Legal Pitfalls for Directors and Officers of Distressed Businesses, Part I: Common Risks
COVID-19-related economic turmoil has left many businesses in financial distress, forcing them to make increasingly tough calls about their future and what might occur upon their insolvency.
For directors and officers, the unprecedented circumstances have placed them under exceptional stress to make difficult decisions fast. This is, of course, a recipe for disaster if risks are not properly identified and mitigated.
As a business nears insolvency or seeks bankruptcy protection, the rights of shareholders and creditors must be considered. Further, guarantors of the business’s debt may face increased liability and demands from financial institutions. And the executives overseeing the business’s payroll and tax obligations must avoid decisions that will place themselves in jeopardy of becoming personally liable for the debts.
In this article, the first of a two-part series, we explore a few of the more apparent legal risks, focusing on issues facing guarantors, issues facing officers making payroll and tax withholding decisions, and issues facing directors and officers. Part two of this series will focus on a few of the hidden risks to directors and officers.
Exposure for Guarantors
Understanding the scope of the liability their guarantors may face often is critical for businesses considering a bankruptcy or facing insolvency. Often, in a small or closely held business, it is the owners of the business themselves or a close family member or friend who has served as a guarantor of the debt that will become personally liable for it if the business cannot pay.
When a business is in distress, those guarantors face the possibility of being held liable for repaying one or more creditors should the company default on its obligations. While a bankruptcy filing may give an entity some brief relief to restructure its indebtedness—the financial burden often shifts to owners and others who have personally guaranteed loans, lines of credit, or leases.
The timing of a financial institution’s decision to exercise its rights under a guaranty also may surprise many guarantors. Financial institutions, anxious to recoup their debts, may quickly look to guarantors with significant personal wealth as an easy avenue to recoup losses versus pursuing a borrower that may not have the immediately available liquid assets to pay what is owed.
Owners who have personally guaranteed their business’s borrowing sometimes believe that financial institutions must first seek repayment from the business before proceeding against their assets. However, arguments made under the marshaling doctrine—in other words, taking collateral of the borrower first before pursuing a guarantor—are typically not applicable. Many guaranty agreements are an “absolute, unconditional, and continuing guaranty of payment” and waive any argument under the marshaling doctrine, allowing a financial institution to move quickly to pursue a guarantor’s assets.
During the COVID-19 crisis, some jurisdictions have offered relief for guarantors, particularly those who have guaranteed commercial leases for restaurants, gyms, retail stores, and other such establishments. Yet these measures have been limited to specific time periods, types of debt, and categories of businesses. Before assuming that relief is available, business owners would be wise to rely on trusted legal counsel to determine if such programs are available in their locales and apply to their circumstances.
Guarantors that are forced to pay the debts of the business should consider either purchasing the loans for which they guaranteed – to maintain priority in any collateral for purposes of securing their own reimbursement claim against the business for recovery of the amount paid for the borrower’s benefit – or perfecting their subrogation claims properly.
Trust Fund Tax Liability
Trust fund taxes are collected by a business and then held in trust until they must be paid to the government. Commonly, this includes federal and state employment-related taxes and local and state sales taxes. When a business is in distress and cash flow is tight, owners or executives may be tempted to withhold taxes from a trust to cover other more pressing expenses. Yet robbing Peter to pay Paul can backfire quickly.
Under federal and many state laws, the “responsible person” in a business can be held personally liable for failure to pay or withhold federal and state payroll taxes, including income tax and both the employer and employee portions of FICA. The government may assess a “trust fund recovery penalty” if federal income, social security, or Medicare taxes are not paid. The penalty is “100% of the unpaid trust fund tax,” according to the IRS. “If these unpaid taxes can’t be immediately collected from the employer or business, the trust fund recovery penalty may be imposed on all persons who are determined by the IRS to be responsible for collecting, accounting for, or paying over these taxes, and who acted willfully in not doing so.”
In addition, the IRS may assess penalties for late deposits caused by willful neglect. And state and local government agencies may pursue their own actions, with the severity of the penalties depending on the jurisdiction.
Bankruptcy may not help matters. In general, trust fund taxes cannot be discharged in a bankruptcy, nor can debt that is taken on to pay those taxes. Again, responsible parties, particularly officers charged with overseeing withholdings, may find they are personally liable to pay the insolvent company’s trust fund tax bills.
Failure to Pay Wages
The individuals responsible for making payroll decisions within a company may be personally liable directly to an employee as well as face criminal liability for “willful” failure to pay wages under both state and federal wage and hour laws.
Risks of Claims Against Directors & Officers
When a business is solvent, directors and officers owe their fiduciary duties of care and loyalty (including good faith, oversight, and disclosure) to the company and its shareholders. What happens, however, when the company is insolvent?
When a business becomes insolvent, risk rises for directors and officers, because they must broaden their fiduciary duties to include the interests of creditors. This is because creditors usually become the primary stakeholders in whatever value is left in the company. Failing to take into account the best interest of creditors can trigger claims against the company and individual directors and officers—and can test the limits of a company’s D&O insurance policy—because creditors often are often more critical of the actions of directors and officers.
Does the same shift occur if company has not yet filed bankruptcy, but is clearly in distress? The law in this circumstance is not well settled, but caution is advisable. Some courts have held that directors and officers must expand their duties to creditors even when a company is in the “vicinity” or “zone” of insolvency, but most courts limit the expansion of the duties of directors and officers to only the time when the company is actually insolvent, which is typically determined by the balance sheet test or the “ability-to-pay” or cash flow test. See North American Catholic Educational Programming, Inc. v. Gheewalla, et al. (Del. 2007). Once duties are expanded to creditors, however, the creditors then have standing to maintain derivative claims against directors and officers on behalf of the corporation for breaches of fiduciary duties. The difficulty for directors and officers is typically determining when the company is insolvent, as the date of insolvency is typically not a date that is easy to peg. Thus, directors and officers would be wise to consider the interests of creditors—even in absence of a legal duty to do so—when the business is in the vicinity or zone of insolvency.
Directors and officers must be cognizant of the unique risks that occur when cash flow ebbs and the potential for an insolvency grows. If they make poor or ill-informed decisions, the potential for liability, litigation, and regulatory enforcement against the company and them personally increases exponentially.
A wise course of action for directors and officers is to educate themselves about their responsibilities, review their director and officer liability insurance with their broker, and seek experienced legal counsel to help them navigate their specific issues to help them avoid being caught off guard and personally liable for debts of the company.