Governance in the zone of insolvency: what changes?

 
When distressed circumstances do arise, it is critical to ensure that best practices are in place and adhered to. Often, there may be little time in a crisis to consider and adopt new governance practices given the speed at which events may unfold. Directors need to get it right, and quickly.

A shift in focus for directors, not a shift in good business sense

So, what changes for directors when the specter of insolvency arises?

• In some respects, nothing changes. Directors owe the same duties to the same persons and—contrary to what is often erroneously believed (due in part to differing laws in the U.S.)—there is no “shifting of duties” from shareholders to creditors under Canadian law. Fiduciary duties are owed at all times to the corporation (not shareholders), and discharging these duties requires consideration of all stakeholder interests (i.e., shareholders, creditors, employees, retirees, pensioners, the environment, customers and governments).
• Which stakeholder interests take priority in any given scenario depends on a director’s business judgment. Courts will defer to directors’ reasonable business decisions so long as they are within a range of reasonable alternatives and made by unconflicted directors (known as the “business judgment rule”).
• While a director’s duties do not shift to creditors upon insolvency, the interests of creditors may be given greater consideration and weight by directors in distressed circumstances.
• Canadian law includes the oppression remedy, which protects the reasonable expectations of stakeholders (including creditors). Directors therefore need to be mindful of respecting reasonable expectations.
• What does change in the zone of insolvency is: 1) the scrutiny brought to bear on whether and how directors discharge their duties; and 2) the severity of the consequences to both directors and their corporations should those duties not be properly discharged. In distressed circumstances, stakeholders that are adversely affected may look to cast blame on, and recover losses from, directors that they believe ought to be accountable. Should formal insolvency proceedings occur, the courts and other actors in the insolvency process (e.g., trustees in bankruptcy, receivers, monitors) may also scrutinize the past and present conduct of directors.

Practical steps for directors of distressed companies

While that may seem intimidating, managing the risks arising in distressed circumstances is not a daunting task. In addition to complying with fiduciary duties and stakeholders’ reasonable expectations, the following are actions that directors can take to minimize their personal liability exposure in distressed circumstances:

• Have the right people in place. Ensure proper management qualification and oversight. Ensure that the corporation has adequate internal controls and that directors are receiving the information they need on a timely basis.
• If governance or management deficiencies are identified, address them in a timely manner.
• Pay attention. Meet regularly (more often in distressed circumstances). Direct strategy and ensure to the extent possible the company’s compliance with its obligations.
• Engage and rely on appropriate advisors (legal, financial, etc.).
• Act in a timely manner, especially where the company may not be able to meet its obligations. Embrace contingency planning early.
• Make informed decisions after relying on all reasonably available information and guidance from advisors. Consider all reasonable alternatives instead of narrowly considering only a single course of action.
• Identify and avoid conflicts of interest and the appearance of conflicts, relying on independent directors and/or committees/subcommittees as needed.
• Embrace common sense. Act in good faith with the proper motivation (i.e., do what you honestly believe is in the best interests of the corporation).
• Be mindful of the record that you create, including internal and external communications. Be especially thoughtful about abbreviated communications sent quickly that may be misconstrued or challenged in hindsight (e.g., text messages, emails, online social media posts).
• Be mindful that some transactions entered into or completed while in the zone of insolvency will attract particular scrutiny, such as: 1) the declaration and payment of dividends; 2) declaring and paying discretionary bonuses or increasing management compensation; 3) the redemption of shares or the conversion of debt/equity on the eve of insolvency; 4) asset dispositions out of the ordinary course (transfers at undervalue/fraudulent conveyances); 5) payment preferences shown to creditors; and 6) providing financial assistance to or otherwise transacting with insiders/non-arm’s length parties.
• Be mindful of the most common sources of potential director liability, including: 1) employee obligations (i.e., wages, vacation pay, and, in some provinces, severance and termination obligations); 2) certain tax obligations (i.e., HST / GST / PST remittances); 3) source deductions (i.e., amounts deducted from employee compensation on account of the employee’s income tax / CPP / EI); 4) employer health tax; and 5) pension contributions/liabilities under a collective agreement if contractually made a director liability. Most or all of these obligations are readily ascertainable and can be managed.
• Review and maintain appropriate D&O insurance and indemnifications.

While distressed circumstances bring unavoidable stress and heightened concern for a corporation and its business, directors should not be intimidated in the zone of insolvency. With a strong governance model and best practices, risks are managed rather than feared. The right governance model should be a source of comfort to directors navigating choppy waters.