In recent testimony before Congress, Fed Chairman, Alan Greenspan, blamed what he quaintly labeled a "soft patch" in the economy on "the fallout from corporate malfeasance." Indeed, cases such as Enron have cast a dark shadow over the boardrooms of companies experiencing financial difficulties. In this environment, virtually all Chapter 11's raise the question of whether the filing was the result of true financial distress, or was the result of internal fraud rising to the surface. To be sure, actual malfeasance by officers or directors is rare, but Enron and its ilk have raised the level of suspicion and scrutiny. Any board considering authorizing the filing of a Chapter 11 petition must appreciate the old adage that "hindsight is 20/20."

Recognizing that a board's reaction will, in each instance, be governed by a unique set of circumstances, I will attempt to set forth some general parameters and suggestions for corporate governance in the face of financial difficulties.

The Legal Guidelines

Numerous court decisions have expanded a corporation's duty to encompass its creditors when it becomes insolvent. These cases hold that upon insolvency the corporation and its directors owe a fiduciary duty to the corporation's creditors.

These standards, while relatively easy to articulate, are virtually impossible to apply with any certainty. A brief examination of the concept of insolvency is illustrative. Is it equitable insolvency ?? the inability of a company to pay its debts as they become due in the ordinary course that triggers the shift? Or is it legal, or "balance sheet" insolvency in which liabilities exceed the value of the assets? What valuation standards will apply? How are liabilities to be calculated? Are contingent liabilities included, at their full value? Needless to say, the insolvency demarcation line is extremely fuzzy.

To further exacerbate matters, it is now generally accepted that the board's fiduciary duties shift when a company enters the "zone of insolvency." Unhappily, there are no signposts to inform a board when a company has entered the zone of insolvency.

The Duty and How to Meet It

In general, directors are expected to act in good faith in exercising their fiduciary duties and their decisions are protected by what is commonly known as the business judgment rule. When the duties shift, an insolvent entity must operate its business in a way that protects and conserves property for the benefit of creditors by applying the care, skill and diligence of an ordinarily prudent person in like circumstances.

Practical Advice

When a board or audit committee believes it might be in the zone of insolvency, extra attention should be focused on the following areas:

1. Financial Reporting. Disclosure is critical but there is a yin and a yang to disclosure. Too little disclosure may be found to be inadequate, but too much information may precipitate a "Henny Penny" crisis where none in fact exists, causing the unnecessary loss of customers, suppliers and lending relationships.


2. Internal Controls. Adequate controls and reporting systems must be in place, especially in the area of cash management.



3. Related Party Transactions. This is the most fertile area for attack on account of real or perceived abuses. Once fiduciary duties have shifted, transfers to insiders or preferred payments on loans guaranteed by insiders can threaten a company's ability to reorganize and can create potential liability for officers and directors.


4. Employment of Turnaround Experts and Insolvency Counsel. It is not uncommon for a troubled company to procrastinate in the engagement of insolvency professionals. Seeking professional assistance at an early stage will actually bolster confidence amongst the shareholder and creditor constituencies because it indicates that the board is being proactive. Moreover, this kind of proactive effort will help insulate the board from liability if a Chapter 11 proceeding is later filed. This last point underscores the message of this article ?? understanding and addressing an admittedly uncertain situation on a proactive basis is the best defense to a potential retrospective investigation should a troubled company become a Chapter 11 debtor.