Approaching the Insolvency Zone – Advising Boards of Directors

Following the height of the COVID-19 pandemic, boards of directors are addressing many issues tied to their business’s ongoing operations previously never on the agenda. While this has no doubt made directors’ jobs more complex, these issues become exacerbated when they are encountered in the context of near-insolvent corporations.

Challenges posed by the global economic slowdown, geopolitical issues, discontinuance of government pandemic financial support, increased borrowing costs, inflation, rising energy prices, supply chain bottlenecks, production and labour issues, and decreased M&A activity, to name a few, are factors that have, and will, result in an increase in the number of insolvent corporations.

Boards encountering these challenges must have heightened awareness of the impact these issues may have on the company’s solvency. If solvency must be addressed, directors must keep in mind that there are additional implications on their responsibilities as directors.

The difficulty for directors lies in the fact they may be expected to protect the interests of stakeholders having different interests. Those stakeholders include the company itself, its creditors, its shareholders and, in some cases, the company’s customers. As a result, directors must keep these interests in mind as they provide direction to the company’s management.

By Bryan Tannenbaum | Chartered Managers Canada

Director obligations

Boards must act within their given authority when faced with financial difficulties. If they exceed such authority, directors may be personally liable for losses incurred as a result of their actions. All decisions they make must be guided by both their statutory and fiduciary duties.

Statutory and common law duties are derived from the statutes of each country or their subnational governments. While each statute may have duties specific to its jurisdiction, in general, the obligations of a director include:

1. Duty of care to the company – making well-informed decisions that are deliberate and cohesive. Directors must implement a robust process to ensure their decision-making is done with reasonable care, skill and due diligence in a commercially reasonable manner; and
2. Duty of loyalty – Directors must be seen to act honestly and in good faith in the best interests of the corporation, without any conflicts of interest, as good corporate citizens. Directors cannot act in silos and must act as a unified board, making decisions collectively and impartially. Their decisions must not be impaired by self-interest or self-dealing. In situations of real or perceived conflict of interest, directors must disclose any conflict of interest and refrain from voting or attending any portion of a board meeting where the issue in question is discussed.

In considering the above, it is critical that the board keeps minutes of all meetings as proof of their activities.

Board decision considerations

For the most part, board decisions are made relying on company information that is based on the books and records maintained by management. As well, compliance demands are continually changing, thereby increasing the burden on directors to stay informed on regulations and compliance processes and may result in boards requesting that management provide third-party evidence to support management’s activities, such as copies of statutory government filings. Accordingly, boards need to be proactive in carrying out their duties.

In the event that a board’s decisions are legally challenged, a usual defense for directors is the business judgment rule. This rule sets out the reasonableness of the process used by the board to make decisions and the rationale behind such decisions. While each case will turn on its facts, boards can mitigate their exposure to potential accusations by acting in good faith and in a commercially reasonable manner, and by carefully documenting their actions in minutes of meetings. The information in the minutes should support the prudence and diligence taken by the board in reaching its decisions.

Insolvency and director responsibilities

When companies enter the “insolvency zone,” directors need to consider how that impacts their responsibilities. The difficult question is how to determine when a company goes from being solvent to being considered insolvent. While there may not be a definable date when that occurs, when directors become concerned that the company may be heading towards being insolvent, the focus of the board should change to ensure, at a minimum, that the directors are not breaching their fiduciary responsibilities.

For example, when a company becomes insolvent, the primary stakeholders of the company become its creditors rather than its shareholders. This may result in the directors considering other points of view and options than they might otherwise have.

As the company approaches the “insolvency zone,” the focus of board meetings often shifts to reviewing the company’s short-term cashflow projections (monitoring actual results to projected), assessing management’s cash management activities, and confirming the adequacy of the directors’ and officers’ insurance (D&O insurance) in place. The board should also consider all alternatives available to the company, including a possible sale and/or merger and obtaining independent professional advice, both restructuring and legal, to assist the board in navigating the difficult decisions.

Potential liability for directors and officers

Directors and officers need to be aware of their potential personal liabilities and the necessity to maintain D&O insurance, even more so when the company is entering the insolvency zone. In addition, directors can consider having the corporation establish an indemnity trust and having protections set out in a court order in the event that the company proceeds to a formal restructuring.

As corporations enter the insolvency zone, directors need to be concerned about the company’s statutory liabilities in respect of which directors may become personally liable if unpaid by the company such as payroll source deductions, wage arrears, vacation pay, harmonized sales tax, provincial sales tax, environmental obligations, pension benefits and income tax. Each jurisdiction may have its own set of liabilities for which directors may become personally liable.

When dealing with public corporations, directors must also be familiar with securities laws in the applicable jurisdiction that set out the directors’ responsibilities in respect of misleading information, material misstatements, and the disclosure of material facts. As well, directors need to be aware of insolvency legislation that addresses matters such as the payment of dividends when a corporation is insolvent, payments to creditors or related parties within specific timeframes, etc.

Facing insolvency can be nerve racking, particularly for a smaller or middle market company that does not have an experienced board of directors. It is important to consider that directors are entitled to retain resources to assist them in carrying out their responsibilities. It is not expected that a board of directors has all of the answers and, if the board does not have the knowledge or expertise to deal with any issue, the board should seek external assistance from professional restructuring advisors to help them navigate the difficult path ahead.

RSM Canada is an audit, tax and consultancy firm dedicated to serving Canada’s middle market businesses.

Bryan A. Tannenbaum is a seasoned restructuring professional with RSM Canada. He practices primarily in the corporate restructuring, recovery and insolvency areas. A licensed insolvency trustee, he provides businesses with leadership, effective strategies and resolutions in corporate reorganizations, business investigations, receivership assignments, proposals, bankruptcy matters and liquidations. As one of Canada's leading restructuring professionals, he has successfully assisted a broad range of companies  and clients with restructuring issues.

Daniel Weisz practices primarily in the corporate restructuring, recovery and insolvency areas for RSM Canada. He is a Licensed Insolvency Trustee and Chartered Insolvency and Restructuring Professional who works with debtors, shareholders, lenders and creditors to develop and implement strategies to address issues facing companies experiencing financial difficulties or other issues.  Daniel has been the lead individual on numerous engagements, including proposals, restructurings, receiverships, bankruptcies   and business investigations and as an Estate Trustee During Litigation.