By Al Davis
Our firm was recently contacted by a company about a problem many businesses face at the moment: It had run out of cash. The company operates in a business sector which was impacted by difficulties specific to that industry, along with challenges caused by the pandemic and the unwillingness of the owners to keep funding losses. They wanted to discuss a wind-down plan.
In subsequent meetings, we learned that the business had a family-based board of directors, with one member of the board serving as the managing member. This individual had a plan to sell some of the assets of the company and use the funds to support the part of the company that could be profitable. The other members of the board disagreed with that plan.
Transparent Failures
In listening to board members who would talk with us (the manager would not), we learned of a number of issues which made the manager’s plan problematic. The first was that the board had not seen any financial statements for months. When asked why, the board members indicated that they had been asking for months, but the manager refused to release them. When asked who prepared them (an outside bookkeeper) the board did not know the contact information for the individual.
In addition, the company was only paying a partial payroll every pay period. When asked about the payment of payroll taxes, the board wasn’t certain. The company’s attorney had resigned, for reasons which were unclear, and there was no attorney advising the company at the time of our contact.
In looking at the company debt, there were liens on the equipment they proposed to sell, UCC filings against all assets by a bank, as well as an EIDL loan with personal guarantees. The board members were not sure which loans contained personal guarantees.
Seeking Restructuring Relief
Given the above and the internal disagreements, we strongly recommended that any restructuring or wind down be done with the protection of a court, meaning a bankruptcy filing or, under Washington law, an Assignment for the Benefit of Creditors (ABC) followed by a receivership.
We proposed an ABC and receivership, but the board members that we were talking with did not have enough information to complete the required information necessary to file with the court. The board decided to hold off on any action and retain a new corporate attorney. This is currently in progress.
We are using this example as a refresher on the fiduciary duties of directors and officers of a Washington corporation in financial distress. Please note that this overview is no substitute for advice of counsel regarding a company’s specific challenges.
• Under Washington law, directors and officers owe fiduciary duties of due care and loyalty. The duty of due care requires directors and officers to make fully-informed, good faith decisions in the best interests of the company. The duty of loyalty imposes on directors and officers the obligation not to engage in self-dealing and instead to put the interests of the company ahead of their own.
• When a company is solvent, the directors and officers owe their fiduciary duties of due care and loyalty to the corporation and its stockholders. That remains true even if the company is in the so-called “zone of insolvency.”
• When a company is insolvent and will not be able to pay its creditors in full, the directors and officers still owe their fiduciary duties of due care and loyalty to the corporation. However, upon insolvency, the creditors have the right to bring derivative claims for breach of fiduciary duty against directors and officers.
• Remember, it can be challenging to determine whether a company is just in the zone of insolvency (meaning still solvent but approaching insolvency) or whether it has crossed the line into actual insolvency.
• Discharging fiduciary duties when a company is insolvent means a focus on maximizing enterprise value. This is a highly fact-dependent exercise with no one-size-fits-all approach. In some cases, maximizing value may mean continuing operations — even though that burns dwindling cash — to allow the company to complete a sale which the directors believe is likely to close and produce significant value for creditors. In other cases, it may mean winding down (or even shutting down) operations quickly to conserve cash, especially if any asset sale is not expected to generate more than the cash required to pursue it.
• These complexities make it critical for directors and officers of a company in financial distress to get advice tailored to the specific facts and circumstances at hand.
Before Heading Down the Hill
If the board decides that the company needs to wind down, options range from an informal approach all the way to a public bankruptcy filing. Note that if the company owes money to a bank or other secured creditors, the lender’s right to foreclose on the company’s assets could become a paramount consideration and affect how the wind down is accomplished.
When a company’s cash is running out and there is no additional financing available, the board may conclude that a wind down is required to fulfill fiduciary duties and maximize value. The discussion above is a general description of certain wind down options. Determining whether any of these paths is best for a particular company is fact-specific and dependent on many factors. In all cases, be sure to get advice from experienced corporate and insolvency consultants and legal counsel when considering wind down or other restructuring options.
Al Davis serves as Principal at Revitalization Partners LLC, a corporate and board advisory firm that specializes in restructuring and receiverships. He is a Court Appointed General Receiver in the State of Washington as well as an interim CEO and advisor to middle market companies. He can be reached at adavis@revitalizationpartners.com or 206.903.1855.
