BOARDS OF DIRECTORS By Cliff Atherton
As the recession continues, the success and survival of many private firms will be challenged, and some will experience financial distress for the first time. A firm experiencing a serious reduction in liquidity may defer investment, reduce its asset base, lay off personnel or take other actions necessary to meet its financial commitments as its cash operating profit (EBITDA) declines.
Directors of these firms will need to be informed about their fiduciary duty to the corporation. The response of management and the board to the early stages of financial distress will ultimately determine the firm’s success in managing its way back to robust financial health. The retention of experienced, independent advisers during the early stages of financial distress will have a positive impact.
As they make difficult operating decisions, directors of a financially distressed firm may have heightened concerns about the discharge of their fiduciary duties to the corporation. Several years ago, I served on the board of a family-owned company experiencing financial distress. When confronted with the initial consequences of diminished liquidity, we invited legal counsel to attend a board meeting and advise us about the changes that might be important to our deliberations and decisions as the firm’s financial condition deteriorated. Counsel advised us that the duties of loyalty and care in the exercise of our business judgment continued to be the guiding principles for the board. However, he also cautioned us about sensitivity to creditor concerns once the company entered the zone of insolvency (“ZOI”), that gray area when a firm approaches insolvency but is not yet insolvent.
The board’s fiduciary duty
The ZOI concept and the uncertainty it created for directors were recently clarified for Delaware corporations. In North American Catholic Educational Programming Foundation, Inc. v. Gheewalla (“NACEPF v. Ghee-walla”), the Delaware Supreme Court explicitly delineated the board’s duties. Whether a firm is solvent or insolvent, the board owes a fiduciary duty to the corporate enterprise and its residual beneficiaries. When a solvent company is in the ZOI, its residual beneficiaries are its shareholders. Only when the corporation is insolvent does the board’s duty shift to the creditors.
Most directors who serve a financially distressed firm know that their actions may later be scrutinized with 20:20 hindsight. The ruling in NACEPF v. Gheewalla provides greater clarity for directors and permits them to pursue the best interests of the corporation. However, the best decisions in the face of uncertainty will not preclude a creditor or disgruntled shareholder from filing a lawsuit long after the board’s decision was implemented. Such a claim might allege that the firm became insolvent much earlier than the date on which the board concluded it was insolvent or that shareholder value was dissipated unnecessarily.
Directors in this unfortunate situation have the benefit of the business judgment rule, a legal principle that renders officers, directors, managers and other corporate agents immune from liability from losses incurred in corporate transactions within their authority, so long as they exercised the care that a prudent person would use in similar circumstances, acted in good faith and reasonably believed their actions were in the best interests of the corporate enterprise.
Both finance theory and corporate law encourage directors to exercise their duties of loyalty and care in making independent and informed business judgments that are expected to be in the best interest of the corporation and its residual beneficiaries. Directors are encouraged and permitted to pursue a business strategy that they believe, in good faith, will increase the corporation’s value. Whether the board’s strategy involves a sale or a restructuring of the business, directors are advised to take reasonable measures to ensure that the residual beneficiaries receive the highest value reasonably attainable.
Because uncertainty is greater when a firm is experiencing financial distress, many boards respond by expanding the types of information they review, deliberating more frequently or securing advice and analysis from independent financial and legal advisers.
An outside perspective
Independent advisers provide the board with an outside view. Most management teams have established methods for understanding the business and solving its problems. While such patterns of analyzing, diagnosing and solving problems may have contributed to the firm’s historical success, they also may have created or contributed to its current operating and financial challenges. By involving independent advisers, the board gains access to an outside view, one that is free to question fundamental assumptions about the business.
Independent advisers have broad experience acquired in a variety of business settings. They also may bring the legal, turnaround, valuation and transaction skills and experience that the firm needs. Ultimately, the involvement of independent advisers can improve the quality of a board’s deliberations and, if necessary, bolster a defense of its deliberations and decisions as afforded by the business judgment rule.
If a board elects to retain independent advisers, it should select them with care and use them appropriately. Corporate law generally permits directors to rely in good faith on opinions and counsel from advisers on matters that the directors reasonably believe are within the advisers’ professional competence. To avoid a perception that they failed to adequately supervise the advisers or otherwise impermissibly abdicated the board’s authority to them, directors should monitor and remain generally informed about the advisers’ recommendations. Directors should also take time to consider the advisers’ recommendations before taking action.
In Beyond Survival, Léon Danco described a call he received from a business owner who had suffered a serious operating setback and was experiencing liquidity problems. Fortunately, Danco had already worked with the owner to recruit independent advisers. Time was critical for Danco’s client, as it is for any company experiencing diminished liquidity, and the advisers assisted the business in responding quickly with a workable plan.
All businesses will encounter a tough operating environment this year. If the recession produces a liquidity crisis or financial distress for your business, your board should take advantage of the role that independent financial and legal advisers can play. Even better, you should become acquainted with outside advisers before you need them. Opportunity favors the prepared board.
Cliff Atherton, Ph.D., is an investment banker with GulfStar Group in Houston. He advises family- and entrepreneur-owned businesses. He is a faculty member in finance at Rice University’s Jones Graduate School and served previously as director of its Family Business Forum. He has been a director of a number of family-owned businesses.