Determining Insolvency: A Critical Duty for Directors at Distressed Companies

With interest rates at 5 percent and the Consumer Price Index 6 percent higher than a year ago, many U.S. companies are at risk of becoming legally insolvent. In fact, the S&P Global Market Intelligence reported 71 corporate bankruptcy petitions in March, resulting in the highest number of first-quarter filings since 2010.

Insolvency is like the edge of a cliff shrouded in mist: It is difficult to discern, and—when a corporation unknowingly falls off it—the consequences for that corporation’s directors can be dire. That’s because a corporation’s directors owe a fiduciary duty to its lenders and other creditors from the moment the corporation qualifies as legally insolvent. Failing to identify the pivotal point when that obligation to creditors kicks in can result in directors being held personally liable for breaching their fiduciary duties.

Making matters even more difficult for boards of directors is the fact that a court will necessarily determine the point at which a company became insolvent after the company’s creditors come calling, when the court has the benefit of hindsight. It is therefore crucial for the boards of all companies showing the first signs of financial distress to have experienced counsel assess the full extent of the corporation’s risk of being deemed insolvent and their resulting fiduciary duties.

Directors’ Fiduciary Duties

Regardless of whether a corporation is solvent, nearing insolvency, or insolvent, directors always owe the duties of care and loyalty to the corporation and its stockholders. Unless a company’s articles of incorporation or certificate of incorporation eliminate it, the duty of care requires a director to be reasonably informed of all relevant information and alternatives, and to act in good faith and in a prudent and deliberate manner when making business decisions. The duty of loyalty requires a director to act independently and make decisions based on the best interests of the corporation. It also requires directors to completely avoid acting out of self-interest. If a corporation’s directors breach these duties, the corporation’s shareholders have the right to bring claims against them on behalf of the corporation.

As soon as a corporation meets the legal definition of insolvency, directors also owe duties to the company’s creditors, meaning that directors become legally obligated to make decisions with the company’s creditors’ best interests in mind. A board's fiduciary duties run to the corporation's creditors beginning at the point of insolvency. If a board fails to identify the point at which a corporation becomes legally insolvent—a nuanced determination—and continues to make decisions without the corporation’s creditors in mind, the board members unknowingly run the risk of being held personally liable for breaching duties to the new corporate stockholders.

The Difficulty of Determining Legal Insolvency

Determining when a company reaches the point of legal insolvency is extremely challenging. That’s largely because, when determining insolvency, courts in all jurisdictions might use one or both of two tests, which can yield different results when applied to the same set of facts. These are the “Balance Sheet Test,” which examines whether a corporation’s liabilities exceed the reasonable market value of its assets, and the “Equity Test,” which examines whether a corporation can pay its debts when they are due.

A corporation’s ability to timely pay its debts, such as its bills, might seem like clear evidence of solvency, but there’s no guarantee that a court faced with creditors’ claims against an insolvent corporation’s directors won’t apply the Balance Sheet Test, which could yield different results. For example, a heavily indebted company that manufactures widgets and uses the profit it makes on every single widget to pay its lenders might be paying its debts as they become due, but could still qualify as insolvent under the Balance Sheet Test.

The Duties of an Insolvent Company’s Board

Even corporations that can pass both the Balance Sheet and Equity tests are sometimes nevertheless headed toward insolvency. This is becoming more and more common in the current economic climate, with high inflation and high interest rates putting pressure on businesses from many directions.

Are sales down while costs are up? In this season of rising interest rates, is the company dependent on hard-to-come-by credit to meet payroll? Is it failing to timely pay its vendors? Are banks declining the corporation’s loan applications?

At the first sign of financial distress, boards should heighten their awareness of the corporation’s lenders’ rights and assume their decisions will be scrutinized by creditors. They should avoid even the slightest appearance of being on both sides of a transaction, and consider how capital raising transactions and asset sales might later impact creditors and stockholders. They should pay increased attention to transactions with insiders to ensure fairness and create adequate records to support approval.

When insolvency is a possibility it is also important for boards of directors to carefully evaluate the sufficiency of their D&O insurance coverage and whether it contains exclusions that would vitiate coverage if the company ceases operations or files for bankruptcy protection.

Ballard Spahr's multidisciplinary Distressed Assets and Opportunities team helps boards of directors navigate whether the corporations they serve are at risk of meeting the legal definition of insolvency.

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This alert is a periodic publication of Ballard Spahr LLP and is intended to notify recipients of new developments in the law. It should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own attorney concerning your situation and specific legal questions you have.