Vicinity of Insolvency: What fiduciary duties are owed by Directors or Officers of Insolvent Entities when going out of business?

Any owner of a business should know that your directors and officers have certain duties to their respective entities, whether it is a corporation or a limited liability company (LLC). Under Florida law, specifically, directors and officers have duties to act 1) in good faith, (2) with reasonable care and (3) with loyalty to their entity. Fla. Stat. §607.0830(1). The duty to act in good faith requires directors and officers to act with honesty of purpose and in the best interest of the corporation. The duty of care requires directors to act as a reasonably prudent person and consider all relevant material when making decisions. The duty of loyalty requires directors to act in a manner the director reasonably believes to be in the best interest of the entity and to promote the best interests of the entity.  What your directors and officers, however, probably do not realize is that in the event of dissolution, insolvency or near-insolvency of the entity, these fiduciary duties also extend to any creditors of the entity. For executives who are involved in forming and managing byzantine corporate structures of large companies with single purpose entities, it is important to know what trailing liabilities or obligations the individuals who run those entities may have.

Under what is commonly known as the business judgment rule, directors and officers are presumed to act on an informed basis, in good faith, and on honest belief that the action was taken in the best interest of the company. In effect, the business judgment rule creates a strong presumption in favor of the board of directors of a corporation, freeing its members from possible liability for decisions that result in harm to the corporation. In short, the business judgment rule exists so that a board will not suffer legal action simply from a bad decision. If a beneficiary, including creditors, can show that the director failed to act with due care or loyalty or lacked good faith in making decisions on behalf of the entity, then courts will scrutinize transactions substantively and the business judgment rule may not be a shield- even post-wind down. Before or after an entity becomes insolvent, a violation of any of these duties can and will likely expose your directors and officers to liability to both the entity and creditors. The following article details what directors and officers need to know and how to avoid violating their fiduciary duties owed to both their entity and the creditors of the entity, with particular emphasis on defunct entities.

Directors and officers should clearly understand what is the vicinity of insolvency so they avoid taking actions that may violate their fiduciary duties.

Maintaining Fiduciary Duties During Dissolution

Dissolution is the process by which a business entity legally terminates its existence and can precede, succeed, or occur contemporaneously with the liquidation process. The dissolution process for corporations and LLC’s are different, but both maintain obligations of the officers and directors to act in good faith, to act with care, and to act with loyalty to the company. Oftentimes, directors and officers dissolving an entity, improperly distribute their assets and expose themselves to personal liability from the entity, its shareholders or members, and creditors. Florida Statutes provide procedures upon dissolution, and if directors and officers follow these procedures, they are less likely to have found to violate their duties.

Upon dissolution a business entity, under Florida law, is required to notice any creditors of dissolution. Notice should include (1) a reasonable description of the claim (2) the extent to which the claim is admitted and any fixed debt obligation, (3) a mailing address (4) the deadline (not less than 120 days) for delivery of the claim and (5) a statement that the dissolved entity may make distributions after the deadline. Fla. Stat. §§ 607.1406 (2), 608.446. Following these statutory procedures will ensure that your directors and officers distribute assets appropriately and avoid in any self-dealing which would violate their duty of loyalty owed to creditors and personally expose them to liability.

Insolvency Or The Vicinity Of Insolvency

Even before dissolution, entities owe fiduciary duties to their shareholders or members and creditors in the event that the entity is insolvent or what Florida courts have described as in “the vicinity of insolvency.” Many courts across many jurisdictions employ a standard for when an entity may be in the “vicinity of insolvency” as: if (1) its assets lack short term liquidity, (2) its debt obligations exceed the value of its asset; and (3) its capital is unable to support future operations. Insolvency or the vicinity of insolvency does not create a new duty for directors and officers, it only causes the existing duties to apply to the corporation’s creditors. In most scenarios, whether the entity is active or inactive, if the directors and officers act diligently and reasonably in the best interest of the entity, then they also act in the best interests of its creditors.

During the insolvency period directors and officers are not discharged of their fiduciary duties. In regard to the duty of loyalty, directors and officers often go wrong when they put shareholders above creditors or engage in other forms of self-dealing (i.e. usurping opportunities, siphoning off assets or taking improper distributions), though there are several common law carve outs that sanitize certain transactions. In regards to the duty of care, directors and officers must continue to be informed and reasonably manage the wind down of the company for the benefit of its creditors in accordance with their priority. The common thread of fiduciary duty breach with defunct entities, is a set of directors and officers engaging in self-dealing and falling asleep at the wheel. If your company finds itself facing financial distress, its directors and officers can generally avoid both of these pitfalls if they continue to act in a manner that maximizes company wealth and act in good faith when transferring assets.

A very practical example of these problems can be viewed in the case of In re SOL, LLC 2012 WL 267254 (Bankr. S.D. Fla. July 5, 2012). In Sol a real estate brokerage firm entered into a franchise agreement with a prominent realty franchise, and incurred debt under a promissory note, which was guaranteed by the managing member. In addition to the debt owed to the franchisor, the LLC also had several other creditors which were not guaranteed by the managing member.  Subsequent to the real estate crash in the late 2000’s, the company experienced financial distress and got behind on its payments to its franchisor. In order to satisfy the debt, the managing member of the LLC sold its franchise rights, and valuable listings to its franchisor. The value of the debt was substantially less than the value of the franchise right and listings. Due to the managing member placing his own interests (as a guarantor of the franchise agreement promissory note), he was ultimately found to have violated his duty of loyalty to other creditors. This case is just one of many that teaches directors and officers two important lessons when facing a financial distress: (1) directors and officers cannot discharge their fiduciary duties by throwing their arms up and doling out assets to the squeakiest wheel at the expense of the other creditors; and (2) directors and officers cannot place their personal interests above the interests of their collective creditors. It may be tempting for directors and officers to satisfy personal obligations when their company will likely become insolvent and dissolve under any circumstance, but they must still be cognizant of their duties owed to all creditors.

Prioritizing creditors, however, is not the only situation where directors and officers must be cognizant of their duties of care and loyalty. Any decision in which the director or officer acts irrationally or in their own interests may result in a breach of their duties of care and loyalty. Common examples include (1) self-dealing by transferring company assets to the directors and officers prior to satisfying creditors, (2) taking unreasonable risks which may devalue assets which can potentially be owed to creditors, and (3) deepening insolvency if a reasonably prudent person would not do so.

Conclusion

Whether restructuring company assets, winding down the business, or filing bankruptcy, directors and officers are not discharged of their duties of loyalty and care. They must affirmatively continue to monitor company assets and act in the best interest of the company. So long as they continue to act in the best interest of the company, even facing insolvency or dissolution, directors and officers should not run afoul of its duties owed to creditors.


Authors:
Charles B. Jimerson, Esq.
Sean P. Lynch, II, Esq.


For more information on the topics of insolvency related to the business judgment rule, read these additional blog articles:

CATEGORY: Florida Business Litigation Blog Practice Areas: