United States: Your Dot.Com Is Dot.Gone: Fulfilling Your Duties At The Helm Of A Sinking Ship

You started a company several years ago. You obtained funding, leased space and equipment, hired employees, grew the business and were on the verge of a lucrative exit. But then, the bear came out of hibernation, and the capital markets dried up. Creditors are on the door steps and investors are mad. Cash is tight. Debt is high. In short, your dot.com is dot.gone. Given the current economy, this scenario is not atypical. When it occurs, a common concern is "How do you wind up your business and fulfill your duties as an officer and director of an insolvent company?" Understanding your duties is a good place to start.

When times are good, the duties of directors and officers are less complex. Corporations are creatures of state law, and state law governs their internal affairs, including the duties of officers and directors. In the absence of corporate insolvency, directors and officers owe fiduciary duties to both a corporation and its shareholders. These include the duty of loyalty, which prohibits self-dealing, and the duty of care, which requires the use of reasonable care in making corporate decisions. Within the limits of their legal authority, officers and directors possess a large amount of discretionary power which, if exercised honestly and reasonably, is not subject to the control of the shareholders or the courts.

Actions and decisions of officers and directors are examined under what is known as the "business judgment rule". This rule requires each director and officer to discharge its duties in good faith, with the care an ordinarily prudent person in a like position would exercise under similar circumstances, and in a manner the actor reasonably believes to be in the best interests of the corporation. In discharging corporate duties, directors and officers are entitled to rely on information, opinions, reports or statements prepared or presented by legal counsel or a public accountant as to matters the director or officer reasonably believes are within such person's professional or expert competence. If corporate actions comply with the business judgment rule, then a rebuttable presumption arises that a director or officer is not liable to a corporation or its shareholders.

When times are bad, the duties of directors and officers become more complex. When a corporation becomes insolvent, the fiduciary duties of its directors and officers expand to include fiduciary duties to a corporation's creditors since the value of a creditor's claim against a corporation may be affected by the directors' and officers' decisions. Generally, the obligations owed to creditors of an insolvent corporation include duties not to favor shareholders over creditors, not to commit corporate waste, and not to favor an insider creditor over other creditors. The directors' and officers' actions during insolvency may be subject to judicial scrutiny; personal liability may result if a duty is breached.

Absent a breach of fiduciary duty, directors and officers of an insolvent corporation have significant latitude in balancing the opposing interests of creditors and shareholders. Generally, the standard of care owed to creditors is that of an ordinarily prudent person in similar circumstances, and actions and decisions may be protected by the business judgment rule. The rule typically only protects disinterested directors or officers who do not derive any personal financial benefit from their decisions or actions. If a director or officer is a shareholder or creditor of the corporation and obtains a benefit by a decision, the presumption arising under the business judgment rule may be rebutted.

Seeking bankruptcy protection to manage a company's insolvency does not obviate the duties of an officer or director. A corporation seeking bankruptcy protection typically files under either Chapter 7 or Chapter 11 of the Bankruptcy Code. Chapter 7 is a liquidation proceeding in which a business typically ceases to operate. An independent trustee is appointed to oversee the disposition of assets and distribution of funds to creditors in order of legal priority. Officers and directors do not play a significant role in a Chapter 7 bankruptcy. However, they remain liable for pre-bankruptcy actions and decisions that were in breach of their duties.

Chapter 11 is a reorganization proceeding. On filing a bankruptcy petition, all of the corporate debtors' assets become property of the bankruptcy estate. The debtor is deemed to be a new legal entity, namely a "debtor-in-possession", and the corporate debtor's assets, although property of the bankruptcy estate, remain in control and possession of the debtor.

Generally, absent court intervention, the pre-petition rights and duties of directors and officers of a company in Chapter 11 reorganization are not limited by the filing of a bankruptcy petition, but are actually increased. Case law provides that a Chapter 11 debtor's directors and officers are fiduciaries to the debtor-in-possession's creditors as well as the corporation, the bankruptcy estate and the shareholders. One court has commented that the nature of the duties changes upon the filing of a bankruptcy petition from "helmsman" to "guardian". Post-petition actions of officers and directors continue to be judged by the business judgment rule.

In Chapter 11, absent court constraint, a board of directors retains the right to implement a company's business objectives. There is no legal requirement that ordinary business goals be approved by a court or revealed to creditors or shareholders. However, when transactions necessary to carry out business are outside the "ordinary course of business," creditors and other parties in interest have a right to notice and a hearing before management can commit to such transactions. Examples include sale of all or most of a company's assets, borrowing money while in bankruptcy, and assumption or rejection of executory contracts existing at the time of a bankruptcy filing. In evaluating such transactions, courts give considerable deference to management's business judgment.

The Bankruptcy Code provides that the directors and officers of a debtor-in-possession have all of the rights, powers and duties of a trustee subject to such limitations as the court prescribes. Although business decisions are typically left to the board, courts have a responsibility to protect creditors' interests from the actions of inexperienced or incapable management. For example, courts have refused to approve the election of new management proposed by a newly-elected board of directors with little understanding of a business.

Management rights may be eliminated entirely by the appointment of a Chapter 11 trustee. Any party in interest may move for the appointment of such trustee, whom the court must appoint upon a showing of cause including fraud, dishonesty, incompetence, or gross mismanagement of the debtor, or if such appointment would be in the interests of creditors.

Closing a business does not mean all officers and directors will be saddled with liability for a company's debts. Personal liability can be avoided by proper exercise of one's fiduciary obligations.