FINANCIAL DISTRESS OR FRAUD?

Putting Pre-Petition Governance to the Test

By Deborah M. Buell, Cleary Gottlieb Steen & Hamilton, and Mohsin Y. Meghji, Loughlin Meghji + Company

Enron, Adelphia, and WorldCom have changed the landscape for directors of financially troubled companies. In the wake of recent scandals and screaming headlines, the reliability of pre-petition corporate governance is being put to the test. Is it only financial distress, or is it internal fraud that is beginning to show itself? In today’s environment, boards of directors are expected to move quickly and aggressively to answer those questions.

Standards for corporate governance of financially troubled companies in a pre-petition period are well defined in case law, although they are often difficult to apply in practical, real-world contexts. Fiduciary duties, zones of insolvency, and preservation of corporate assets are concepts that boards and their restructuring advisors have worked with well before the current wave of scandals.

But only in the occasional case has alleged malfeasance by officers or directors been such a central part of the problem. The eye-opening track records of Enron, Adelphia, and WorldCom, however, should compel proactive boards faced with increasing signs of financial pressure to consider that possibility. A board that is contemplating filing Chapter 11 also must be cognizant of the potential for significant retrospective scrutiny. In recent cases, requests to appoint an examiner have become commonplace.

How a board’s focus expands obviously depends on its unique circumstances, but in the general context of concepts of corporate governance as applied to financially troubled companies, this article offers some ideas. First, however, it reviews some of the core legal and financial governance guidelines for financially troubled companies in the pre-petition period.

Legal Standards

In general, the board of directors of a corporation is responsible for overseeing the company’s management and business affairs. In carrying out these tasks, directors are considered to stand in a fiduciary relationship to the corporation and its shareholders. Broadly speaking, the fiduciary duties governing the board’s actions on behalf of the corporation fall under two categories: the duty of loyalty and the duty of care.

Under the first category, directors are expected to act in good faith in a manner reasonably believed to be in the best interests of the corporation and its shareholders. A disqualifying conflict of interest can exist if a director is "controlled" by a party to a particular transaction. In situations of insolvency, at least one case has held that directors who are "imbued with" the interests of a particular shareholder have a conflict of interest in making decisions that also impact creditors.

Under the duty of care, directors are expected to consider all reasonably available material information and to act with requisite care in making decisions.

In reviewing business decisions, courts in most jurisdictions generally defer to the judgment of directors. Under what is commonly known as the "business judgment rule," directors who are not subject to a disqualifying interests are entitled to a judicial presumption that they acted on an informed basis, in good faith, and in the honest belief that the action in question was in the corporation’s best interests. A shareholder who challenges such a decision in court bears the legal burden of proving that the directors breached their fiduciary duties. The business judgment rule thus forms a key aspect of the duty of care.

How do these fiduciary duties change during the pre-petition period? It is widely accepted that a board of directors’ duties — which normally are exclusively to the corporation’s shareholders — shift to the company’s creditors once the corporation becomes insolvent. That shift was defined by the Delaware Chancery Court in Geyer v. Ingersoll Publications as taking place when a corporation "has liabilities in excess of a reasonable market value of assets held" or "is unable to pay its debts as they fall due in the usual course of business." Directors are then considered trustees for the corporation’s creditors, and the board is expected to preserve the company’s assets accordingly.

It is likewise accepted that a board’s duties shift once a corporation enters what has been termed the "vicinity of insolvency." In Credit Lyonnais Bank, N.V. v. Pathe Communications Corp., a shareholder who owned 98 percent of a troubled company’s stock sued the board of directors for breach of fiduciary duty over its refusal to approve the sale of the company’s assets at a price it deemed to low. The proceeds of the sale could have been used to pay off bank debt, thereby restoring the shareholder to a position of control.

The Delaware Chancery Court found no breach of fiduciary duty, noting that "where a corporation is operating the vicinity of insolvency, a board of directors is not merely the agent of the residue risk bearers, but owes its duty to the corporate enterprise."

The court further observed that "in managing the business affairs of a solvent corporation in the vicinity of insolvency, circumstances may arise when the right (both the efficient and the fair) course to follow for the corporation may diverge from the choice that the stockholders (or the creditors, or the employees, or any single group interested in the corporation) would make if given the opportunity to act." The Credit Lyonnais case can thus be understood as representing the idea of shifting responsibilities to a larger community of interests in the pre-petition, vicinity-of-insolvency context.

Most courts have held that once a shift in fiduciary duties occurs, a debtor in possession must operate the business in a way that protects and conserves property for the benefits of creditors by applying the care, skill, and diligence of an ordinarily prudent person in like circumstances. In other words, the duties of loyalty and care are now owed to the creditors, not to the corporation’s shareholders.

But there remains a margin of uncertainty in that period in which a corporation can be said to be in the vicinity of insolvency: what duties do directors owe to creditors then, and when precisely are they triggered?

A recent case shed some light on this question. In Re Ben Franklin Retail Stores, Inc., involved allegations that directors of a corporation in the vicinity of insolvency overvalued receivables to convince the company’s creditors to lend it additional funds. When the corporation eventually filed for bankruptcy, the trustee brought a claim on behalf of the unsecured creditors against the board for breach of fiduciary duty.

