What is the “Zone of Insolvency” We Keep Hearing About, and What Must an Officer or Director Do Once They Enter This Zone?

October 26, 2011 at 11:00 am Leave a comment

During the past few years, most small companies have heard someone refer to the Zone of Insolvency, and reference how dangerous this is to the Directors and Officers.

In this post, we will review what the definition of “zone of insolvency” is, and what Directors and Officers are supposed to do, and say, if they find themselves in or approaching this zone.

Two tests for insolvency

There are really two primary tests for determining insolvency

1. Balance sheet test: a company is insolvent if its liabilities exceed the fair value of its assets.

2. Cash flow test: a company is insolvent if it is unable to pay its debts as they become due in the ordinary course of business.

But in reality, smaller companies may see themselves within these definitions a number of times in their early lives, particularly companies seeking institutional funding. Logically, if you find yourself meeting these tests, but are in the process of closing a new round of financing, you can look past these tests to the reality that you will be out of this Zone of Insolvency soon enough to make taking actions a moot point. That doesn’t mean you have discharged your obligations as a Director or an Officer that will be discussed below, but simply says that you are in this Zone of Insolvency only on a temporary or short term basis.

However, each company and its board must take a long look at the facts surrounding their ability to raise additional capital to get them out of this zone. Merely “hoping” that you will raise more money in the short term does not take you out of the Zone of Insolvency. You may be trying to raise money, but you must be honest with yourself and your stakeholders regarding your chances of success.

What’s expected, once you are in the “zone”?

If you find yourself in this Zone of Insolvency, there are certain legal actions which are reasonably expected of the company and its Directors and Officers.

For Delaware Corporations

• The directors of an insolvent corporation have the traditional fiduciary duties of care and loyalty to both the creditors and the stockholders;

• Creditors may bring derivative claims against to board for a breach of these duties, but may not directly due the directors; and

• Business Judgment rule will apply

For California Corporations:

• In these cases, the board does not owe any broad based fiduciary duties to its creditors simply because it is insolvent.

• The scope of a director’s duty to creditors is limited to the “trust fund doctrine”: avoiding actions that divert, dissipate or unduly risk cooperate assets that might otherwise be used to pay creditor’s claims.

The differences between these two are not major, but your legal advisor should give you advice about what your specific duties are to avoid exposing the Directors and/or Officers to personal liability from the creditors. Basically, there is a theory that if the company knowingly incurs debts after it has recognized that it is in the Zone of Insolvency, the Directors and Officer have allowed a fraud to be committed, and as such, they become personally liable for these debts. This is difficult to prove, but it has been done. In these cases, D&O insurance will not protect the D’s and O’s because “fraud” is not a covered liability in these policies.

Navigating the turbulent waters of the “zone”

So, what are we supposed to do to avoid liability and abide by the legal requirements of your State of incorporation? The short answer is that the D’s & O’s are supposed to stop incurring ANY liability after knowingly having entered this Zone of Insolvency. This means, no further payroll, contract or vendor costs are to be incurred. This could mean furloughing employees, or simply laying them off. It could mean notifying creditors that you are in this zone, and you agree to not incur further liability without having a solid plan to leave this zone.

Below are some important things for executive management and Boards to remember as they navigate the Zone of Insolvency:

• Prepare and regularly update an honest appraisal of company status and prospects:

o Fund-raising assessment – why have you so far been unable to raise funds?

o Where are you in the fund raising process and do you have any investors lined up or in discussion?

o What timeline are you setting for the fund raising, before Plan B actions will be taken?

o Are you really in the Zone of Insolvency?

o Enumerate and understand all creditor obligations by type: secured, unsecured, statutory, etc.

o What is the potential enterprise value, or separate value of your IP?

o Identify potential buyers. Having this list done early helps the process.

• Focus internally

o Conserve cash—scrub balance sheet to convert whatever assets are available into liquid resources, like CASH

o Reserve cash for statutory obligations and liquidation costs. Statutory obligations include payroll and payroll taxes.

o Do not disseminate any information behind required “circle of people” until decisions are clear about what you will do.

• Understand, prepare for, and pursue multiple liquidation options in the event fund raising is ultimately unsuccessful

o It is very important that the Directors are on the same page

o Having the Board in agreement goes a long way to a smooth set of actions.

Legal and financial advisors are available to help companies that find themselves in, or approaching the Zone of Insolvency. It is not an enjoyable place to be, but to avoid liability it is essential that D’s and O’s understand their responsibilities and consider the interests of all stakeholders as they decide whether to continue the business, suspend the business, or simply close the doors.

Rich Brenner is Founder and CEO of The Brenner Group, one of Silicon Valley’s premier professional services firms. Rich is a veteran executive, entrepreneur, investor, board member, and philanthropist.

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Entry filed under: Financial Advisory, Interim Management, Restructurings, Shareholder Services.

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