Zone of Insolvency - How to Conduct Business When Bankruptcy is a Looming Possibility

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Zone of Insolvency - How to Conduct Business When Bankruptcy is a Looming Possibility

By: LawInfo

Published: 06/2010

Corporate Boards of Directors always have complicated decisions to make. However, those decisions become incredibly more complex when the company has entered a “zone of insolvency” and is considering bankruptcy. Generally, Boards of Directors owe a fiduciary duty to the company’s shareholders. That means that they must make decisions for the company based on a duty of care, a duty of loyalty and a duty of good faith to the shareholders. In other words, the board of directors must act like reasonably prudent people would and make decisions based on the best interests of the company.

The fiduciary duty of Boards of Directors changes when a bankruptcy is a looming possibility. While the Board of Directors still owes a fiduciary duty to the company, the zone of insolvency may also require Boards of Directors to exercise fiduciary duties with regard to creditors.

How Boards of Directors Know They’ve Entered a Zone of Insolvency

It can be difficult to pinpoint a moment in time when a company becomes insolvent. It takes time for the financial books to reflect the current condition of the business. Therefore, the courts have created a concept called the zone of insolvency. The zone of insolvency begins when the company is in financial distress and could possibly be insolvent. Generally, courts apply either a balance sheet test or a cash flow test to determine if the company should be considered in the zone of insolvency. Courts applying a balance sheet test will consider whether the company’s assets are greater than its liabilities and courts applying the cash flow test will consider whether the company has a sufficient cash flow to pay its bills and financial obligations.

Boards of Directors Fiduciary Duties to Creditors

Once a company has entered the zone of insolvency, the Board of Directors continues to owe a fiduciary duty to the company’s shareholders but, now, it also owes a fiduciary duty to its creditors. Sometimes this can create a conflict of interest for the Board of Directors since a decision may be in the best interest of the creditors but not of the shareholders. In some states, Boards of Directors primary fiduciary duty shifts to the creditors once a company is in the zone of insolvency. In other states, the fiduciary duty does not shift to creditors until a company is officially insolvent. In the remaining states, Boards of Directors are not required to make creditors interests a priority over shareholder interests but that are required to protect the rights of creditors. In these complicated situations it is important for Boards of Directors to seek legal advice to avoid future legal problems.

A company is not required to seek the advice of creditors nor inform them of the company’s financial troubles even if the Board of Directors owes the creditors a fiduciary duty. Likewise, it is important for Boards of Directors to focus on their fiduciary duties to all shareholders and to all creditors when answering individual questions about the company’s financial health.

Businesses that are within the zone of insolvency often face difficult choices. It is prudent for Boards of Directors to make every single decision with a focus on their duties of care, loyalty and good faith to both shareholders and creditors to avoid future litigation.