Board risk management when on the brink of insolvency

In recent years, the world and the business landscape has been tested, managing risk and change at an accelerated speed, and at times, undergoing significant transformation. Boards of directors are now grappling with a host of unprecedented challenges never previously on the agenda. Amidst the complexity that directors now face, the situation becomes even more daunting when dealing with corporations teetering on the edge of insolvency. 

A convergence of factors, such as the global economic slowdown, geopolitical tensions, the end of government pandemic financial aid, surging borrowing costs, inflation, rising energy prices, supply chain bottlenecks, production and labour issues, and diminished M&A activity, among others, are contributing to an upsurge in the number of insolvent corporations. 

When confronted with these challenges, boards will be acutely aware of how they might impact the company's solvency – and addressing solvency issues also means directors must recognise the additional implications it brings to their already significant responsibilities. 

The difficulty for directors lies in balancing the interests of diverse stakeholders within and outside their organisation. These stakeholders encompass the company itself, its creditors, its shareholders, and sometimes even the company's customers. Consequently, directors are increasingly required to take into account a growing number of new stakeholders and their varied interests while managing the company. 

Director obligations 

When facing financial difficulties, boards must operate within the bounds of their authorised power and increasingly face new risks, should they not do so. More and more, directors are being personally held liable for any losses resulting from their decisions and actions they take. All decisions made by directors must align with their statutory and fiduciary duties. 

Statutory and common law duties are derived from the laws of each country or subnational jurisdiction. Although specific duties may vary, in general, a director's obligations include: 

• Duty of care to the company – Making well-informed and deliberate decisions with cohesion. Directors must establish a robust decision-making process, demonstrating reasonable care, skill, and due diligence in a commercially sensible manner. 
   
• Duty of loyalty – Acting honestly and in good faith for the corporation’s best interests, avoiding conflicts of interest, and exemplifying good corporate citizenship. Directors must work as a cohesive board, making impartial and collective decisions. Their choices must not be influenced by self-interest or self-dealing. In case of any actual or perceived conflicts of interest, directors must disclose them and abstain from voting or participating in discussions related to the matter. 

Keeping a record of all board meetings in the form of minutes is crucial in order to demonstrate their activities transparently. 

Board decision considerations 

Typically, board decisions rely on company information based on the records maintained by management. However, the constantly changing demands of compliance increase the burden on directors to stay informed about regulations and any associated compliance processes. This may also prompt boards to seek third-party evidence supporting management's activities, such as government filings. Consequently, boards need to be proactive in carrying out their duties. 

If a board's decision ends up facing legal challenges, a common defence for directors is the business judgment rule. This rule assesses the reasonableness of the decision-making process and the rationale behind those decisions. While each case is unique, boards can mitigate potential accusations by acting in good faith, making commercially sensible decisions, and meticulously documenting their actions in meeting minutes. The information in these minutes should support the prudence and diligence the board takes in reaching their decisions. 

Insolvency and director responsibilities 

When companies approach the "insolvency zone," directors must carefully consider its impact on their responsibilities. Determining the exact point when a company transitions from solvent to insolvent might not be clear-cut. Still, when directors sense that insolvency is looming, the focus should shift to ensuring they do not breach their fiduciary duties - as a bare minimum. 

For instance, in an insolvency scenario, the company's primary stakeholders become its creditors rather than shareholders. This may prompt directors to explore alternative viewpoints and options. 

As the company approaches the "insolvency zone," board meetings often revolve around reviewing short-term cash flow projections, closely monitoring actual results against projections, assessing management's cash management activities, and confirming the sufficiency of Directors' and Officers' (D&O) insurance coverage. The board should also explore all available alternatives, including potential sales and mergers, and seek independent professional advice in restructuring and legal matters to guide them through the challenging decisions. 

Potential liability for directors and officers 

Directors and officers need to be conscious of their potential personal liabilities, especially as the company nears insolvency. It becomes even more crucial to maintain D&O insurance coverage. Additionally, directors can consider having the corporation establish an indemnity trust and securing protections through a court order if the company proceeds with a formal restructuring. 

As companies approach insolvency, directors must be wary of the corporation's statutory liabilities. Depending on each jurisdiction's laws, directors could become personally liable for unpaid payroll source deductions, wage arrears, vacation pay, harmonised sales tax, provincial sales tax, environmental obligations, pension benefits, and income tax. 

In the case of public corporations, directors need to be well-versed in securities laws relevant to their jurisdiction, which outline their responsibilities concerning misleading information, material misstatements, and disclosure of material facts. Furthermore, directors must be acquainted with insolvency legislation that addresses issues like dividend payments when a corporation is insolvent and payments to creditors or related parties within specified timeframes. 

Facing insolvency can be a nerve-racking experience, especially for smaller or middle-market companies needing more experienced boards of directors. It is essential to remember that directors are entitled to seek assistance in carrying out their responsibilities. A board of directors is not expected to have all the answers, and if they lack the knowledge or expertise to handle a particular issue, seeking external assistance from professional restructuring advisors is a prudent course of action. 

If you require any further information or support, please contact Graham Bushby.