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The Role of Directors Appointed by Preferred Stockholders in the Zone of Insolvency

Date

May 10, 2010

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7 minutes

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The Role of Directors Appointed by Preferred Stockholders in the Zone of Insolvency

By: Russell Shapiro

With so many companies financially distressed, the question about the fiduciary duties of directors in the “”zone of insolvency”” has re-raised itself as a hot topic. Complicating the application of the director duties in many companies is the existence of preferred stockholders and the directors appointed by them. This article briefly explores the fiduciary duties in the zone of insolvency and then the special issues that come into play with preferred stockholders and the directors whom they have appointed. The one caveat the reader should understand is that this article is directed at the non-lawyer; it generalizes in some areas and summarize in others. With that in mind, let us begin…

Fiduciary Duty of Directors Generally

There are two duties of directors: (1) the duty of care and (2) the duty of loyalty. The duty of care requires that directors act with the care an ordinarily prudent person in a like position would exercise under the circumstances, and that they make informed decisions that demonstrate a deliberate consideration of the potential benefits and risks to the company. The duty of loyalty requires directors to put the interests of the company above their own personal interests. Under normal circumstances, directors owe fiduciary duties only to the stockholders of a company. A board of directors’ business decision will be respected by the courts if the decision was made on a fully-informed basis, without self-interest, in good faith, and in the honest belief that the decision was in the best interests of the company and its stockholders. This is referred to by courts and practitioners as the “”business judgment rule.””

Zone of Insolvency

To whom fiduciary duties are owed may expand when a company enters the zone of insolvency. No longer are duties owed exclusively to stockholders. In the zone of insolvency, fiduciary duties (which themselves remain unchanged) are owed to the entire corporate enterprise, including the creditors of the company. If a board acts in order to maximize the enterprise value of the company, and so long as it did nothing to favor stockholders over creditors, the board will have satisfied its duties. Note that in actual insolvency, the duties are owed to the company’s creditors. The reader should understand that many lawyers could read the prior paragraph and argue that it is incorrect. And, these lawyers would technically be correct depending on whose law applies. The fact of the matter is that state law governs the issues discussed and, so, the state in which the company at issue is incorporated is a key factor that must be known before definitive advice can be responsibly dispensed. In Delaware, there is recent case law that suggests that duties do not expand to include creditors until the company is actually insolvent (as opposed to being in the zone of insolvency). Regardless, the practical way a lawyer should advise a board to act will largely be the same no matter what state the company happens to be chartered in. That is, seeking to maximize the enterprise value of the company as a whole is generally a proper approach to take. A company is insolvent when its debts exceed the fair value of its property or when it cannot pay its debts as they become due. A company enters the zone of insolvency at some point before this. Signs of entering the zone of insolvency may include breach of financial covenants, officer concerns about the company’s cash flow, vendors threatening to cease shipment, etc. Unfortunately, there is little guidance from the courts on exactly when a company enters the zone of insolvency and it is even harder to say for certain when a company is actually insolvent. For these reasons, too, the approach of seeking to maximize enterprise value is a prudent one.

Preferred Stockholders

Preferred stock occupies a space in a company’s capital structure somewhere between common stock and debt. Typically, the interests of the preferred stockholders and the common stockholders are aligned, and the preferred stockholders are thought of as having the benefit of the directors’ fiduciary duties.

Preferred stockholders often have a right to appoint one or more director to a company’s board. Those directors have the same fiduciary duties as do the other directors. However, actual or perceived conflicts can arise when the interests of the preferred and common stockholders differ. In theory, if the value of the corporate enterprise is maximized, the directors have done their job.

In a sale context, this may mean that there are sufficient funds to pay creditors and some or all of the liquidation preference payable to the preferred stockholders, but little or nothing to the common stockholders. In this case, the directors must take care to avoid potential claims by common stockholders that the preferred stockholders were favored. In a recent Delaware case, the court allowed a plaintiff to continue its case alleging breach of fiduciary duty to the common stockholders where a majority of the directors were designees of and each of whom had a financial relationship with the venture capital sponsor of the company. In the case, the board approved a merger where the preferred stockholders were substantially paid their liquidation preference and the common stockholders received nothing.

If a company is financially distressed and is evaluating its options, and there are directors who are designees of preferred stockholders, special care must be taken not only to avoid potential claims of creditors, but also potential claims of common stockholders. This is all well and good, but on a practical level, what does it mean?

Some Practical Measures

  • Whenever possible, the board should seek the unanimous approval of the common stockholders for a transaction in which the common stockholders will receive little or no consideration.
    • This is a tricky area; directors need to assume that someone will sue them later, regardless of what action they take, and act accordingly. Fortunately, good process will usually protect directors from such litigation. Good counsel is experienced in helping directors use good process.

    • The board should consider appointing a committee consisting of independent directors to recommend a course of action. This is not critical, but the circumstances may make it preferable. If the board does this, a transaction should be approved both by the committee and by the full board.
    • To be clear, when a director is appointed by a stockholder, that director is a fiduciary to all stockholders and the corporate enterprise, not just to the stockholder who appointed him or her.
    • To the extent that any director believes he or she is (or an affiliate is) self-interested or has a conflict of interest, that should be made known to the other directors (and to the stockholders if the stockholders are required to vote or consent to the transaction). The mere appointment of a person as a director by a stockholder does not make the director self-interested or result in a conflict of interest, but other connections might (for example, the director would personally benefit from a transaction that would not similarly benefit other stockholders). This must be examined closely for preferred stockholder appointees.
    • If time is of the essence, the board should consider the ability of any prospective purchaser to timely consummate a transaction.  This consideration may outweigh small differences in economics. Areas of inquiry include whether a prospective purchaser has funds at the ready and whether it has done similar deals recently.
    • All offers and proposals should be presented to the board with supporting materials.  The board should be given as much time as possible to consider the alternatives.  The board should meet, review critically, and deliberate.  A record of this should be kept.
    • Engage outside experts as needed to evaluate the options for the company. This may involve a restructuring or a sale of the business.
    • Retain independent board counsel. This allows the directors to focus on their duties by using counsel who are separate from counsel that may have historically represented management or a particular stockholder.

       


Filed under: Corporate

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