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Zone of Insolvency: How To Conduct Business When Bankruptcy Is a Looming Possibility

Corporate boards of directors always have complicated business decisions to make. Those decisions become much more complex when the company approaches a “zone of insolvency.” The fiduciary duties of corporate officers and directors change when the company starts running out of money.

Even for small businesses facing financial trouble, any creditors may file derivative claims for any directors of an insolvent corporation for not acting in the best interests of the corporation. Facing creditors’ claims can put a business owner’s investments at risk. If your business faces insolvency or liquidation, talk to an experienced bankruptcy attorney for legal advice.

What Are the Fiduciary Duties of Directors of a Corporation?

Generally, the board of directors owes a fiduciary duty to the company’s shareholders. That means they must make decisions for the company based on a duty of care, a duty of loyalty, and a duty of good faith to the shareholders. In other words, the board of directors must act like reasonably prudent people would. It must make decisions based on the best interests of the company.

The directors must continue operating under the business judgment rule in a solvent corporation. That means they must act in the best interests of the corporation and shareholders. Once the business becomes insolvent, however, those duties shift to “residual stakeholder claimants,” including your business’s creditors.

How Boards of Directors Know They’ve Entered a ‘Zone of Insolvency’

The tricky part is the transition between solvent and insolvent, known as the “zone of insolvency.” Financial duties in this case depend on state laws.

For example, according to Delaware law, directors still have a duty to shareholders when Delaware corporations approach insolvency. If directors change their decision-making at this point, it could create a conflict of interest. While in the zone of insolvency, creditors generally cannot bring direct claims against the officers for breach of fiduciary duty.

It can be difficult to pinpoint a moment in time when a company becomes insolvent. It takes time for the financial books to reflect the business’s current condition. The zone of insolvency begins when the company is in financial distress and could be insolvent.

Generally, courts apply either a balance sheet test or a cash flow test to determine if the company is in the zone of insolvency or actually insolvent. Courts applying a balance sheet test will consider whether the company’s assets are greater than its liabilities. Courts applying the cash flow test will consider whether the company has enough cash flow to pay its bills and financial obligations.

Boards of Directors’ Fiduciary Duties to Creditors

Once a company enters the zone of insolvency, the board of directors continues to owe a fiduciary duty to the company’s shareholders. This can create a conflict of interest for the board because a decision may be in the best interests of all claimants, but they are not prioritizing shareholders.

In some states, the primary fiduciary duty shifts to the creditors once a company is in the zone of insolvency. In other states, the fiduciary duty doesn’t shift to creditors until a company reaches actual insolvency. In the remaining states, the boards of directors do not have to focus on creditor interests over shareholder interests, but they do have to protect the rights of creditors. In these difficult situations, boards of directors need to seek legal advice to avoid future legal problems.

A company does not have to seek the advice of creditors or tell them of the company’s financial troubles. This is true even if the board of directors owes the creditors a fiduciary duty. Likewise, boards of directors must focus on their fiduciary duties to all shareholders and creditors when answering questions about the company’s financial health.

What Decisions Can a Small Business Owner Make Before Filing for Bankruptcy?

Depending on the state, a small corporation could file for bankruptcy even when it prioritizes the claims of equity shareholders over creditors. It is possible to justify some risky business decisions for the benefit of shareholders even if it increases the risk of loss in creditors’ interests.

Small business officers and directors may still face fiduciary duty claims. They can come from lenders, secured and unsecured creditors, and stockholders. If your small business is facing financial trouble and you worry about personal liability or self-dealing claims from creditors, get advice from an experienced business bankruptcy attorney.

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