What are my fiduciary duties when my company is in the zone of insolvency?
Takeaway: When your company enters the "zone of insolvency," your fiduciary duties as a director expand to include the interests of your creditors; your primary obligation is no longer to maximize value for stockholders, but to preserve the value of the corporate assets for all stakeholders.
In a healthy, solvent company, the fiduciary duties of a director are clear: you have a duty of care and loyalty to the corporation and its stockholders. But when the company becomes insolvent, or even enters the "zone of insolvency," a critical and dramatic shift occurs. Your fiduciary duties expand to encompass a new constituency: the company's creditors.
This is one of the most significant and perilous transitions in all of corporate governance. The decisions you make as a director when the company is insolvent will be viewed through a different legal lens. A failure to understand this shift can expose you to personal liability in a future bankruptcy proceeding or a lawsuit from an unpaid creditor.
The Shift: From Stockholders to Creditors
The Rationale: The law recognizes that once a company is insolvent, the stockholders' equity is likely worthless. The real "owners" of any remaining value in the company are now the creditors—the people to whom the company owes money. Therefore, the board's primary duty is no longer to swing for the fences for the stockholders, but to act as a responsible steward of the company's remaining assets for the benefit of those creditors.
This does not mean you now have a direct fiduciary duty to any single creditor. Your duty is to the corporate enterprise as a whole, which now includes the interests of the entire creditor body.
What This Means in Practice
When your company is in the zone of insolvency, the board must shift its mindset from risk-taking to preservation. Your job is to maximize the total value of the corporate assets, not to engage in risky "bet the company" strategies that might create a small chance of a return for the stockholders at the expense of the creditors.
Actions that could be seen as a breach of this expanded duty include:
Making preferential payments to certain "friendly" or insider creditors while not paying others.
Approving a risky new business line that consumes the company's remaining cash with a low probability of success.
Paying large executive bonuses or dividends when the company is unable to pay its debts.
The Board's Best Defense: Process and Prudence
The best way for a board to protect itself in the zone of insolvency is to run a highly disciplined and well-documented process.
Hold Regular Board Meetings: Your board should be meeting frequently to monitor the company's financial situation.
Rely on Expert Advisors: This is the time to lean heavily on your outside legal counsel and financial advisors. The board's decisions should be based on the expert advice of these professionals.
Document Everything: The minutes of your board meetings should meticulously document the board's careful and prudent decision-making process, showing that it considered the interests of all stakeholders, including creditors, in every decision it made.
Navigating the zone of insolvency is the ultimate test of a board's leadership. It requires a fundamental shift in perspective and a deep commitment to a process that is fair, transparent, and designed to preserve the remaining value of the enterprise for all of its constituents.
Disclaimer: This post is for general informational purposes only and does not constitute legal, tax, or financial advice. Reading or relying on this content does not create an attorney–client relationship. Every startup’s situation is unique, and you should consult qualified legal or tax professionals before making decisions that may affect your business.