An earlier version of this post originally appeared on In The (Red): The Business Bankruptcy Blog, which I createdfor CEOs, CFOs, boards of directors, credit professionals, in-house counsel and othersto stay informed about important business bankruptcy issues and developments.
Many start-up companies backed by venture capital financing, especially those still in the development phase or which otherwise are not cash flow breakeven, at some point may face the prospect of running out of cash. Although many will timely close another round of financing, others may not. This post focuses on options available to companies when investors have decided not to fund and the company needs to consider a wind down.
Fiduciary Duties And Maximizing Value
Let’s start witha refresher on the fiduciary duties of directors and officersof a Delaware corporation in financial distress. Please note that this high-level overview is no substitute for actual legal advice on a company’s specific situation.
- Under Delaware law, directors and officers owe fiduciary duties of due care and loyalty. The duty of due care requires directors and officers to make fully-informed, good faith decisions in the best interests of the company. The duty of loyalty imposes on directors and officers the obligation not to engage in self-dealing and instead to put the interests of the company ahead of their own.
- When a company is solvent, the directors and officers owe their fiduciary duties of due care and loyalty to the corporation and its stockholders. That remains true even if the company is in the so-called “zone of insolvency.”
- When a company is insolvent and will not be able to pay its creditors in full, the directors and officers still owe their fiduciary duties of due care and loyalty to the corporation. However, upon insolvency, the creditors have the right to bring derivative (but not direct) claims for breach of fiduciary duty against directors and officers.
- Learn more on In The (Red)about akey Delaware decision discussing the fiduciary duties of directors and officers in the insolvency context.
- Remember, it can be challenging to determine whether a company is just in the zone of insolvency (meaning still solvent but approaching insolvency) or whetherit has crossed the line into actual insolvency.
- Discharging fiduciary duties when a company is insolvent means a focus on maximizing enterprise value.This is a highly fact-dependent exercise with no one-size-fits-all approach. In some cases, maximizing value may mean continuing operations — even though that burns dwindling cash — to allow the company to complete a sale that the directors believe is likely to close and produce significant value for creditors. In other cases, it may mean winding down (or even shutting down) operations quickly to conserve cash, especially if any asset sale is not expected to generate more than the cash required to pursue it.
- These complexities make it critical for directors and officers of a company in financial distress to get legal advice tailored to the specific facts and circ*mstances at hand.
Legal Options For A Wind Down
When the board decides that the company needs to wind down, options range from an informal approachall the way to a public bankruptcy filing. Note that if the company owes money to a bank or other secured creditor, the lender’s right to foreclose on the company’s assets couldbecome a paramount consideration and affect how the wind down is accomplished. Although beyond the scope of this post to analyze each wind down option in detail, the followingis a brief overview of different approaches, together with links giving more information.
- Informal wind down: In an informal wind down, the company typically tries to find a buyer for its assets, eventually lays off its employees, and shuts down any unsold business operations, but does not complete a formal end to the corporate existence. This lack of finality can leave legal loose ends, so alternatives should be carefully considered.
- Corporate dissolution: A corporate dissolution is a formal process under Delaware law, typically managed by a company officer, for winding up the affairs of the corporation, liquidating assets, and ending the company’s legal existence. A company may choose to do a corporate dissolution when it doesn’t need bankruptcy protection (and prefers not to file bankruptcy) but wants a formal, legal wind down of the corporate entity.
- Assignment for the benefit of creditors: Many states, notably including California and Delaware, recognize a formal process through which a company can hire a professional fiduciary and make a general assignment of the company’s assets and liabilities to that fiduciary, known as the Assignee. In California, no court filing is involved. The Assignee in turn is charged with liquidating the company’s assets for the benefit of creditors, who are notified of the ABC process and instructed to submit claims to the Assignee. If a buyer has been identified, an Assignee may be able to close an asset sale soon after the ABC is made. Visit our Business Bankruptcy Blog foran in-depth look at the ABC process.
- Chapter 7 bankruptcy: AChapter 7 bankruptcy is a public filing with the United States Bankruptcy Court. A bankruptcy trustee is appointed to take control of all of the company’s assets,including the company’s attorney-client privilege, and the directors and officers no longer have any decision-making authority over the company or its assets.A Chapter 7 trustee rarely operates the business and instead typically terminates any remaining employees and liquidates all assets of the company. The filing triggers thebankruptcy automatic stay, which prevents secured creditors from foreclosing on the company’s assets and creditors from pursuing or continuing lawsuits. The trustee has authority to bring litigation claims on behalf of the corporation, often to recover preferential transfers but sometimes asserting breach of fiduciary duty claims against directors or officers.Unlike a dissolution or an ABC, the bankruptcy trustee in charge of the liquidation process is not chosen by the company.
- Chapter 11 bankruptcy:A Chapter 11 bankruptcy is also a public filing with the U.S. Bankruptcy Court, and it similarly triggers the bankruptcy automatic stay. Unlike a Chapter 7 bankruptcy, in Chapter 11 — often known as a reorganization bankruptcy — the board and management remain in control of the company’s assets (at least initially) as a “debtor in possession” or DIP, and an official committee of unsecured creditors may be appointed. Business operations often continue and funding them and the higher cost of the Chapter 11 process may require DIP financing and/or use of a lender’s cash collateral. One primary use of Chapter 11 by a venture-backed company is to sell assets “free and clear” of liens, claims and interests through a Bankruptcy Court-approved sale process under Section 363 of the Bankruptcy Code. Visit In The (Red)for a discussion ofhow a Section 363 bankruptcy sale in the right circ*mstances can maximize value for creditors and shareholders.
- Subchapter V small business bankruptcy: A relatively new type of small business bankruptcy filing is a case under Subchapter V of Chapter 11. It too involves a public filing with the U.S. Bankruptcy Court that triggers the bankruptcy automatic stay, but it is available only for companies that meet the Bankruptcy Code’s definition of a small business debtor. Specifically, the company must have less than $7.5 million in aggregate noncontingent liquidated secured and unsecured debts (but excluding debts owed to one or more affiliates or insiders) and not be a reporting company under relevant provisions of the Securities Exchange Act of 1934. As in regular Chapter 11, the company remains a debtor in possession but there is no creditors committee and a Subchapter V trustee (with a more limited role than a Chapter 7 trustee) is appointed. Importantly, equity holders may be able to retain their stake in the company under a confirmed bankruptcy plan even if all creditors are not paid in full. For such a plan to be confirmed, Subchapter V requires that unsecured creditors receive an amount under the plan equal to the company’s projected net disposable income for at least three (and up to five) years, and any unsecured creditors that object to the Subchapter V plan must recover more under the plan than they would in a Chapter 7 case liquidation.
Conclusion
When a company’s cash is running out and investors have decidednot to provide additional financing, the board may conclude thatawind down is required to fulfill fiduciary duties and maximize value. The discussion above isa general description ofcertain wind down options. Determining whether any of these paths is best for a particular company is fact-specific and dependent on many factors. Besure to get advice from experienced corporate and insolvency counsel when considering wind down or other restructuring options.
