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Directors on alert to litigation exposure

Amy Jacks and Sean Scott, Chicago from Mayer Brown discuss duties of directors in scenarios involving insolvency with restructuring

By Amy Jacks, London restructuring partner and Sean Scott, Chicago restructuring partner at Mayer Brown

With insolvencies on the rise – the number of corporate insolvencies in 2019 being at their highest level since 2013 – directors need to be increasingly vigilant in understanding their role on boards.

There has also been a surge in corporate transactions and restructurings creating litigation exposure for individual directors. The incentive to pursue post-insolvency claims is growing through the increased availability of specialist litigation funding, coupled with D&O insurance providing a substantial pot of gold at the end of the claim. The insolvency claims industry is rapidly evolving; it now has specialist lawyers, insolvency practitioners and litigation funders who are focusing on a portfolio approach. As such, the emphasis for a litigation funder is to launch a volume of claims rather than focus only on those with merit and for an individual director, the risk of their earlier actions being reviewed in an insolvency scenario is greater. Therefore, careful planning and recording of the actions taken in the run-up to restructuring and insolvency is critical to limit exposure.

The number of businesses operating globally is ever increasing. During periods of rapid growth, it is often the case that board composition and corresponding local law directors’ duties are overlooked. Businesses are often run on a divisional basis and individuals can quickly find themselves on multiple boards across a number of countries.

However, in situations of financial distress or restructuring, there is increased focus and interrogation on these group structures and the position of individual directors. Decisions made solely for the greater good of the group are rarely an adequate defence. Consequently, the law creates tension with the commercial reality of running global organisations and the company-by-company and country-by-country approach fractures interdependencies and centralised services, paradoxically, often increasing financial distress.

Finance directors can suffer increased scrutiny given the vast majority of businesses fail due to liquidity and other finance-related issues. Whilst directors may be cognisant of their duties around day-to-day operations, the shift from promoting the success of the business for the benefit of an English company’s shareholders, to acting in the interests of the company’s creditors in the “twilight zone” before insolvency, is frequently not understood, particularly as there is no definitive point at which the duty shifts.

When one adds the challenge of international business with directorships across multiple jurisdictions, the complexity increases. Directors’ duties vary from country-to-country. An English director can be personally liable if they continue to trade in the run-up to formal insolvency unless they took every step to minimise loss to the company’s creditors. They ought to continue if doing so would result in a better outcome to creditors.

By contrast, in Germany, directors can be liable under both civil and criminal law if they fail to file for formal insolvency proceedings within 21 days of illiquidity or over-indebtedness. In the US, directors and officers owe duties of care (to act in a reasonable, prudent manner) and loyalty (not to act in their self-interest) to the enterprise itself, rather than to particular stakeholders. However, if the enterprise is insolvent, creditors may bring derivative claims of breaches of fiduciary duty, including that the directors failed to maximise the enterprise’s value for the benefit of all stakeholders.

Another area for consideration is conflicts of interest. Where an individual director sits on the board of different companies, they need to be increasingly mindful of the “hat” they are wearing when making decisions for that company. In the US, it is common for aggressive creditors to argue conflict as evidence of directors’ inability to faithfully discharge their fiduciary duties. This is not to say that multi-directorships should be prohibited and resigning is also not necessarily the answer, but it is important that a director acknowledges and navigates any potential conflict and, critically, ensures that any process and decision-making is adequately documented. In the US, there is a trend to appoint one or more independent directors and, for global organisations facing distress, it is increasingly common to form a special committee of independent directors who has the authority to negotiate, review and, ultimately, recommend/reject a proposed transaction, based on what is in the best interests of the corporation and its stockholders.

A global general counsel or CFO is often left to pilot challenging situations with individual directors expecting a group strategy which will enable them to discharge individual duties in their respective countries. In such scenarios, the addition of independent directors to the board or a chief restructuring officer is often prudent, as these individuals will have the experience to guide the group through the unchartered territory of a restructuring.

The engagement of financial and legal professional advisers will assist the directors in making informed and reasoned decisions, ideally from the earliest stages of financial distress, which will invariably assist the directors in mitigating the risk of potential claims against them in a later insolvency.

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