Venture capital firms often require a seat on a company’s board of directors as a condition of their investment. There are good business reasons for doing so. A board seat can help a venture firm monitor its investment in a company and can add value to the venture firm’s investment in the company through the expert advice and useful contacts of the venture firm’s designated board member. However, board seats can also expose venture capitalists and venture firms to unique liabilities when a portfolio company becomes insolvent.
Directors owe fiduciary duties of loyalty and care to the company’s shareholders. However, when a company becomes insolvent, directors also owe duties to the company’s creditors. This is because the creditors of the company will have the first claim to the company’s assets if it becomes insolvent and not the shareholders.
When directors must begin to consider the interests of creditors is as unclear as the precise moment a company becomes insolvent. Courts generally apply either of two standards: whether the company is able to pay its debts as they come due or whether the company’s liabilities exceed its assets. Some courts have held that directors have duties to creditors at a possibly earlier stage, once the company is operating in "the zone of insolvency." Credit Lyonnais Bank Nederland N.V. v. Pathe Communications Corp. (Del.Ch. Dec. 30, 1991). Little guidance exists as to how directors should balance their fiduciary duties to shareholders and creditors.
Regardless of these ambiguities, two things are certain: directors of insolvent companies owe fiduciary duties to the company’s creditors, and courts will evaluate directors’ discharge of those fiduciary duties with the benefit of hindsight. Accordingly, directors of financially distressed companies, and particularly directors representing shareholder constituencies such as venture capitalists representing their firms, should exercise extra care in the discharge of these duties.
The potential for personal liability can be a particular concern for venture firm directors. Many states have laws that impose personal liability on a company’s officers if the company fails to pay wages and make proper withholdings for taxes. Federal laws also impose personal liability. For example, if federal income and FICA taxes are not withheld and paid by the company to the federal government, they become the personal liability of the "responsible officer." These laws typically impose liability on a company’s officers but, as is often the case in small, insolvent companies, if directors become involved in the management of the company, they may also find themselves personally liable. Indeed, federal and state tax authorities often pursue all directors and officers for unpaid taxes in search of the "responsible officer." Consequently, it is advisable that venture firm directors ensure that the insolvent companies have adequate reserves to meet payroll and withholding taxes, and should consider shutting the company down before exhausting these reserves.
Confronted with these liability issues, venture firm directors should pay particular attention to the "D&O" insurance policies of the companies on whose boards they serve as directors. Many small companies simply do not have insurance coverage for their directors and officers and venture firms should consider obtaining their own insurance for professionals representing their firms on the boards of portfolio companies. Even when small companies do have D&O insurance, the dollar limits and claims covered by individual policies can vary widely. In the specific context of an insolvent company, venture firm directors may also discover that, while all D&O policies provide coverage for shareholder claims, some policies do not provide coverage claims made by creditors, employees or government agencies for unpaid wages and taxes. Because it will be difficult or expensive (or both) to adjust a D&O policy once a company is in distress, it is advisable that venture firm directors review their D&O coverage before they join a portfolio company’s board.
When a portfolio company is running out of capital, venture firm directors should consider all alternatives to avoid criticism and potential liability after the fact. The inability to raise capital is not always recognized at the outset of financial difficulties and may only become clear when the portfolio company’s business has deteriorated and other strategic alternatives are no longer available. It is advisable that venture firm directors be diligent and active participants. Receiving reports from the portfolio company’s officers may not be adequate. Depending on the severity of the portfolio company’s circumstances, venture firm directors should actively explore alternatives, including bankruptcy protection which may limit or extinguish the possibility of recovery for equity holders such as the director’s own venture firm but may preserve assets for the benefit of the portfolio company’s creditors.
Venture firm directors should further protect themselves in these circumstances by ensuring that the discharge of their fiduciary duties of loyalty and care are adequately documented. Written records can be powerful evidence if it becomes necessary to defend against claims and care should be taken in the careful documentation of the discharge of fiduciary duties. Chief among these written records are board minutes and the materials provided at board meetings. Thoughtfully prepared board minutes may serve to document the decision making process, the issues considered and the advice sought and preserve evidence of what was known, or could be known, about a portfolio company’s financial health at a particular point in time. It is advisable that venture firm directors build a well documented record of their actions as supplemental insurance against liability.
Given these hazards, the question of whether a venture firm director should simply resign if a portfolio company encounters financial difficulties seems obvious. The reasons for the answer that he or she likely should not, are less obvious. First off, while resigning may eliminate liability for actions after the venture firm director resigned, the director will still be liable for acts before resigning. If litigation results, the parties controlling the corporation may ascribe more, or perhaps all, blame to former directors than their current board. Moreover, venture firm directors may be more effective in reducing their firm’s liability exposure by remaining on the board and offering thoughtful advice. Indeed, as critical decisions may lie ahead, continued service may produce better results for the portfolio company and the venture firm’s investment. Nevertheless, there are circumstances in which continued service is inadvisable. For example, if the venture firm director is confronted with transactions that sacrifice a good probability of creditor recovery for a risky opportunity that will permit equity holders a recovery.
If it becomes inescapable that a portfolio can neither raise additional capital nor find a buyer, several alternatives should be considered short of bankruptcy. The company may consider winding down its business and liquidating its assets so that some or all of its creditors may be paid. It may also consider an assignment for the benefit of creditors (or "ABC"), pursuant to which the company’s assets are assigned to a fiduciary for liquidation, with the proceeds distributed to creditors in the same priority as provided for by bankruptcy laws. If these alternatives are not appropriate, the portfolio company may make a bankruptcy filing. If the portfolio company makes a Chapter 7 filing, a trustee is appointed to liquidate the portfolio company’s assets and distribute the proceeds to creditors as provided by bankruptcy laws. Venture firm directors play little or no role in these proceedings and accordingly have little or no liability exposure. A Chapter 11 proceeding may be appropriate if the portfolio company can be reorganized and emerge from bankruptcy.
For many venture-backed companies, a wind down or ABC may be attractive because they can be cheap and quick. With the assistance of a few outside professionals, management can achieve a orderly and efficient resolution of liabilities through a wind-down or ABC. The engagement of outside professional firms may be advisable for several reasons. In part, because the processes are complicated their execution relies on experienced professionals. But perhaps as importantly, outside professionals can bring detachment to negotiate with creditors, equity holders, employees and other possible claimants without the potentially for liability that venture firm directors may expose themselves to as representatives of a constituency.
If the portfolio company is to be wound down, venture firm directors should be circumspect about distributions. In the process of winding down and liquidating many claimants will pressure for payment. Venture directors must ensure that portfolio company liabilities are satisfied before equity holders are paid and that adequate reserves are set aside for unforeseen liabilities and the costs of liquidation. If a court later concludes that inappropriate payments were made, the directors authorizing the payments might be liable with the equity holders receiving payment. This outcome is avoidable by setting aside a reasonable reserve for unknown liabilities and the costs of liquidation, to be released when the board of directors is confident that all liabilities have been satisfied.
Despite these considerable risks, board seats remain valuable tools for venture firms to monitor their investments and add value. But while protecting their investments in portfolio companies, venture capitalists must be conscious of the risk to their firm’s assets and their own assets and act prudently.
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