In ruling against the trustee, the court observed that, absent bad faith, self-dealing or fraud, "directors do not owe a duty to liquidate and pay their creditors when the corporation is near insolvency." Noting the contradictory interests of shareholders and creditors in such a situation and citing Credit Lyonnais approvingly, the court therefore essentially upheld the application of the business judgment rule in the pre-petition period.

Financial Oversight

Financial oversight for troubled companies is challenging in the best of times. This is usually compounded by the strain on a company’s management team during times of distress, when it is focused not only on dealing with the issues around liquidity, financing, and potentially sorting through transactional alternatives, but also with attempting to keep the business running as steadily as possible.

During times of financial distress, its is critical that the board and its audit committee in particular provide independent oversight and checks and balances on the management team and its advisors, even if the frequency of board/audit committee meetings must increase. Key areas of risk on which a board and its audit committee should focus include:

1. Internal Controls. While the law clearly recognizes that non-management directors are not expected to participate in the day-to-day affairs of a company, this must be balanced against the requirement that a board take reasonable steps to ensure that adequate internal controls and reporting systems are in place within a business enterprise.

During times of financial crisis, it is especially critical that the board/audit committee exercise basic diligence in overseeing that the company’s internal controls continue to function effectively. This diligence could include discussions with management, external auditors, and other external consultants/advisors, and commissioning specific reviews by the internal audit group.

2. Cash Management. In times of financial distress, cash management generally has the greatest potential risk for a company. It is critical that management and the board assess personnel who handle the cash-management system to determine whether this function is adequately staffed and appropriately controlled. Frequently, an early diagnosis of issues in this area leads to hiring of external advisors, sometimes with some prompting by creditors (usually lenders).

 

3. Financial Reporting. Recent high-profile lapses related to financial reporting issues have significantly raised the bar in terms of the nature, extent, and clarity of financial reporting that troubled companies, particularly public companies, should provide. Recently, a number of companies have openly declared in public disclosures that they are contemplating filing Chapter 11. Such a decision obviously must be balanced against concerns relating to the impact of "overdisclosure" on enterprise value, but these public declarations nevertheless signal that better disclosure is on the rise.
4. Confidentiality and Communications with Creditors. Federal law prohibits corporate insiders from buying or selling securities when they possess material undisclosed information about a company. It is important that appropriate safeguards are in place to ensure that sensitive information is not inappropriately communicated to anyone within or outside an organization.

Confidential information should be shared on a need-to-know basis except for the most senior managers. Employees who are privy to inside information should be given clear guidelines on activities that are permissible and what prior authorizations are required. Typically these involve clearance by the general or outside counsel.

5. Related-Party Transactions. An area of frequent abuse in times of distress, related-party transactions should be reviewed to identify potential inappropriate or unauthorized inter-company transactions or self-dealing. These types of issues are frequent targets of Chapter 11 litigation. They can threaten a company’s ability to reorganize and create potential liability for directors and officers.

 

6. External Counsel and Advisors. It is not uncommon for company management in times of distress to resist outside assistance without prompting from the board or other stakeholders, such as shareholders and creditors. Reasons for this range from absolute denial to strong self confidence in management’s ability to work through the problem. This is clearly an area in which a board must make an unemotional assessment of management’s ability to deal with issues facing the company and seek appropriate assistance from external sources. Timely decisions on these issues can help build credibility with stakeholders.
7. Strategic and Contingency Plans. Creditors frequently accuse boards and company management of delaying the filing of bankruptcy cases. While there is no simple formula for determining the perfect time to file Chapter 11, a company opens itself to accusations of delay when it pursues transactional (sale or merger) alternatives without making appropriate and timely contingency plans for a bankruptcy filing.

Post-Enron

Corporate governance in the post-Enron world will carry with it draconian sanctions, especially for chief executives and chief financial officers under the Sarbanes-Oxley Act. How can a board that is already addressing issues of financial stress best protect the corporation from scandal as well?

Clarity, Not Complication. Ensure that the company’s financial disclosure practices are simple and understandable. Overly complicated financial statements — as Enron, Adelphia, and WorldCom have shown — can be recipes for disaster. Requiring that expressions of a company’s financial condition and comments about that condition are kept simple helps flush out suspects transactions or accounting treatments. A lesson to carry into the post-Enron world is that overly complicated financial transactions may conceal problems.

Early Investigation. If suspicious activity is identified, a board must investigate early, aided by either internal auditors or outside advisors reporting directly to the board. Early efforts to determine the facts contributing to a hard-to-understand situation not only move forward possible solutions, but also can strengthen the integrity of the governance process.

Preservation of Potential Evidence. One advantage of early internal inquiries is that they often help a board identify and preserve relevant documents. The prosecution of Arthur Andersen in the Enron case underscores the importance of preserving potential evidence. Document-retention policies —and implementation procedures for those policies —should be reviewed and evaluated routinely.

Disclosure. For a financially troubled company, disclosure can be a double-edged sword. Too little disclosure is deemed inadequate; yet, too much disclosure can create a run on the bank, precipitating the very crisis the board is seeking to prevent. With increased understanding in the business community, however, financially troubled companies increasingly are reporting in a straightforward manner the factors creating financial pressures and their consequences, including potential Chapter 11 filings.

If an investigation uncovers and error in the financial reports, prompt corrective actions are nearly always required. While acknowledging and correcting errors cannot change the past, these actions can do a great deal to improve the prospects for the future, including enhancing the credibility of corporate managers.