Legal Pitfalls for Directors and Officers of Distressed Businesses, Part II: Hidden Risks
Not long ago, Reuters reported that more than 5,500 commercial bankruptcies had been filed in the United States in 2020, a 33 percent increase over the previous year. Many businesses have been hit especially hard by the COVID-19 pandemic’s economic fallout, and thousands more are distressed and facing the prospect of potential insolvency in the weeks and months ahead.
For directors and officers of those businesses, financial distress can create substantially heightened legal risks. Directors and officers often are forced to make fast and difficult decisions about issues like employee layoffs, shareholder and employee compensation, and repayment of debt. If a business becomes insolvent, aggrieved creditors and the government may scrutinize the choices made as the business faltered—and target the business’s individual decision-makers for mistakes they may have made. Compounding the risks of personal liability, the business may lack the resources necessary to indemnify its directors and officers, notwithstanding any requirements to do so. Further, the business’s director and officer insurance policies may not be applicable or the business may not have funds to pay the premium of its director and officer insurance policies, allowing those to lapse.
In this article, the second of a two-part series on the legal risks faced by distressed businesses and the directors and officers of those distressed businesses, we explore hidden risks to those directors and officers. (Read part one of our series regarding more common risks here.) Taking the time to carefully consider these issues can spare businesses and their directors and officers from later liability.
In bankruptcy law, claims for preferences are a mechanism used by courts to attempt to ensure that creditors are treated equitably by a debtor. If one creditor is found to have been preferred, then the bankruptcy court may claw back money paid to it and redistribute the proceeds in a more equitable fashion.
At least, that is the theory. In practice, claims for preferences often result in clawed-back money being used to pay administrative expenses of the bankruptcy—including fees of attorneys and other professionals—with very little redistributed to the creditors.
To avoid this scenario later surprising an insider of the business, distressed businesses must pay careful attention to how they pay back creditors who are insiders, such as officers and directors or their relatives. The reach back period is lengthy: any preferential payments made to an insider within a year prior to the date the business files bankruptcy may subject the insider to a claim. This can come as an unwelcome surprise to business insiders who have loaned the business money and may make a business reconsider filing a bankruptcy on a particular date if it means an insider could avoid a preference claim with a later filing.
Fraudulent Transfer Claims
Claims for fraudulent transfer are somewhat more expansive in scope. In these actions, creditors argue that the business fraudulently transferred the business’s assets for less than reasonably equivalent value while the business was insolvent and seek that the recipient return whatever was received or the value thereof.
Creditors may subject parties to claims over:
- Excessive compensation. A creditor may target payments made to company executives, claiming large salaries, severance, bonuses or fringe benefits were not received in exchange for reasonably equivalent value (or constituted a breach of fiduciary duty by the company’s directors and officers, as discussed in part one). As a result, creditors may attempt to claw back money paid to executives in excess of the value they provided in the form of their services.
- Distributions to owners. Creditors also may seek to claw back distributions – which may come in the form of regular distributions or dividend recapitalizations – paid out to owners, arguing the business did not receive reasonably equivalent value and that the directors breached their fiduciary duties by over-levering the business and contributing to its insolvency. Dividend recaps are often scrutinized very closely, and, as discussed immediately below, claims can target individual directors that approved the distribution as well as the recipients of the distributions. The look-back time to raise these types of claims is often long, stretching from four-to-six years depending on the jurisdiction.
Statutory Claims for Wrongful Distributions to Shareholders
Under Delaware law, under which many corporations are organized, a corporation cannot make any distributions to its shareholders unless the distributions are made from the corporation’s surplus (which is defined as the amount by which the company’s net assets exceed its stated capital) or the company’s net profits from the current or preceding fiscal year; provided, that a dividend may not be declared out of net profits if the company’s capital has been diminished to an amount less than the aggregate capital represented by the issued and outstanding stock having a preference on the distributions. A director who votes for or consents to a distribution made in violation of the foregoing rules or the corporation’s articles of incorporation is personally liable to the corporation for the amount of the distribution that exceeds the amount that could have been legally distributed.
Tax Liability for Cancelled Debts
Convincing a creditor to forgive all or a portion of a debt may be good news for a distressed business—but owners of businesses taxed as partnerships should be aware that a cancelled or reduced debt could have significant tax implications for those owners. In general terms, the amount of the cancelled debt is taxable as income and must be reported to the Internal Revenue Service in the tax year in which the debt forgiveness occurs.
This often comes as a surprise to business owners, who may not think of the debt they have incurred as a form of income if it is forgiven. They may, in fact, not realize that they face potential tax liability at all until they receive a Form 1099(c) from a creditor. A 1099(c) is a document reported to the IRS and issued to the taxpayer that shows the date of the cancellation, the amount of debt discharged, and a description of the debt, among other information.
WARN Act Liability
Employee layoffs are often a key component of efforts to cut costs at a distressed business. Certain employers must take care, however, to ensure that they comply with a federal law designed to provide workers with fair warning of an impending job loss and similar state laws.
The Worker Adjustment and Retraining Notification Act of 1988, better known as the WARN Act, is a federal law that requires most employers with more than 100 employees to provide 60 calendar days of advance notice of plant closures and mass layoffs, absent some special circumstances. The rules also include provisions about how communications should be made and who must be notified.
Businesses that fail to comply with the WARN Act can be held liable for back pay to each employee affected by the layoff for each day of the violation, among other potential penalties. In addition, state-level laws can be even more restrictive and require another level of diligence on the part of the business prior to a layoff.
Every distressed business faces its own unique set of circumstances that must be navigated with care by directors and officers to avoid individual liability and to avoid the business incurring additional liability. To avoid unexpected liability, directors and officers must obtain a clear understanding of the consequences of their potential action and arm themselves with information to make wise decisions that will be in the best interest of the business and help those directors and officers avoid personal liability.