As a corporate officer or director, the only way to take a bad situation like bankruptcy and make it worse is to be confronted with personal liability for the company’s debts, when you could have taken simple steps to position yourself better. Senior management must pay close attention to specific responsibilities and the resulting potential for liability when insolvency is on the horizon. This is especially important during the COVID-19 pandemic when bankruptcies are on the rise.
The most common but preventable mistake companies make when contemplating bankruptcy is not filing soon enough. Perhaps counterintuitively, the company needs cash to get through a bankruptcy filing. You can’t pay all of your creditors, but you still need cash for some critical items. In addition to needing cash to address unpaid wages and taxes, your bankruptcy attorney will need a substantial retainer before any filing will occur.
The decision to wind down a company involves more than a company’s management team: the board of directors will also be involved. As you consider the timing of either a bankruptcy filing or an out-of-court wind down of the company, differences of opinion may emerge, as the various board members and officers may have differing incentives. For example, some board members may be investors who are indemnified by the ownership groups they represent. These board members may be more comfortable letting a failing company continue to operate as the cliffs loom, in the hope that a last-minute bet might pay off, leading to a better return for their investment. Indeed, there is some support in the case law for such an approach, so long as the “business judgment” of the officers and directors is exercised appropriately. However, we are aware of at least one pending case where a Creditor’s Committee has asserted that the directors and officers breached their duties by not filing the bankruptcy case six months earlier, before the crucial Christmas selling season.
However, if you are a corporate officer without an indemnification arrangement with a third party, your timing calculation may well be different. Specifically, you will want to understand how much runway you have and the company’s likely actual shutdown costs or you may be looking at tricky situations including personal liability for unpaid wages and employment taxes.
Ounce of Prevention
Be diligent about taking good meeting minutes when your company is distressed. It is common for officers and directors to meet (including with outside advisors) much more frequently when a company is sinking—sometimes as often as daily. With so much going on, documenting multiple short meetings, who attended, and what was discussed may be a burden, but it is always a best practice and can be valuable evidence of how the board and officers discharged their duties of care and loyalty at the moment. Once in bankruptcy, companies enjoy a stay on most litigation, but disgruntled creditors and others can still sue directors and officers. Having detailed notes or minutes that give evidence of your diligence can go a long way to deflect these lawsuits.
A directors and officers (D&O) insurance policy can cover many liabilities you may face during bankruptcy. For example, such a D&O insurance policy can pay your legal fees if you are sued when your company goes bankrupt. Hopefully, your company has worked with an insurance broker that specializes in D&O insurance, since the bigger your company, the more customized these policies can be.
Potential Personal Liability
Unfortunately, there are items that may not be covered by even the best D&O insurance policy. Unpaid employee wages and unpaid employment taxes head this list. Officers could also face potential personal liability for unpaid wages. The Fair Labor Standards Act of 1938 (FLSA) is one such law that could impose personal liability for unpaid wages and for misclassifying independent contractors or employees.
Certain types of taxes left unpaid can also trigger personal liability. Payroll taxes and related payroll expenses must be withheld and remitted during a company wind down so that is not an issue in the future.
The Worker Adjustment and Retraining Notification Act of 1988 (WARN) Act is a federal law that requires most employers with 100 or more employees to give a 60-day notice in advance of mass layoffs or plant closings. Some state law versions can be more stringent. It is important to pay attention to the WARN Act and its state-law equivalents. In certain, limited circumstances, violations could result in assertions of personal liability for officers and directors. There are exceptions to the notice requirements. The federal government and some state governments (like California) have stated that the current COVID-19 pandemic will trigger exceptions. In those cases, the "unforeseen business circumstances" may relax the 60-day notice requirements.
When a company is in serious trouble, the best-case scenario is selling or winding down the company when there is still enough cash to meet critical obligations, including obligations to employees and tax collectors. You can avoid compounding your misery by taking a few steps to avoid personal liability: take a clear look at the situation, understand your obligations, and mitigate some of the risks described in this article.
Please visit our COVID-19 Toolkit for all of Taft’s updates on the coronavirus that includes specific articles related to distressed companies.
We will continue to provide any guidance on companies under distress. If you have additional questions our Distressed Company Task Force can answer, please email email@example.com.