World Turned Upside Down

In the "insolvency zone," creditors exert a strong pull that often throws CFOs off balance.

Vincent Ryan is a senior editor at CFO.

Could This Get Personal?

Can creditors sue directors and officers for breach of fiduciary duty in the zone of insolvency? The answer, usually, is no — not directly, that is. When a company is actually insolvent, though, a creditor can pursue a “derivative claim” for breach of fiduciary duty — a suit on behalf of the company claiming fraud, mismanagement, or some kind of self-dealing.

Under the business-judgment rule, directors and officers can’t be held liable as long as they made decisions in good faith and in the best interests of the company. But it’s not bulletproof. Most CFOs need to review insurance policies and corporate charters to ensure that other defenses are in place.

Directors’-and-officers’ (D&O) insurance provides some cover. But in a 2007 survey by Towers & Perrin, only 37% of companies reported purchasing coverage for fiduciary liability, even though that was the second-most common D&O claim. The reason: the coverage was too expensive.

Yet, officers should insist on fiduciary coverage — and insist it be large enough, experts say. Defending shareholder and creditor lawsuits is costlier than many other kinds of litigation. Attorney James W. Parkman III recommends that CFOs consider buying their own insurance. If a company files for bankruptcy, the trustee could deem the D&O policy an asset of the corporation and freeze any payments for attorney’s fees, Parkman says.

Many companies indemnify directors and officers in charters and bylaws, which can limit their liability for breaches of the duty of care. “Indemnification basically protects them from the assertion that they acted negligently,” says attorney Sam Alberts of White & Case.

Such agreements need to be penned before a company draws near the zone of insolvency. Last February, Freescale Semiconductor signed an indemnification agreement with directors and certain officers (including the CFO) because of “the increased risk of litigation” and the need to retain executive talent. But the timing of the agreement drew attention. The company had reported a 2008 fourth-quarter loss of $4.2 billion. It had also offered to exchange $2.8 billion in bonds for $1 billion in term loans, a transaction that “reduced the possible recovery rate of existing notes,” according to CreditSights. Senior lenders subsequently sued Freescale. — V.R.


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