interests of the company and its shareholders due to personal, professional or financial relationships or dependence on another. person or entity.

An effective board should not be dominated by one person or by a group of board members. For example, a board of directors dominated by the founder or CEO of the company is an invitation to exorbitant compensation for the CEO and approval of shares without proper control by the board of directors. A board chaired by the CEO or made up of a majority of insiders raises conflict issues since the board is supposed to oversee management, especially in times of distress.

A malfunction may prevent the board from providing management with the required oversight or guidance. Board members who dominated the board, who were not active on the board, who sat on too many boards to devote the necessary time to the business, or who were not independent may indicate a malfunction.

A board member should know his fellow board members well so as not to risk being painted with the same brush if other board members fail in their duties. Board members are responsible for helping to ensure that the board as a whole functions properly. They shouldn’t just be concerned with their individual behavior.

When distress arises

Failure to see the need for change in a timely manner has resulted in many chapters 11. Companies often initiate bankruptcy proceedings because management has not reacted in a timely manner to changes in market conditions or change. obsolescence of the company’s products. Sometimes senior executives stubbornly handle disputes unrealistically. And, sometimes, the failure of a debt restructuring attempt is due to competing interests. The question is whether the board was aware or should have been aware of the above and whether it responded in an informed and timely manner without personal conflict or influence.

Thus, the board of directors must be aware of competitive intelligence and ensure that management reacts to it. The board needs to make sure that a CEO looks at the future environment rather than just the current one.

The fiduciary duties of directors and officers do not change as a company approaches insolvency. However, when a company becomes insolvent, the scope of a board’s fiduciary duties widens from a limited focus on shareholders to include creditors as well. It is not as usual in the insolvency zone. Fortunately, administrators cannot be held responsible for continuing the business of an insolvent debtor by believing in good faith that they can achieve profitability or achieve a better outcome for stakeholders, even if their decisions ultimately result in greater losses or expectations that do not materialize.

Board members should be alert to signs of financial distress, and they must ensure that the distress is treated early enough to be corrected. Board members should be involved in resolving a distress situation before it gets too far advanced. This forces the manager to regularly monitor actions and negotiations intended to resolve the financial distress.

Board members also need to be realistic about the situation and have an understanding of the value of the business and the stakeholders that are out of the money. Additionally, when insolvency threatens, directors should consider the interests of other stakeholders besides shareholders, such as creditors, and then balance the interests. In Delaware, the responsibility of the insolvency board is transferred to the creditors.

There is no liability for pre-bankruptcy actions in the absence of a breach of fiduciary duty. The business judgment rule presumes that the board member acted knowingly, and the onus is on the person challenging a board decision to establish facts that rebut the presumption.

The debtor does not need to win the battle to avoid Chapter 11. However, the board must be able to demonstrate that management’s actions in attempting to avoid bankruptcy have been controlled with benefit. an untainted contribution from the board. Reports, analyzes or opinions received by directors must be more than a facade.

Finally, resigning from the board of directors rather than committing to find a solution to a debtor’s financial difficulties can be considered a derogation from duty. In terms of minimizing or eliminating potential liability, it may be better to stay and try to fix things. The resignation will not change the past and a board member may still be investigated.

Reprinted with permission from the November 9, 2021 issue of Corporate compliance information. © 2021 Corporate Compliance Insights. All rights reserved.

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