The pandemic, the risk of insolvency and director liability protection

What's well understood is the catastrophic impact of the pandemic on the financial performance of hospitals, physician groups and other providers. It's also well understood that the board has an obligation to monitor such financial performance. What's less understood is that this obligation becomes even more important and more difficult when the organization is experiencing real financial distress.

Certainly management doesn't need to be reminded about the severe financial hit that hospitals and other healthcare providers took in March, as the impact of the pandemic set in. Reports from Kaufman Hall reflect dramatic volume and revenue declines, with a corresponding dramatic fall in margin within a short time. And the board doesn't need to be reminded that it should be monitoring these financial results, and consulting with the CFO and its outside advisors on their impact.

But both management and the board should be made aware of the potential impact on board liability exposure as the financial distress continues; i.e., the potential that their actions and oversight, and not the pandemic and its implications, become "the issue." But that's exactly what the law calls for when companies confront the reality of potential insolvency-be it only for a limited period, or more permanently.

We're not talking about old concepts of the "Zone of Insolvency," and the fiduciary challenges it presented. Those concepts have been rejected by many courts. But we are talking about significant case law which recognizes a fundamental shift in directors' fiduciary duties (and their related liability exposure) as a company descends towards insolvency. It’s a very real risk that's followed very closely by creditors' counsel, and something of which both the board and the company's financial management should be aware.

Of course, the corporation's business and day-to-day operational performance are managed under the oversight of the board of directors. More specifically, the board is expected to focus on the integrity and clarity of the company's financial reporting and other disclosures about corporate performance. The board is also expected to have meaningful involvement in the company’s capital allocation process and strategy, and in reviewing, understanding and overseeing annual operating plans and budgets.

But things change when potential insolvency looms. At that point, the law recognizes an expansion in the identity of to whom (or what) the board's fiduciary duties are owed. In the normal course, the fiduciary duties of directors of solvent companies run to the shareholders (in the case of for profit companies) and to the corporate mission (in the case of not-for-profit corporations).

Everything changes, however, should the company become insolvent. In that case, those duties may also be extended to the creditors of the company, given their equitable interests in the company at that point in time. As a result, creditors may be able to pursue derivative claims based on allegations of breach of fiduciary duties owed to the totality of the company's claimants (including its creditors). A fine mess indeed, for the board-and one that creates all kinds of governance challenges.

This doesn't mean, however, that when a company enters insolvency its directors must pursue certain creditor-focused extraordinary actions. Directors are able to act consistent with informed business judgment to pursue corporate strategies that reflect the best interests of all of the residual claimants. In other words, fiduciary duties are owed to the enterprise itself rather than any particular stakeholder.

But given the volatile financial circumstances providers are confronting, it shouts out for a pro-active board response. That could include a variety of steps: (i) increased monitoring of the organization's financial condition and proximity to insolvency; (ii) greater engagement by the finance committee or a subset thereof on solvency matters; (iii) more regular consultation by the committee with financial officers and with outside financial advisors; (iv) more fulsome management and committee reporting on financial condition to the full board; (v) coordination of financial monitoring with efforts focused on business resiliency; and (vi) careful consideration of business decisions should the company approach insolvency.

Courts have defined "insolvency" under both a balance sheet test and a cash flow test. Under the balance sheet test, a company is insolvent if the sum of its debts exceed the aggregate value of its assets. A company is insolvent under the cash flow test if it is unable to pay its debts as they become due.

It's very important for the board and management to recognize that fiduciary issues may arise even where actual or potential insolvency is expected to be only temporary. Creditors may pursue breach of duty claims as long as the insolvency existed at the time of the alleged breach and the plaintiff was a creditor of the company at that time. And that pursuit can be expected to be dogged.

The ultimate message for corporate leadership is to be particularly alert in this time of crisis to the warning signs of insolvency. Being fully informed, well advised and actively engaged in discussions regarding the financial health of the organization is one of the best defenses to any subsequent claim. Directors themselves should also be attentive to the proper exercise of their fiduciary obligations (including the avoidance of material board-level conflicts of interest) to the extent they could be perceived as damaging to the interests of creditors. It is important to remember that it is difficult to determine when a company may become insolvent, and any cause of action will be brought with the benefit of hindsight.

Case law suggests that a creditor will have a difficult time obtaining judgment on a derivative claim for breach of fiduciary duty during a time when the company was insolvent. But, these claims often follow a notoriously slow pace through the courts. Directors and financial officers should thus be mindful of the old saying that "you may avoid the result, but you will not avoid the ride." For this and other reasons, proper planning by the finance committee can be critical.

 

Michael W. Peregrine, a partner at McDermott Will & Emery who advises corporations, officers, and directors on matters relating to corporate governance, fiduciary duties, and officer and director liability issues, is outside governance counsel to many prominent corporations, including hospitals and health systems.

Felicia Gerber Perlman, a partner at McDermott Will & Emery and global co-head of the Firm’s Restructuring and Insolvency Practice Group, focuses her practice on complex business reorganizations, debt restructurings and insolvency matters. 

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