by John F. Higgins and James Matthew Vaughn
Porter & Hedges, L.L.P.
The Houston Business Journal
Business Survival Guide
June 6, 2002
One of the questions that a board almost always raises when the specter of bankruptcy looms on the horizon is what duties do I have to creditors? Generally, directors of a solvent corporation owe a fiduciary duty only to the corporation and its shareholders, while debtholders and other creditors are left to rely on the protections, if any, in their debt instruments or contracts.
The differing duties owed to creditors and shareholders are explained by the differing rights of the two constituencies. Shareholders, as the owners of the residual value of the company, have an unlimited return on their investment. Shareholders, however, have no downside protection. Because the shareholdersâ€™ investment is subject to discretionary board action, shareholders (other than preferred shareholders) are without any fixed return. By contrast, creditors, whose returns are fixed by agreement, have priority over shareholders in the repayment of their debts. Shareholders generally have no right of direct action against the board of directors or the corporation. Creditors, however, may enforce their rights directly and in their own names.
At the point in time where a corporation is unable to pay its debts in the usual course of business, or the point where the corporationâ€™s liabilities exceed the reasonable market value of its assets, directors must consider their fiduciary duties to creditors. Upon insolvency, the directors become â€œtrusteesâ€ for the creditors and hold corporate assets as a â€œtrust fundâ€ for the benefit of creditors and shareholders. This exception to the â€œnormalâ€ duties of a board of directors of a solvent corporation is exactly that, an exception, which exists only to protect the contractual and priority rights of creditors. This concept arises from the belief that creditors have a right to expect that directors will not divert, dissipate or unduly risk assets necessary to satisfy their claims.
Directors are able to understand the expansion of their responsibilities to act on behalf of both creditors and shareholders. The difficulty facing directors is determining the exact moment when the shift in duties occurs. The change typically is determined by one of the following tests:
Liquidity Test. Under this test, a corporation with assets in excess of liabilities may still be viewed as insolvent if, because of cash flow problems or inability to secure working capital financing, it is unable to service trade debt or the current portion of long term debt as those obligations come due.
Appraised Value. Under this test, a corporation will be found insolvent if the fair market value of its assets is less than the fair market value of its liabilities. There is a wide range of valuation methods that may be employed for these purposes. Appraisals or valuations must be made of assets as well as liabilities. For example, in â€œvaluingâ€ liabilities, the balance sheet amounts may need to be increased for contingent liabilities which, under generally accepted accounting principles, need not be reported in the body of financial statements, and similarly may be decreased for expense reserves, deferred items, and similar items which, realistically, may not have to be paid.
Balance Sheet Method. Because generally accepted accounting principles permit balance sheet items (with certain exceptions) to be valued at historically cost, balance sheet valuation for non-current or fixed assets are inherently unreliable. Similarly, long term liabilities may be subject to discount, changes in estimate, etc., which may not be reflected in the balance sheet accounts kept in accordance with generally accepted accounting principles. However, historical cost is an accurate reflection, generally, for current assets and liabilities. Depending upon the type of business involved, a court may determine insolvency by means of an evaluation of a balance sheet.
Because calculation of solvency is not a precise science, it is almost impossible to fix the moment of insolvency. However, management should keep these valuation methods in mind while discharging their obligations.
When a corporation is nearly insolvent, certain corporate decisions such those regarding long-term contracts, long-term borrowings, or sales of major assets, affect the interests of creditors and shareholders differently. Thus, where a managerial decision can swing a corporation from solvent to insolvent, or vice versa, prudent officers and directors discharge their fiduciary duty both on behalf of the creditors and shareholders. At least where a corporation is operating in the vicinity of insolvency, the board of directors is not merely the agent of the residual risk bearers, i.e., equity, but owes its duty to the corporate enterprise.
The corporate enterprise consists of numerous interests that must be protected to maintain the overall business. Directors must recognize that in managing the business affairs of a solvent corporation in the vicinity of insolvency, circumstances may arise when the right 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. Thus, directors of a corporation on the brink of insolvency owe a duty to the enterprise, not to shareholders alone, at least where the interests of shareholders conflict with those of the enterprise.
This article, in slightly different form, was originally published in the Houston Business Journal, Business Survival Guide, June 6, 2002.