A few recent corporate chapter 11 cases have drawn public and Congressional attention to corporate behavior in bankruptcy. And yet, much conventional advice to corporate directors about their fiduciary duties in circumstances of financial distress remains out-of-date. Delaware law and market conventions have both changed significantly over the past years. Today, the rules of the road for directors are clearer than they have been in the past. Directors can continue to be actively involved in the oversight of the corporation during a restructuring, confidently approving even risky transactions, without fear of liability, so long as they are aware of current law and take specific precautions. Indeed, active and engaged directors are the most effective way for a corporation to avoid criticism during a reorganization. This memorandum dispels some old myths about the “Zone of Insolvency” and suggests practical steps to replace it with a modern “Zone of Safety,” within which directors can defend and preserve corporate value with confidence.
The topic of director fiduciary duties is perhaps the most important one in restructuring law today. The American system of reorganizing corporations as going concerns depends upon a consensus that management, overseen by the board, is in the best position to decide what to do when a firm cannot pay its debts. This is not intuitive, and other countries take a different approach. Nevertheless, our American restructuring process remains solidly board-centered. When restructuring is done right, the boardroom—not the courtroom—is the first and primary venue where the fate of the corporation is determined. When the various classes of creditors have confidence in the board process, it is easier to find consensus on a restructuring path—even when some creditors initially disagree. When the court has confidence in the board process, the standard of review is usually more favorable and necessary approvals are easier to obtain. Conversely, when the board does not earn the confidence of stakeholders and, especially, the court, a restructuring plan can lose its way quickly. From a political perspective, if too many restructurings lose their way because too many corporate directors fail to follow best practices, our system of restructuring itself will weaken and change.
The good news first. If you are an appropriately informed and involved director during a corporate restructuring today—whether appointed pre-restructuring or specifically in a restructuring context—the law has your back. It was common decades ago for restructuring lawyers to tell the board of directors of a distressed corporation that they had entered the “Zone of Insolvency,” a confusing and dangerous place (reminiscent of the Twilight Zone) where normal fiduciary duties to the corporation changed and the risk of director liability increased exponentially. The “Zone of Insolvency” was a place of fear where the safe decision was to commence a prompt chapter 11 filing and turn the keys over to the most influential group of creditors. Taking risks that might increase creditor losses was discouraged, even when the pay-off of a successful rescue strategy was substantial. In other words, for a director, the Zone of Insolvency was a place where his or her ordinary expertise was no longer relevant and the smart director was the one who walked quietly down the path of least resistance.
None of that is sensible advice today. Corporate law now protects legitimate corporate risk-taking by distressed corporations and their directors. We can confidently say the following for corporations organized in Delaware, or other jurisdictions to the extent they look to Delaware law:
Putting this together, given the developments in the law in this area over the past decade, it is more accurate to speak today of a Zone of Safety, than a Zone of Insolvency. Within the Zone of Safety, protected by a solid board process, boards can take appropriate business risks – whether to avoid a chapter 11 filing altogether or to choose a more challenging path through chapter 11 in pursuit of corporate objectives.
The Zone of Safety does not arise automatically. It requires preparation and a compelling record that the board truly did comply with its fiduciary duties. In particular, a good corporate process must involve a critical mass of directors whom a court will regard as informed, involved and disinterested. In this respect, U.S. restructuring practice over the past years has a mixed report card. Restructuring professionals know chapter 11 conventions, but sometimes struggle to incorporate best practices from the broader corporate governance community. In addition, there is too often a view that “consensus” at the end of a restructuring will allow the debtor to sweep corporate governance concerns under the rug in the plan of reorganization—a proposition that works only until tested. These dynamics can be especially dangerous for directors of public corporations because many restructuring conventions arise from cases involving, not public corporations, but private equity portfolio companies with more limited stakeholder constituencies.
One example of how corporate governance best practices have changed recently relates to failure-to-supervise claims under the Caremark doctrine. In Caremark, the Delaware Supreme Court held that, on sufficiently egregious facts, a failure by directors to establish reporting and oversight procedures could constitute a breach of the duty of loyalty. For many years, practitioners had a sense that these claims would rarely survive a motion to dismiss. However, in the last three years, Delaware courts have allowed Caremark claims to survive a motion to dismiss in five cases where the plaintiffs alleged that the board ignored foreseeable risks, including risks related to food safety (Marchand), clinical drug trials (Clovis), oil pipeline reliability (Inter-Marketing), financial reporting (Hughes) and airplane safety (Boeing). The risk of a successful Caremark claim is especially salient for directors because it would involve a breach of the duty of loyalty and, therefore, personal liability that is neither indemnifiable nor insurable. Boardroom advice is changing in response to this perceived risk. Corporate governance lawyers now routinely advise boards to identify specific risks material to the business and, where appropriate and necessary, document appropriate reporting and oversight procedures. In a restructuring context, the recent Caremark cases may caution against the board “checking out” and delegating decisions to management or professional restructuring directors without the board understanding—and establishing reasonable oversight procedures for—material risks specific to the restructuring context.
Accordingly, drawing from U.S. corporate governance best practices broadly, here are some reminders of best practices for corporate directors during a restructuring—the boundary lines for the Zone of Safety. These practices will be important over the coming years for many directors, especially those faced with challenging transactions, aggressive stakeholders or potential conflicts of interest.
