The Covid-19 outbreak, and the measures that governments around the world have taken to counter it, has seriously and negatively impacted businesses across all industries and eliminated or greatly reduced many companies’ sources of revenues.
The pandemic pushed corporations that were already struggling over the edge into insolvency, and is forcing otherwise healthy companies down a new road of financial distress.
Now is the time corporate governance is critical to maximize prospects of saving the going concern. Especially in these unprecedented times, it is important that directors exercise good corporate governance, both to keep their business afloat and to avoid liability.
Directors’ Duties When the Business Faces Distress
In a nutshell, directors have a duty to act in good faith, on an informed basis, to maximize corporate value. When insolvency is a plausible danger, directors must take several actions to provide the business and its owners the best prospect of success.
Specifically, directors of companies in the “zone of insolvency” should begin by having management formulate the company’s “critical path,” namely the shortest time under worst case assumptions the company can continue as a going concern before having insufficient cash to do so. This tells the board and management the minimum time they have to implement measures to avoid failure.
Because the situation is fluid and unpredictable, the assumptions underlying the critical path must be re-evaluated constantly and compared to actual performance to determine necessary adjustments to the critical path. With the timeframe established, the board and management must dispassionately make contingency plans based on a list of every plausible solution maintaining the business as a going concern. When necessary, the board must choose the best solution. Sounds easy. It is not.
The decision making process is not easy because the best solution in times of distress is often the least-worst solution. That means every possible solution has a distasteful component. The distasteful component could be as simple as accepting a low value for the company’s shares. Or it could be selling a promising asset, diluting shareholders, losing control to a new board, downsizing, or accepting additional loan covenants restricting the company’s freedom of action.
As shown by such cases as Eastman Kodak and Lehman Brothers, when choosing the best solution is choosing the least-worst solution, boards sometimes fail to choose. That is the equivalent of praying for a miracle. In the absence of miracles, Kodak and Lehman ended up with the most worst results—the total destruction of shareholder value, huge creditor losses, and job eliminations.
The psychological phenomenon that causes boards not to choose a least-worst result is explained by prospect theory developed by Nobel prize winner Daniel Kahneman. In short, human beings abhor losses far more than they relish profits, and their aversion to losses deters them from choosing an alternative having an embedded loss. The good news is that explaining the foregoing inoculates boards against the inability to choose the least-worst solution.
While considering its options, the board must also instruct management to focus on the company’s lifelines. The lifelines are those factors without which the company cannot be a going concern. Thus, management must tailor-make a plan to retain support from vendors, lenders, investors, key employees, regulators, and customers.
Fiduciary Duties to the Corporation and Shareholders—Not to Creditors
Critically, when formulating and choosing solutions to distress, the board’s fiduciary duties remain owing to the corporation and its shareholders, not to its creditors, even when the company is in the vicinity of insolvency or insolvent. While creditors of insolvent corporations may gain standing to pursue derivative claims against directors, their prosecution of derivative claims is for the corporation. The corporation gets any proceeds, not the creditors.
As the Delaware courts have shown, the logical conclusion of the principle that the board’s fiduciary duties do not expand to benefit creditors, is that the board is entitled to take more risk to help shareholders, even if creditors will be worse off if the risky transactions fail. This might appear unfair to creditors, but creditors can decide not to extend credit to the corporation.
From a governance perspective, as the Delaware courts explained, if directors owe duties to both shareholders and creditors, then directors are virtually assured of analysis-paralysis. If they approve a transaction helping creditors (such as paying interest when cash is scarce), shareholders will sue them. If they determine to default on interest, creditors will sue them.
Thus, the Delaware courts had an easy time determining the board’s fiduciary duties must not expand to include creditors. Needless to say, in the current pandemic, fiduciary duties to creditors would turn daunting challenges into legal jeopardy.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Martin J. Bienenstock is chairman of the Business Solutions, Governance, Reorganization & Bankruptcy group at Proskauer Rose LLP. He teaches corporate reorganization at Harvard Law School, University of Michigan Law School, and University of Pennsylvania Law School.
Ehud Barak is a partner in the Business Solutions, Governance, Reorganization & Bankruptcy group at Proskauer Rose LLP.
Elliot Stevens is an associate in Business Solutions, Governance, Reorganization & Bankruptcy group at Proskauer Rose LLP.
The views expressed herein are the authors’ views and not the views of Proskauer or any law school.