Risk & Compliance

Fiduciary Duty in the Zone of Insolvency

A recent appeals-court decision highlights the responsibilities of private-company directors and officers, though it does little to clarify the mur...
Helen ShawAugust 25, 2005

During the past few years, the corporate-governance spotlight has been shining brightly on larger public companies. However, one lesson of a recent court case, Pereira v. Cogan, might be that because private companies are subject to a lower level of regulatory scrutiny than their public counterparts, their directors and officers shoulder an even higher level of responsibility.

In 1999, Trace International Holdings — a closely held private company whose assets consisted primarily of shares in three public companies — filed for Chapter 11 protection. The following year, the proceeding was converted to a Chapter 7 liquidation, and John Pereira was appointed trustee. Pereira brought an action against majority shareholder, chairman of the board, and chief executive officer Marshall Cogan and certain of Trace’s other officers and directors, alleging that they breached their fiduciary duty to creditors. Specifically, the trustee alleged, the defendants allowed Cogan to authorize loans and excess compensation for himself and others, and to engage in other self-dealing, after the company had become insolvent but before it filed for bankruptcy.

In 2003, Judge Robert Sweet of the U.S. District Court for the Southern District of New York — who denied the defendants a jury trial, on the grounds that Pereira was seeking restitution, not damages — found the defendants liable for $45 million of losses suffered by Trace. Although earlier this summer an appeals court dismissed certain claims against the defendants and remanded the case for a jury trial, it did little to clarify the borders of what’s often called the “zone of insolvency.”

When a company enters this “zone,” also sometimes referred to as the “vicinity of insolvency” or “deepening insolvency,” it owes duties to credit holders as well as to shareholders, says Joseph Monteleone, a partner with the law firm Duane Morris. Though laws vary from state to state, actions that benefit shareholders rather than maximize recovery for creditors can give rise to liability — and in recent years, observes Quarles & Brady partner John Vail, has given creditors “another pot of money for their claims.”

Traditionally, courts have tried to ascertain whether or not a company is in the zone by applying one of two tests, says Alec Ostrow, an attorney in the bankruptcy workout group at Stevens & Lee and former counsel for Cogan. In the balance-sheet test, a company would be insolvent if its liabilities exceeded its assets. In the cash-flow test, the measure would be the inability of the company to meet continuing obligations, such as payroll and operating expenses, as they came due, though Vail notes that courts have not agreed on a single standard for applying this test. Further complicating matters: A company might be insolvent for months or years before it declares bankruptcy, and it might be found insolvent under one test but not the other.

Identifying just when a company has slipped into this murky area often leads to “classic Monday morning quarterbacking,” says Steve Shappell, managing director of the legal department at AON Financial Services Group. “It’s easy to know what to do after the fact.” To begin, the best advice might be to go slow, advises David De Berry, a vice president of The Hartford Financial Services Group Inc. — that is, to slow down the burn rate of capital. Especially in the case of smaller private companies, seeking advice from independent directors, outside financial experts, or attorneys might also be wise.

Documenting the findings of outside experts, as well as the deliberations of directors and officers, is essential for private companies, says William Lenhart, the national director of BDO Seidman’s financial recovery services practice. As it happened, observes Ostrow, during the trial Trace’s board was unable to produce formal minutes regarding approval of Cogan’s additional compensation and loans, so there was no basis for its directors to invoke the protection of the business-judgment rule when those payments were challenged by the trustee.

In light of the staggering levels of personal liability threatening directors and officers, De Berry observes that some companies are supplementing standard D&O insurance policies with “Side A-only” excess coverage. Side A coverage is paid to directors and officers themselves when the company can not or will not indemnify them (as opposed to “Side B” and “Side C” coverage, which reimburse the company itself). Benchmarking the D&O insurance limits purchased by other companies is certainly worthwhile, adds Richard Betterley of Betterley Risk Consultants, although he acknowledges that “the magnitude of the potential liabilities probably greatly exceeds the availability of insurance in the marketplace.”

As for the case at hand: Cogan settled with the trustee before the appellate decision was handed down. The remaining defendants in Pereira v. Farace, as the case is now called, will have a second chance, this time before a jury, to defend themselves against charges that they mismanaged Trace International’s assets while it was insolvent.