COVID‑19: potential liability of directors and officers of insolvent companies
April 21, 2020
The COVID-19 pandemic raises unique challenges not only for companies generally, but for their directors and officers personally. Corporate insolvency may be a looming and unexpected threat in the face of restricted operations and the liquidity crunch resulting from significant revenue declines (including from sales declines and challenges collecting receivables) and increased costs (such as those driven by transitioning to a remote work force, keeping employees safe and workplaces operational, and downsizing).
The pressure on directors and officers is two-fold: a) increased emphasis on the discharge of their fiduciary duties and the prospect of heightened scrutiny—including with hindsight at a future date—of present decision-making; and b) potential personal liability of directors and officers for certain obligations of the company. Directors and officers of non-profit organizations should be aware that similar considerations and risks apply to them.
We explore key considerations for directors and officers as they navigate companies through the choppy waters brought on by the crisis.
Insolvency is of particular concern for directors and officers because: a) there may be heightened risk of personal liability in such circumstances, including by reason of additional duties or obligations arising under applicable insolvency legislation; b) some protections customarily available to directors and officers—such as indemnification from the company—may be of little or no comfort where the company is insolvent; and c) the ensuing financial losses that may be suffered by creditors and shareholders of the company, together with the public court process that accompanies formal insolvency proceedings, typically results in the conduct and activities of directors and officers in the lead-up to and during insolvency receiving much greater scrutiny, often with the benefit of hindsight.
Where insolvency occurs, certain claims may be made against the directors and officers personally (which claims vary by jurisdiction), including:
- claims by employees arising from their employment—for example, unpaid wages and vacation pay, and in some jurisdictions also unpaid claims for severance and termination entitlements;
- claims by the company (and trustees in bankruptcy) against directors who vote for or consent to payments of dividends or redemptions of shares when the company is insolvent or rendered insolvent as a result and without reasonable grounds for the directors to have believed otherwise;
- claims by governmental entities for the failure to deduct, remit and pay requisite taxes and certain payroll and other source deductions (i.e., amounts deducted from employee wages on account of pensions, unemployment insurance, and income tax);
- claims in respect of outstanding pension obligations;
- claims in respect of environmental obligations; and
- claims in respect of an offence by the corporation under bankruptcy and insolvency legislation, where a director has directed, authorized, assented to, acquiesced in or participated in the commission of the offence.
In addition, directors and officers may be personally liable if the company conducts business while insolvent. Accordingly, directors and officers ought to ensure that the company carries on business only if it can meet its liabilities as they become due and there is a reasonable expectation of newly incurred obligations being satisfied. That may be particularly challenging in the midst of the COVID-19 pandemic, given the high degree of uncertainty that exists.
Directors and officers of insolvent companies also face heightened risk under their corporate duties of loyalty and of care. Although they do not owe a fiduciary duty to creditors, they must consider the interests of creditors as well as the interests of shareholders and other stakeholders. However, in these circumstances, the interests of these different constituencies may conflict; therefore, directors and officers face the difficulty of balancing competing interests without definitive criteria to guide their decision making.
In addition, directors and officers of public companies are likely to face difficult decisions regarding the timely disclosure of material information in the context of a potential insolvency and the impacts of the COVID-19 pandemic on the company.
Steps to consider
Directors and officers of companies experiencing financial difficulty should take heightened measures to protect themselves, including seeking timely legal advice. Typically, actions that would involve changes to the company’s financial course of conduct should be taken well before the financial difficulties of the company become acute, because changes made while the corporation is insolvent, or on the eve of insolvency, may later be reviewed and even reversed. That timeline may be highly accelerated in the midst of the COVID-19 pandemic. In addition to taking necessary steps to demonstrate due care and diligence in all their decision making, directors may wish to take special steps that include the following:
- review and enhance corporate governance systems and protocols, and ensure that minute books and corporate records are current and well-maintained;
- ensure that the financial reporting and payment systems of the company are operating appropriately and that reports are being received by directors on an accelerated basis so that they can monitor key financial numbers on a real time basis;
- ensure that management is properly directed, equipped and empowered to address the challenges facing the company, including obtaining additional expertise / skillsets if needed to navigate financial distress;
- make optimal use of available time and resources / liquidity, including commencing the pursuit of restructuring, refinancing, recapitalization and other strategic initiatives in a timely manner (even if only contingencies);
- increase the frequency of board meetings and enhanced reporting to the board by management;
- review emergency planning and systems intended to permit operations to continue remotely—cyber-security and privacy considerations may be particularly important to ensure that systems are not compromised during this pandemic;
- ensure that segregated trust accounts and remittance procedures have been established to adequately provide for wages, taxes, source deductions and other statutory trusts;
- have all director dissents to board resolutions noted in the minutes of the meeting;
- balance short-term liquidity needs with long-term viability considerations—in particular, incurring significant additional debt may address an immediate liquidity need but ultimately threaten long-term viability if the company does not have the means to manage an increased debt-load;
- obtain appropriate professional advice, including legal advice, and prepare for the possibility of a bankruptcy or insolvency filing under applicable legislation;
- be especially mindful of making requisite disclosure and avoiding potential misrepresentation allegations, including with respect to the impact of COVID-19 on the business;
- review the scope of any directors and officers’ liability insurance and give notice under such insurance of any potential claims and ensure that appropriate coverage (including run-off insurance) is in place;
- ensure that the company has entered into an indemnity agreement with each director, as permitted by the by-laws and the relevant governing statute—recognize, however, that in an insolvency, such an indemnity may be of limited or no value;
- where appropriate, charge unencumbered corporate assets, or obtain third-party guarantees or indemnities, to stand as security for the payment of amounts for which directors may be liable; and
- if necessary in extreme circumstances, resign.
In appropriate cases, directors and officers should consider retaining independent legal counsel to advise them on how to protect against personal liability in the circumstances.
In many instances, there are “safe harbours” for directors and officers, including due diligence defences and deference to informed business judgments. Attending to the foregoing considerations and obtaining timely legal advice will assist directors and officers in obtaining the benefit of these “safe harbours” and otherwise mitigating the risks to which they are subject.