8 Ways to Limit the Liability of Directors of a Distressed Private Company, an Executive Summary

Since the emergence of the COVID-19 pandemic in March, 2020 and the resulting disruption to retail, hospitality and other industries, and the more recent severe disruptions in the international supply chain, many businesses are experiencing severe challenges. And most directors of private companies know that when the company begins to experience financial distress, they need to be especially vigilant to avoid breaching their fiduciary duties of loyalty and care.

This Executive Summary of a more detailed article (available in full in the PDA Body of Knowledge) describes these fiduciary duties as they are generally understood and applied under Delaware law. It also considers when and how not only the company and its ownership, but also the company’s creditors, may be able to bring actions against the company’s directors.

In light of these considerations, the full article then describes a series of actions that the prudent board of directors should take to limit its exposure for breach of fiduciary duties when the company is at risk of becoming insolvent. These actions include:

1. Research the Applicable State Law on the “Zone of Insolvency” and Directors’ Fiduciary Duties to Creditors. The rule in Delaware (where many companies are formed) is that a company’s approach into the “zone of insolvency” doesn’t afford its creditors any special rights or status to assert claims for the directors’ breach of a fiduciary duty. Yet, other states may have different views on this contentious issue, imposing special duties to creditors. If any such duties exist under the applicable state law, they must be taken into account in board deliberations. Otherwise, the board should be laser-focused on the interests of the company itself and the preservation of the value of its assets and business.

2. Make a Record of the Board’s Careful and Thorough Consideration of the Company’s Financial Situation and its Alternative Paths Forward.  To protect itself against challenges, the board should have strong evidence that it fully investigated the company’s financial situation. This includes having gathered all relevant facts as to the company’s capital requirements, reviewed the accuracy and reliability of the facts as presented, inquired of management as to the alternatives for raising capital, and assessed the benefits and detriments of each of these alternatives. Consider if the company should be required to engage an independent financial advisor to assist with strategy. Minutes of board meetings should indicate that the board engaged in meaningful deliberations with regard to all of these matters.

3. Have Interested Directors Recuse Themselves. The fiduciary duty of loyalty requires that a director not participate in decisions that benefit the director’s own interests at the expense of the company. A director in a conflict position should avoid attending any meeting where the subject of the conflict is raised, avoid participating in any deliberations of the matter and have the minutes reflect that the director was recused and did not deliberate or vote on the matter.

4. If Possible, Form an Independent Special Committee of the Board.  If the company is proposing to engage in a transaction with a controlling owner or if a majority of the board is “interested” in the transaction which is under consideration, Delaware’s stringent “entire fairness” standard is likely to be applied when reviewing the board’s decision to approve the transaction. Consider whether it is possible for the company to establish a special committee, consisting of independent and disinterested directors, which can be empowered to evaluate, negotiate and approve the transaction and its material terms. If so, then any party challenging the transaction will have the burden of proving that the transaction was not “entirely fair.”

5. Obtain Approval from a Majority of the Disinterested Ownership.  Again, if the company has a controlling owner, the board should consider if the transaction under consideration may be reviewed and approved by the equity holders with a majority of the votes held by the company’s disinterested equity holders. This is the other way to shift the burden of proof to any party that might challenge the transaction.

6. Allow Minority Equityholders to Participate in any New Investment.  Whether or not any minority owners have “preemptive rights” which would allow them to invest on a pro-rata basis in a proposed capital infusion, consider inviting them to participate. This will soften any future challenge based on a claim that the new equity interests were sold as a below-market price, or otherwise on terms unfavorable to the minority owners.

7. Make Reasonable Efforts to Secure Outside Investors.  Whenever a distressed company is in need of emergency capital, the most likely source of funds is an existing owner. But when minority ownership is in place, a fresh investment by the majority owner may be challenged as unfair to the minority owners in its pricing or other terms. But if the board undertakes good faith efforts to secure capital from an independent party, the true market value can be ascertained. Then, whether the investment is made by the independent party or on matching terms by the majority owner, the fairness of the transaction is readily measured.

8. Get a Fairness Opinion.  If time allows and the company’s budget can support it, the board or special committee should consider engaging an independent financial advisor to review the proposed transaction and to deliver a formal opinion on the fairness of the price and terms to the minority owners. If a fairness opinion has been prepared by a respected financial advisor afforded a reasonable amount of time to conduct its due diligence and deliver its opinion, it can greatly enhance the defense of any challenge to the transaction.

Serving on the board of a privately-held company is certainly an honor, but it comes with duties and the attendant risk. To manage that risk, directors should take these duties seriously—in a privately-held company no less than in a publicly-traded one—and zealously discharge them for the benefit of the company to maximize the value available for all of its stakeholders.



Bruce Fox is a partner in the Corporate & Securities practice group of Neal Gerber Eisenberg, a Chicago-based law firm. Throughout his career he has counseled businesses and their ownership and boards of directors in all aspects of their affairs, including corporate governance, mergers and acquisitions, cybersecurity, strategic alliances, intellectual property rights, and more. His clients operate in many industries, including information technology, manufacturing, distribution, healthcare, law, broadcasting and construction.
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