VideoThe economy has weakened most companies, but it has strengthened the hand of one group: creditors. Marginalized somewhat the past few years, banks are once again imposing stiff covenants and pricing risk profitably. Bondholders, determined not to bear the brunt of restructurings, are beating back offers to exchange their notes at a discount. Commercial lenders are extracting highly prized collateral from companies needing working capital.
In short, creditors have their groove back. They're peering over the shoulders of CFOs to make sure that company assets, many of which are at risk, are preserved. With good reason: Moody's Investors Service projects that the recovery rate for senior unsecured bonds will average 33% in 2009, the lowest rate since 2002 (see "Slim Pickings" below). "If there are fewer funds to pay out to creditors, they always look for ways to increase their recovery," says Sam Alberts, a partner in restructuring at law firm White & Case.
The revival of the creditor class presents a major challenge for CFOs of financially stressed companies — particularly those approaching the "zone of insolvency," a legal term for when a company is in imminent danger of going bankrupt. Since 1991, the Delaware courts have found that when companies are in the zone of insolvency, management and boards are not just the agents of shareholders. They have a fiduciary obligation to a wider community of interests, particularly creditors. Delaware case law has evolved over the past two years to shelter directors and officers from direct creditor claims (see "Could This Get Personal?" at the end of this article), but the zone-of-insolvency issue is far from resolved.
"It has always been the case that directors owe their duties to the corporation and that the residual owners of the corporation [creditors] have the ability to enforce the performance of those duties," says Corinne Ball, a partner at law firm Jones Day.
But when, exactly, does a company enter the zone of insolvency and trigger that new obligation? The law offers no bright-line test. And how do you run a company for the simultaneous benefit of shareholders and creditors? Their demands can be vastly different. Shareholders have a strong incentive to avoid bankruptcy, even if that means dissipating the firm's assets with last-ditch strategies. But creditors want to preserve capital, so a sale of those assets — or even the company's liquidation — may be their preference. To whom do CFOs owe their fiduciary duty, and to what degree?
One thing is clear: the finance chief is the company's point person in navigating this poorly defined terrain. "It's incumbent upon the CFO to bring this to the attention of the president and the board on a timely basis," says Charles Kuoni of turnaround firm CRG Partners.
Where Is the Zone?
Identifying the zone of insolvency is anything but simple. "You never know for sure if you are operating in it," says Richard Lindenmuth, managing director of Boulder International LLC, a management consultancy. "You're not stepping across a well-defined border."
Delaware law sets out two tests for determining insolvency. In the balance-sheet test, a company is insolvent if liabilities exceed assets, with no reasonable prospect that the business can be continued. The cash-flow test says a company is insolvent if it is unable to meet maturing obligations as they fall due in the ordinary course of business. Neither standard is definitive. General Motors's liabilities have exceeded its assets by tens of billions of dollars for more than five reporting periods: Does that mean the company is in the zone of insolvency? Insolvency is often clear only in the rear-view mirror.
"[Asset] valuations right now are so ridiculous, you could venture to say many companies are in the zone of insolvency and they don't even know it," says William Lenhart, national director of restructuring at BDO Consulting. If a company is in the middle of a quarter and asset values are fluctuating wildly, the fair value of its assets and liabilities would be hard to pin down. Certain items, such as intangible assets, could be worth nothing if a company is liquidated. Other assets might be too illiquid for a company to pay its bills.
And how far behind on its debt payments does a company have to be to be considered insolvent? The prospect of recovery is one way to frame the question. "Are there reasonable expectations that the shareholder is money-good?" asks Jim Fogarty, a managing director at Alvarez & Marsal. "If a reasonable read on the future shows positive value for shareholders — and liquidity — the CFO still needs to be concerned about them. If not, he has to start thinking about creditors."
The due diligence for an insolvency test is similar to what auditors perform for a going-concern opinion. Recurring operating losses, negative cash flow, adverse key financial ratios, payables growing in number and aging, denial of trade credit — all are negative indicators. But a qualification on a going-concern opinion doesn't equal insolvency; a company that earns a qualification could be solvent for months. (Studies show that only half of firms that go bankrupt earn going-concern opinions prior to bankruptcy.)
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