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These eleven points are neither new nor particularly difficult. Directors and their corporate governance advisors need only to remember them and tailor as appropriately to the facts of each case. With directors in the Zone of Safety who are comfortable making hard decisions and taking appropriate risks, the U.S. system of corporate reorganization—whether out-of-court or pursuant to chapter 11—can continue to be managed by boards rather than creditors or court-appointed officials. In other words, our uniquely American approach to restructuring can continue on its remarkable path of preserving distressed going concerns and creating value for stakeholders.
Andy Dietderich is co-head of S&C’s Global Finance & Restructuring Group. He focuses on helping U.S. and multinational companies address balance sheet challenges and navigate periods of financial distress. Andy regularly represents companies in out-of-court restructurings, chapter 11 cases, strategic bankruptcy investments and difficult corporate governance disputes. Andy has spent his entire career at S&C, joining the firm in 1996 and becoming partner in 2004.
S&C’s Restructuring practice combines elite transactional and litigation attorneys with a deep knowledge of insolvency laws and significant experience working on a diverse mix of international and domestic distressed situations. Clients working with S&C on a restructuring benefit from our three competitive strengths:
Best Practices from Restructuring and Beyond. S&C’s restructuring practice is a fully integrated part of the Firm. S&C’s top lawyers in every area – including the senior lawyers of every practice group – are available to every restructuring client. As a result, we have a remarkable record of importing into a restructuring assignment cutting-edge legal techniques from beyond the normal restructuring playbook. Real dollar differences in M&A, finance, litigation, tax and executive compensation results demonstrate the value of our approach.
Taking Bankruptcy Litigation Seriously. Our restructuring assignments have the support of the entire 300+-person litigation group at S&C – arguably the most elite team of generalist business litigators in the world. We prepare for bankruptcy litigation in the same comprehensive manner we prepare for other Federal court litigation, and we win.
Independence. Our restructuring lawyers are widely respected as some of the smartest on the street. Yet we have never seen ourselves as members of the restructuring “club” dependent on referrals from repeat players in the bankruptcy industry. Our uncompromisable loyalty is to the client and is the bedrock of everything we do.
1. It has happened before. In the1930s, outrage about corporate fiduciary misbehavior inspired Congress to pass the Bankruptcy Act of 1938 (the Chandler Act), which dismantled the robust private restructuring industry of the early 20th century and replaced it with a bureaucratic system dominated by court-appointed trustees. The “debtor in possession” did not reappear in large corporate cases until the Bankruptcy Act of 1978.
2. Occasionally, a director would respond to this dismal picture by resigning prior to the restructuring. However, most directors stayed through the restructuring because of a belief among restructuring professionals that directors who resign (flee the sinking ship) are even more likely to become the target of litigation in a subsequent chapter 11 case.
3. The Delaware Supreme Court confirmed this principle in 2007 in North American Catholic Educational Programming v. Gheewalla, 930 A.2d 92 (Del. Supr. 2007), and Delaware courts have applied it consistently since.
4. There is some debate under Delaware law whether directors of a solvent corporation owe fiduciary duties to the corporation alone or also to stockholders, and it is prudent for the board of a solvent (or potentially solvent) corporation to consider the separate interests of stockholders. The nuance is not relevant for our purpose here; under no circumstances do directors have a duty to creditors.
5. In re Caremark Int’l Inc. Deriv. Litig., 698 A.3d 959, 967 (Del. Ch. 1996).
6. The five cases are Marchand v. Barnhill, 212 A.3d 805 (Del. 2019), In re Clovis Oncology Derivative Litigation, 2019 WL 4850188 (Del. Ch. Oct. 1, 2019), Inter-Marketing Group USA, Inc. v. Armstrong, C.A. No. 2017-0030-TMR, 2020 WL 756965 (Del. Ch. Jan. 31, 2020), Hughes v. Hu, C.A. No. 2019-0112-JTL, 2020 WL 1987029 (Del. Ch. Apr. 27, 2020), and In re The Boeing Company Deriv. Litig., 2021 WL 4059934 (Del. Ch. Sept. 7, 2021).
7. Although the directors of a (Delaware) corporation do not have a direct fiduciary duty to creditors, the Bankruptcy Code does impose trustee-like fiduciary duties on the corporation itself during chapter 11 when the corporation acts as a “debtor in possession.” A violation of these trustee duties by the corporation may cause the bankruptcy court to deny approval of corporate actions, may be grounds to remove the corporation as “debtor in possession” or may give rise to monetary claims against the corporation.
8. In 2005, a few notorious examples led Congress to amend the Bankruptcy Code by adding special limitations on senior management compensation that debtors must now navigate. Recently, a handful of cases involving large executive retention bonuses paid prior to bankruptcy (to avoid application of the 2005 rules once the bankruptcy commences) have elicited additional calls for reform. See Daniel Gill, Pre-Bankruptcy Pay a New Target for Fairness Advocates (November 2, 2021, 6:01 AM), https://news.bloomberglaw.com/bankruptcy-law/pre-bankruptcy-executive-pay-a-new-target-for-fairness-advocates.
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