The first thing the Board of Directors should do is take a deep breath and recognize that their role has changed. A company that is struggling financially is said to enter the “zone of insolvency” when its liabilities exceed the value of its assets or it cannot pay its debts as they become due. A company does not need to be in formal bankruptcy to be in the zone of insolvency. When a company crosses over into that insolvency zone, as the 5th Circuit Court of Appeals once stated:

“the officers and directors have an expanded fiduciary duty to all creditors of the corporation, not just the equity holders”

(Carrieri v. Jobs.com Inc., 393 F.3d 508, 534 (5th Cir. 2004)) (emph. in original).

This quote from Carrieri is the general principle in insolvency cases. A creditor, just like shareholders, can claim breach of fiduciary duties when the directors or management fail to consider the impact of the management action or inaction on the creditors as a whole. Directors who have faithfully followed their duties of care and loyalty are protected if they acted in good faith and made informed decisions. However, those duties expand when creditors’ rights are involved. When in the zone of insolvency, directors must consider not only what is best for shareholders, but what is fair to creditors as a whole. This is known as the “Trust Fund Doctrine” which is that the assets of an insolvent company belong in effect, to all creditors equally. The Texas Supreme Court, in Lyons-Thomas Hardware Co. v. Perry Stove Mfg. Co. (86 Tex. 143, 1893) has held that the trust fund doctrine applies in Texas.

How Fiduciary Duties Expand During Insolvency

  • Payment to a creditor that is not made to other creditors: While it might seem obvious to pay a debt when it can be paid, if a company is insolvent, a payment to one creditor but not another could constitute an impermissible preference under federal bankruptcy law or a fraudulent transfer under the Texas Uniform Fraudulent Transfer Act (TUFTA).
  • Transfers of Assets to an Affiliate: Transfers of assets to a related company or to insiders (officers, directors or key employees) may be voidable under TUFTA if no reasonably equivalent value is received for the transfer or if the transfer is made with the actual intent to hinder, delay, or defraud a creditor.
  • Continue Operating a Business that is Losing Money: This is perhaps the most common issue we see in fiduciary cases. A company is losing money and there is an obligation to consider whether operating the business is depleting company assets rather than preserving those assets to pay creditors. A company is not required to immediately shut down just because its creditors are unhappy with its operations. But, management should have an analysis of whether the company should continue operating and make the good faith decision to either continue or wind down the operations accordingly.

There are several things that directors and management can do at the outset to protect themselves:

  • Get an opinion from an independent third party that the company is or is not insolvent: Insolvency can be determined on either a balance sheet basis (liabilities exceed asset value) or an equitable insolvency basis (the value of assets may be less than the present value of all liabilities and future capital needs).
  • Get help to manage the transition: The directors or management of the company may become conflicted or simply not be able to manage through a distress situation. Often in these cases, an independent fiduciary, such as a CRO, receiver, or trustee is appointed who has experience leading companies through restructuring.
  • Manage cash like a CFO: Cash management is the key to getting through financial distress situations. There are a number of techniques we regularly employ to maximize cash flow during these situations.

If your company is or is expected to be financially distressed, it is important to get help early in the process. We work frequently with both the company and its creditors to ensure the best outcome for all stakeholders. We regularly represent boards of directors and management in their dealings with creditors or in responding to claims from creditors.

Call us today to discuss how we might be able to help.

John Tittle, Jr. is a CPA/CFF/CGMA, CTP, CIRA, and CDBV. John is a former Deloitte Partner and a public-company CFO. In his 35+ years of business experience, he has been an expert witness in more than 100 cases and has been testifying since 1983.

Directors and officers of financially healthy companies owe fiduciary duties of care and loyalty to the company and its stockholders. The directors’ and officers’ actions are reviewed based upon whether they acted in good faith and on sufficient information. But if the company falls on hard times, the legal rules become more complicated. If the company is in financial distress, in “the zone of insolvency,” the fiduciary duties owed by directors and officers are expanded to include the company’s creditors. In that situation, “the officers and directors have an expanded fiduciary duty to all creditors of the corporation, not just the equity holders” (Carrieri v. Jobs.com Inc., 393 F.3d 508, 534 (5th Cir. 2004)).

Document Decision-Making Rigorously

  • Ensure that the board’s minutes are thorough, that board members are aware of their legal responsibilities, and that actions the board has been advised of and approved have been recorded.
  • Save the advice you receive and the reasons you made your decisions.
  • In distress situations, these will protect board members. If a company later goes bankrupt and a director made decisions that may have violated his or her fiduciary duties, creditors will seek to hold the directors responsible.

Engage Experienced Restructuring Counsel and Advisors

The earlier in the distress situation, the better. Engaging an advisor when serious distress first appears allows the company to assess its condition and options before they narrow.

When a business is in financial distress, its directors and officers still owe fiduciary duties of loyalty and care to their constituents. In Texas, the creditors may have standing to sue the directors for a breach of duty.

When creditors or other third parties call into question management’s decisions, it is also helpful to retain an independent fiduciary (CRO, receiver, trustee, etc.) who is knowledgeable and experienced in cash management and turnaround. The independent fiduciary can assume leadership and alleviate concerns about conflict.

When a Texas business is in financial distress, what are directors’ fiduciary duties to creditors?

When a Texas business is in financial distress, directors’ fiduciary duties to creditors are to act in a manner to maximize enterprise value for all stakeholders. Directors of a company in financial distress do not have a duty to continue the business if the company’s creditors are being deprived of the proceeds of the business. Directors are only protected if they acted in good faith and were reasonably fully informed.

What are the consequences if a director of a financially troubled Texas corporation violates a fiduciary duty to a creditor?

A creditor may bring a breach of fiduciary duty claim against a director of a financially troubled company. The creditor is entitled to fair and equal treatment.

The zone of insolvency is not a legal term. It is meant to describe a certain financial condition.

What is solvency analysis in bankruptcy or restructuring cases?

Solvency analysis is the process of determining a corporation’s or individual’s financial status: is the entity solvent or insolvent? The analysis looks at whether the business is able to pay its debts. The analysis is performed to rebut or support preference or fraudulent transfer claims and to support damages claims. The analysis determines the company’s ability to pay its debts on a balance sheet basis.

How can a business avoid bankruptcy?

  • Cash flow management.
  • Consider hiring a CRO.
  • Talk to your creditors.
  • Consider alternatives to liquidation.
  • Consider an out of court workout.
  • Turn the business around.

The Intersection of Valuation, Restructuring, and Expert Witness Services

Corporate financial distress is a complex and changing process and the best advisors reflect that by providing assistance during each stage of that process. At John Tittle, Jr., CPA, CFF, we specialize in business valuations, corporate restructuring, and expert-witness services, and we offer clients all three services, as the need arises. Our expertise in restructuring and financial turnaround is backed up by 100+ expert-witness appearances (since 1983) and 35+ years of experience.

John Tittle, Jr., CPA/CFF/CGMA, CTP, CIRA, CDBV, is a former Deloitte Partner and public-company CFO who has provided valuation and restructuring services to businesses and individuals nationwide for more than 35 years. For more information on our restructuring services, or to schedule an initial consultation, please visit tittlefinancial.com or call (214) 341-6043.

We will be pleased to address your business concerns, and to assist you with valuation, financial restructuring, and expert-witness needs. Our services are performed by John Tittle, Jr., himself, and we look forward to hearing from you.

Frequently Asked Questions

  • What are fiduciary duties to creditors of a financially distressed company in Texas?
  • What is the zone of insolvency?
  • How is it determined whether an insolvent company is solvent?
  • How can a company avoid bankruptcy in Texas?