These challenges may be even more pronounced for constituent directors who have been appointed by private fund investors to serve on the board of a portfolio company investment.
Directors should keep their fiduciary duties in mind when considering potential actions and approaches, whether to preserve the corporation, to address short-term liquidity needs or take advantage of market opportunities. (This note generally assumes that the director serves on the board of a Delaware corporation and may not be applicable to a director or manager of a limited liability company, to the extent that fiduciary duties have been disclaimed in the LLC agreement.)
Fiduciary Duties Continue to Apply
COVID-19 does not change the fact that, generally, directors still owe a duty of care and a duty of loyalty and must act with due care, good faith, and in the best interests of the company.
- In short, the Board should be informed about the business, including results of operations, and should understand the company’s strategies and corporate plans. The Board should be involved in and approve major decisions, while remembering that the duty of care cannot be delegated to other decision-makers (but directors can rely in good faith upon the advice of experts and management).
- Level of appropriate involvement increases when risks to the enterprise present themselves. Prudent oversight is a matter of facts and circumstances—these are not normal facts and circumstances.
Solvency v. Insolvency
- When the portfolio company is solvent, a director owes fiduciary duties to the stockholders—as well as to the company itself as an enterprise.
- When the portfolio company becomes insolvent, or where a proposed transaction would render the portfolio company insolvent, creditors have the right to bring derivative claims for alleged violations of fiduciary duties. In the case of an insolvent company, it’s the creditors, not the shareholders, who would have been harmed.
- Insolvent means either:
- When the sum of the portfolio company’s debts exceeds the fair value of its property. “Debts” includes contingent, unliquidated and disputed debts that are not necessarily reflected on a balance sheet. “Fair value” of property means fair market value or the amount of cash that could be realized from a sale of the property during a reasonable period of time.
- If the portfolio company lacks sufficient resources to pay its debts as they come due. Resources for this purpose include the portfolio company’s ability to finance further operations and not just its income from internally generated funds. Potential inability to refinance future debt maturities can also indicate insolvency.
- What about the so-called “Zone of Insolvency”?
- Prior Delaware cases had suggested that creditors could bring suit based on actions taken while the company was in the “zone of insolvency.” This is no longer the operative analysis. Yet, for directors’ real-time decisions, this may be a distinction without a difference because of the difficulty in determining when a company moves from the zone of insolvency to actual insolvency—which often is determined in hindsight.
- Given the uncertainty, boards should be aware that their actions will be second-guessed by creditors, even where actions were only in the “zone of insolvency.” Boards may be charged with constructive knowledge of insolvency, even absent a formal opinion to that effect.
- In practice, the law favors directors who preserve and enhance corporate value for the benefit of all stakeholders.
So What Should I Do?
- Stay actively (even more than normal) informed about the business and understand the portfolio company’s strategies and corporate plans, rely on the advice of experts and management, and establish an adequate record of regular communications and meetings to reflect the decision-making process.
- Even though the COVID-19 pandemic may result in issues that need to be addressed quickly, the crisis creates conditions for poor decision making—be sure to allot adequate time for the Board to make an informed decision regarding a course of action, especially significant transactions.
- Consider forming a COVID-19 task force to meet regularly and assist in providing oversight to the portfolio company via regular reporting to the Board. Such a task force can include representatives from management, operations, legal, finance, and risk management/compliance.
- Exercise oversight and monitor the portfolio company’s operational viability, legal compliance and financial performance during the pandemic.
- Implement COVID-19 reporting systems at the Board level;
- Schedule regular Board or committee meetings with management to discuss COVID-19 issues, especially compliance issues involving public health and safety developments;
- Maintain appropriate meeting minutes that document the Board’s oversight activities; and
- Retain appropriate experts and advisors to consult (e.g., legal counsel) but do not outsource the Board’s decision-making responsibilities.
- Specific areas on which to focus include:
- Disaster recovery/business continuity;
- Monitoring governmental and regulatory updates;
- Pursuit of available loans, grants, and other disaster relief funding;
- Supply chain interruption/stressors (including legal analysis of force majeure, termination, indemnity, and/or other potentially relevant clauses); and
- Mitigating cybersecurity/data privacy threats.
- Act in the best interests of the corporation and its stockholders, which might take precedence over personal interests or those of the private equity sponsor. Provide full disclosure of any potential conflicts to the Board and stockholders, implement procedural safeguards throughout the transactions process, and, if necessary, consider empowering a special transaction committee.
Consider Implications of Control/Affiliation for Purposes of Available Financing
The CARES Act has proposed a number of potential financing routes for companies impacted by COVID-19. However, many portfolio companies will find it difficult to qualify due to the affiliation rules. While guidance may be issued that will loosen these restrictions, directors of companies with immediate needs should consider whether any steps may be taken to sever affiliation status and gain eligibility. Given the potential liability under the False Claims Act for improper filings, companies should seek the advice of experienced counsel to avoid missteps.
M&A Provides Opportunities (and Challenges)
Valuations may be opportunistic for private equity sponsors to acquire assets, but there are potential challenges to address.
- Complete financial and legal due diligence with consideration of COVID-19 issues, including impact on financial projections, operations, demand, supply chain, etc.
- For signed deals, consider whether to invoke a material adverse effect provision (or otherwise propose modifications to the transaction) if the prospects of a counterparty have been affected.
- For deals still in negotiation, be wary of carve-outs to MAE and consider requiring additional representations regarding a target’s exposure to COVID-19.
- Ensure that your financing document mirror the risks you’ve assumed due to COVID-19.
- Consider potential delays to closing (including regulatory approvals, given the shutdown of certain governmental agencies) and ensure that financing commitments remain open for sufficient period of time.
Interested Party Transactions
If a potential transaction would involve a conflict of interest (e.g., a transaction with the private equity sponsor), consider establishing an independent committee of disinterested directors and obtaining approval of a majority of the minority stockholders and/or obtaining a fairness opinion.
Be Wary of Fraudulent Conveyances
The economic disruptions caused by COVID-19 may call into question the solvency and capital adequacy of many businesses previously thought to be solid. When a company is insolvent, fraudulent conveyance law addresses and potentially unwinds transfers other than for reasonably equivalent value. The same applies if the company has unreasonably small capital or is left insolvent as the result of the transfer. More specifically, affiliate party transactions and rescue capital transactions can be subject to after-the-fact litigation. In addition, there are legal arguments available in bankruptcy for an extended look-back period with respect to alleged fraudulent conveyances.
Do Not Resign—It May Make Things Worse
Generally, it is advisable to stay on the Board, as you have a better chance of persuading stakeholders that you are not responsible for the problem, but rather contributed to the solution. In addition, the board member who remains also has a better chance of obtaining a release in any bankruptcy plan. However, if you are aware that other directors or management are committing fraud and not willing to fix the problem, you should resign, as it is possible that you could be considered part of the fraud. In such a situation, you should consult your own counsel and not rely on the company’s counsel.
For more information, please reach out to your regular Pillsbury contact or the authors of this client alert.
Pillsbury’s experienced crisis management professionals are closely monitoring the global threat of COVID-19, drawing on the firm’s capabilities in supply chain management, insurance law, cybersecurity, employment law, corporate law and other areas to provide critical guidance to clients in an urgent and quickly evolving situation. For more thought leadership on this rapidly developing topic, please visit our COVID-19 (Coronavirus) Resource Center.