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Directors And Officers: Increased Risks In Troubled Times

4/28/2009 Articles

When times get tough, directors and officers expect shareholders to hold them accountable for how well the business is being managed.  Those same officers and directors may not, however, expect increased personal exposure to creditors and the IRS or that deals they thought had safely closed may be unwound.  The current state of the economy makes this a good time to remind our clients and friends of some of these risks.

  • Directors and the "Zone of Insolvency": Normally, directors of a business owe fiduciary duties solely to the entity's equity owners. However, when a business looks as if it may no longer be "solvent" (a technical term of art), courts have held that the directors owe fiduciary duties to (and therefore have personal exposure to) both owners and the business's creditors. In other words, directors of companies with financial difficulties may need to consider the impact of their decisions on the interests of creditors-as true stakeholders of a business in the zone of insolvency-not just of owners. Directors can protect themselves from this liability by documenting efforts to preserve value for all stakeholders in the exercise of their business judgment and exploring all practical options.
  • Payroll Taxes: Withheld payroll taxes are treated as "trust funds" until turned over to state and federal tax authorities. If withheld taxes are applied to other pressing business needs and not timely remitted to these authorities, in many instances the officers of the entity with control over disbursement of funds may have personal liability for their unpaid trust fund taxes.
  • Preference Claw-Backs: If one of your customers goes bankrupt and you do not hold collateral for their obligations, sometimes a bankruptcy trustee (or debtor in a Chapter 11 case) will be able to recover as a "preference" some payments made by your customer to you in the 90-day period preceding bankruptcy. There are defenses to these preference claims, such as "payments in the ordinary course of business" defense or the right to offset the supposed preference against new goods or services or credit provided afterward. Accordingly, it is imperative to keep track of your customers' financial condition, to exert efforts to keep your customers that may be in financial trouble on regular payment terms and to keep good records of when credit is extended to customers.

On a more general note:

  • No Surprises for Lenders: Finally, creditors generally, and commercial lenders in particular, understand that problems may arise for many reasons. However, as we've counseled before, it is usually best to talk to your lender as soon as you see a significant possibility of a default (whether a payment or a non-payment default). Lenders, like most people, do not like surprises and are more likely to try and work matters out if they hear about these issues in advance. A loan in sudden default, on the other hand, often means reclassification as "non-performing" and reassignment to a different and less accommodating department.

Farella Braun + Martel brings together the talent and experience of attorneys in our Bankruptcy and Creditor's Rights, Business Transactions, Real Estate, TaxBusiness Litigation and Family Wealth groups to help our clients to develop and implement strategies with creditors, investors and partners to achieve viable, practical resolutions to difficult issues in today's challenging business environment. For more information, please contact Farella Braun + Martel attorneys Hank Evans, Dean Gloster or Matt Lewis at 415.954.4400.

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