Deepening Insolvency

A theory that should scare directors

Directors of a corporation (including LLC's) have an obligation to the corporation to serve in good faith and with a duty of due care and loyalty. For the most part, they are protected by the business judgment rule which presumes that directors have acted on an informed basis and in an honest belief that they have acted in the best interests of the company.

(A recent decision highlighted some of the concerns on this page. A director was found liable after he decided to divert funds to repayment of his loans while the company was insolvent and undercapitalized. That action was viewed by the court as not in the best interests of the company.)

However, when a company is approaching insolvency or has become insolvent a new theory of director liability has emerged. The new theory states that when a company is in the zone of insolvency, then directors also have a duty to creditors which in some cases may be of a higher priority than the duty to the corporation and its shareholders. Yet, even under this theory directors may still protected by the business judgment rule.

The gist of the deepening insolvency rule is that directors should not continue the business of the corporation if the continuation results in a worsening of the business to the detriment of the creditors. This is a very European theory which is in practice there.

The theory is not well defined in the United States and has been rejected in Delaware as a ground for imposing liability on directors. Nevertheless it has been considered as a basis for damages against directors in certain breach of fiduciary duty lawsuits.

The theory appears to follow the European model that suggests that directors who know the company is insolvent must act to prevent further insolvency or be held personally liable for the further erosion.

If a corporation fails, the directors should be prepared for the creditors to argue, with the benefit of hindsight, that had the company had ceased operations and liquidated rather than continued to incur losses, it would have been better able to repay the creditors.  Creditors may also claim that the board's decision to delay liquidation while it investigated alternatives or made last-ditch efforts to save the business was negligent. In many cases in which this argument is raised, those last efforts will have been unsuccessful, and, again with the benefit of hindsight, may look as if they had been ill-considered.

Directors must be especially vigilant when confronted with insolvency. Directors should (1) take adequate time to consider and analyze a course of action; (2) employ experts such as insolvency counsel and financial advisers; (3) create a record of thorough consideration of alternatives; and, (4) candidly disclose potential conflicts.

The doctrine of deepening insolvency is emerging. Directors would be wise to tackle it now.