The COVID-19 pandemic has caused unprecedented economic disruptions worldwide.  Businesses that were previously flourishing are now seeing rapid declines in demand and revenue, disruptions in their supply chains, and other operational interferences.  Previously projected business plans for development and expansion may no longer be feasible.  Boards of directors facing these challenges would be well served to review their legal obligations and fiduciary duties as they help guide their companies through these challenges.

 Coronavirus, FFCRA.

Under Delaware law, directors owe fiduciaries duties of care and loyalty to their company.  These duties continue even during a crisis – including the COVID-19 pandemic.

  • The duty of care requires that directors make careful and informed decisions. Directors must make sure their decisions are based on adequate information and in the best interest of the company and its stockholders.  The duty itself is non-delegable, but directors can, if useful, rely on information and opinions of experts and management.
  • The duty of loyalty requires that directors act in the best interests of the corporation and its stockholders over the director’s own personal or financial interests.  While directors can have personal and financial interests that differ from the company, those interests and conflicts must be fully disclosed and safeguards must be put into place.

When a company is solvent, the directors and officers owe their duties to the corporation and the stockholders.  However, once a company becomes insolvent, the directors and officers owe their duties to all the corporation’s stakeholders – including the company’s creditors who upon insolvency have standing to bring derivative claims, i.e., claims on behalf of the company for the benefit of creditors who are functionally the real “stakeholder” in an insolvent company, against directors and officers for alleged violations of the duties of care and loyalty.

But, what happens when a company is in the so called “vicinity” or “zone of insolvency”?  The current COVID-19 pandemic has threatened many companies’ financial security and potentially impaired their ability to repay debt; businesses maybe be approaching insolvency, while not yet reaching that point.  Who do the directors owe duties to then?

The Delaware Supreme Court has held that a company in the “zone of insolvency” has no legal significance when it comes to fiduciary duties.  Put differently, being in the “vicinity” or “zone of insolvency” neither imposes upon directors any additional duties, or a “switch” of the duties from the equity holders to the creditors, nor does it allow creditors to pursue derivative actions for breaches of any duties (the way they could after insolvency occurs).  Thus, prior to any insolvency, the officers and directors owe their duties to the corporation and its shareholders.  But, upon insolvency, the duties expand to include creditors, so a board cannot act solely in the interests of shareholders.

So, what can directors do during these uncertain times where, for example, the duration, the depth and scope of the COVID-19 pandemic impact are, at best, difficult to quantify and plan for?  Moreover, it is difficult for boards to forecast and plan for how quickly consumer activity and spending will resume when the pandemic plateaus or even when there is a vaccine available.

Despite these business uncertainties, there are precautions and “best practices” that boards can follow to fulfill their duties and navigate the uncertainties posed by COVID-19 such as:

  • Keep Good Records. Document the information presented to the board and the analysis behind the board’s decision.  Meeting minutes tend to only capture big picture conversations, but boards would now be well served to ensure that their processes are properly recorded and that their governance procedures are carefully adhered to.  The company should have a written document retention policy, and carefully follow it, including as to board minutes and records.
  • Provide Board Packages In Advance. While business changes can be rapid in these uncertain times, and boards may need to meet more often than normal, any board packages, decks, and reports should be circulated as far in advance of meetings as reasonably practical to allow the board members to review them in advance and thereby facilitate a fulsome and critical discussion of the relevant issues.  Lively discussion, and even “debate” can facilitate a thorough review of the issues to produce a well-reasoned decision.  It is best practice for board members to use an email account separate from any personal or other business email accounts for all board-related communications, which can help preserve any attorney-client privilege and simplify the ease of being responsive to any discovery requests in any litigation involving any board decision.
  • Engage Experts. Use all available resources in making decisions.  Engage with management that is on the ground and consult industry experts that might be able to assist by providing insight and suggestions.  Any such management and outside expert advice should be carefully deliberated by the board.  Although the duty of care is non-delegable, directors must kept themselves informed in making decisions – even in these times.
  • Be Flexible. Uncertain times might require boards to reevaluate prior decisions that were made because of the changing climate.  Put differently, what might have been in the best interest of the company and shareholders several months ago, may no longer be the case.
  • Do Not Overextend. Be careful not to take on more debt or obligations than the company believes, based on its current projections, it would be able to reasonably repay when due and after recovery.
  • Disclose Any Conflicts or Lack of Disinterestedness. To avoid violations of the duties, or any interference with a thorough review of any issue before a board, all board members should be vigilant about disclosing any potential conflicts of interest as well as inquiring about any conflicts the company’s advisors may have.  In some situations, after full disclosure of any potential conflicts, which may be more prevalent in smaller or more closely held companies, formation of a special independent committee to review an issue and report back to the full board may be advisable.
  • Company Counsel/Board Counsel. Board members should always be aware that counsel for the company is typically not counsel to the board and its members.  If the board or its members wish to have their own counsel, they should retain separate counsel.  The board members should also be aware that advice between any dedicated board counsel and board members should only be among the board members and their counsel, and not with others such as the company or its advisors to preserve their board members’ attorney-client privilege.
  • Director & Officer Insurance. Boards and companies should review their existing director and officer coverage to determine if it is sufficient and that it covers any potential defense costs.
  • Other Insurance Policies Review. Reviews should also be performed of all other insurance policies to see whether any aspect of the pandemic or its effects could be covered.  If applicable, claims should be filed promptly and notice should be given to carriers to ensure that the company is preserving its rights.   
  • Stay Abreast of Legal Developments. Boards and management should be sure to stay informed on the various changes in laws and regulations, and to seek relevant advice on these changes.  The legal environment is rapidly changing as the country tries to address the COVID-19 crisis.  Some things to consider are the effect on labor laws, mask-wearing, health and safety of employees and customers, and governmental shutdown and pause orders with respect to the company’s continuing operations.
  • Government Relief Packages. Boards and management should consider whether government stimulus packages – like the Coronavirus Aid, Relief, and Economic Security (CARES) Act – can help their company.

Ultimately, when Delaware courts review the propriety of board decisions, they apply the business judgment rule  – i.e., the presumption that, in making business decisions, the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interest of the company and its stockholders (if it is solvent), or the best interest of the company and its creditors (if it is insolvent).  The courts do not apply a “20-20 hindsight” test; the review is based upon the known and knowable facts at the time of the questioned decision.  The presumption may only be overcome if the plaintiff can show disloyalty, bad faith, or gross negligence – a high bar for plaintiffs.

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*This alert is provided for information purposes only and does not constitute legal advice and is not intended to form an attorney client relationship.  Please contact your Sheppard Mullin attorney contact for additional information.*