Meaning
The legal obligations of corporate directors undergo a fundamental shift when a company approaches the zone of insolvency. Under corporate law, fiduciary duties in distress require board members to expand their focus to include the interests of creditors. This shift occurs because the risk of loss transfers from the equity holders to the lenders.
Directorial Obligation
Boards must balance the competing interests of diverse stakeholders during a financial crisis. In a solvent company, directors owe their primary allegiance to the shareholders. When insolvency is imminent, fiduciary duties in distress demand that the board avoids taking high-risk actions that could deplete the assets available to pay creditors.
Failing to adjust this focus can expose individual directors to personal liability for breach of loyalty or care. They must document their decision-making process carefully to prove they acted in the best interest of the entire enterprise.
Insolvency trigger
Identifying the precise moment of transition is one of the most difficult challenges for corporate governance. Courts use two main tests to determine if a company has entered insolvency, which are the balance sheet test and the cash flow test. Once either test is met, the shift in fiduciary duties in distress is triggered automatically.
Directors must then seek professional advice to ensure their decisions do not run afoul of the new legal requirements.
Risk management
Restructuring the board and hiring turnaround professionals are common strategies to manage these risks. Independent directors who have experience in corporate insolvency are often appointed to the board to provide objective guidance. This action helps to demonstrate that the board is acting in good faith and fulfilling its fiduciary duties in distress.
It also reduces the likelihood of litigation from dissatisfied creditors after the restructuring is complete.
