Liquidity Crises and Fiduciary Duties of Directors of Early-Stage Companies

The FDIC receiverships of Silicon Valley Bank and Signature Bank have caused certain early-stage companies to face potentially crippling near-term liquidity issues. These liquidity issues may result in a company becoming insolvent. Therefore, boards of directors of such companies need to consider their fiduciary duties as well as steps that can be taken to mitigate risks.

Fiduciary duties are typically owed to the company for the benefit of its owners.

While each state has its own interpretation of fiduciary duties, the general rule is that a corporation owes fiduciary duties to the corporation and its owners. That rule changes, however, when a company is insolvent. During insolvency, the board owes its duties to the corporation and its creditors. Note that Delaware law no longer holds that fiduciary duties begin to shift from equity holders to creditors when a company is approaching the so-called “zone of insolvency,” and duties continue to be owed to the enterprise as a whole.

There is no single definition of insolvency.

Courts historically use a number of “tests” to determine when a company is insolvent. These determinations of insolvency include reviewing whether: (i) the value of a company’s liabilities exceeds the value of its assets (the “balance sheet test”), or (ii) a company’s cash flow is no longer sufficient to pay obligations as they become due in the ordinary course of business (the “equitable insolvency test”). Moreover, insolvency can occur gradually or all at once—including because of a liquidity shortfall due to the loss of a financing or banking relationship. In the current environment, if a company knows (or should know) that it will not be able to pay its obligations, either due to the loss of a banking relationship or otherwise, it may have reached the point of insolvency.

In practice, it is challenging to determine when insolvency occurs, especially for early-stage companies without recurring sources of revenue. Forecasting cash inflows and outflows is key, and a company should be conservative in its cash planning. It may be necessary for companies to seek emergency funding from their current investors or outside sources. A board should seek the advice of its trusted advisors to help determine how much “runway” a company has and whether additional capital is available to avoid insolvency.

Fiduciary duties include the duty of care and duty of loyalty.

The actions of directors—and the fiduciary duties that underlie them—are governed by the law of the state in which a company is organized or formed. These duties typically include the duty of care and the duty of loyalty, and they require a board to act in good faith and in the best interests of the corporation and its stakeholders (be they shareholders or creditors).

The duty of care requires a board to stay informed and make decisions with the “requisite care.”

To meet the duty of care, a board should examine all material information about the business that is reasonably available and, in making decisions, consider all relevant information and reasonable alternatives. This may even permit a board to approve “long-shot” or “Hail Mary” transactions so long as the decisions are well-informed and the risks of success are properly weighed against the likelihood of failure.

In practice, and especially when insolvency is a consideration, a board should consult with its legal and financial advisors to ensure that it is taking all necessary actions to protect the business. In discharging the duty of care, directors may reasonably rely on the advice of advisors whom the directors reasonably believe are acting in areas of their professional expertise and who have been selected with reasonable care.

During a liquidity shortfall, it is particularly important that directors and officers preserve cash to pay employee wages and benefits as well as employment-related taxes; otherwise, directors and officers may face personal liability if they continue to allow employees to work beyond the point in time at which they know the corporation does not have sufficient funds to pay employee wages, benefits, and related tax liabilities. Boards should also consider whether a state-law WARN Act applies to employee reductions in force or layoffs.

A board may also consider appointing a “liquidity management” committee to focus on these issues specifically.

The duty of loyalty requires a board to balance the interests of various groups.

Directors must act in good faith and in a manner they reasonably believe to be in the best interests of the enterprise. Taking action will require understanding the conflicts that exist or may exist between various stakeholders.

It is of particular importance for employees of venture capital funds who sit on boards of portfolio companies to recuse themselves from decisions that create the impression of a conflict between the interests of the corporation and the interests of the venture capital fund. For example, if a venture capital fund is seeking to provide the company with “rescue financing,” board members associated with the fund or sponsor should not be part of the decision-making process and the company should consider all reasonably accessible potential sources of capital before agreeing to funding from existing sources.

If a board member/venture capital employee is involved in a “dual fiduciary” decision, and that decision is later challenged, courts will look to the “entire fairness” of the transaction. That is, courts will take a closer look at whether the transaction was the product of both fair dealing and fair pricing. It is of the utmost importance that a board and venture capital fund obtain proper counsel before entering into a transaction that could later be challenged as “self-dealing.”

The actions of a board and management team are protected—to a degree.

In most circumstances, assuming the above-mentioned rules are followed, a board’s decision-making will be protected. However, if a board’s decision-making is subsequently challenged, a court will typically avoid “second-guessing” decisions by deferring to the “business judgment” exercised by directors; this includes any judgment made by relying on the advice of legal or financial advisors.

However, certain actions will remove this protection from a board’s decisions. Obvious pitfalls include engaging in self-dealing or insider transactions, committing fraud, and failing to fulfill certain corporate responsibilities. In addition, directors may be liable for the unlawful payment of dividends or unlawful stock repurchases when the corporation is undercapitalized. A board must discuss these pitfalls with its trusted advisors before taking any such actions.

Practical measures for limiting director liability in the face of a liquidity crisis.

While there is no way to prevent a disgruntled shareholder or creditor from filing suit, boards can protect themselves by considering the following actions in consultation with discussions with their advisors:

• Maintain an appropriate amount and type of D&O insurance, even if liquidity is tight. In addition, a board may want to consult a specialized “restructuring” insurer who can review existing policies and suggest changes to the policies to maximize protection.
• Ensure that corporate records reflect a sufficiently deliberative process and the board’s awareness of its fiduciary duties.
• Thoroughly review actions that may prefer one constituency over another constituency.
• Document the scope of fundraising efforts and alternatives to financings (such as a merger, asset sale, or reduction of operations to conserve cash).
• Exercise care in approving transactions that leave a corporation inadequately capitalized, even if the corporation is solvent at the time.
• Disclose any potential conflicts of interest and scrutinize all insider transactions.
• Confirm that all tax obligations (such as franchise taxes, sales and use taxes, and withholding obligations) are satisfied or that funds have been set aside to satisfy the obligations.
• Do not require employees to come to work if it is clear, or should be clear, that the company does not have sufficient funds to pay employees.
• If the decision is made to wind-down the company or prepare a bankruptcy filing, create a realistic budget that allows for an orderly process rather than a fire sale.