Furthering Insolvency: How did we get here from there?

Michael J. Epstein, Director and Shareholder, TRG

What was Enron’s Board thinking? Where were the Tyco Directors while Dennis went shopping? Had MCI’s Director’s been invited to Scott’s new Florida mansion?

This stuff makes the headlines, but all across the country, decisions are made by boards of directors that don’t come close to this scale and will never see the light of day, much less a courtroom. However, these decisions are no less questionable and susceptible to attack, leaving a director in litigation for years. This is particularly true should the company end up in bankruptcy with creditors having been harmed.

Witness this example:

A roll-up of IT consulting companies is formed in 1997 with $500 million in capital and 9:1 leverage. Performance peaks in 1999 at $680 million in revenues and $90 million in EBITDA. The acquisitions were never integrated, the operations remained decentralized and controls were weak. Cash flow, however, is strong and the D&O insurance is paid. The board (4 investors and 1 independent director) is pleased with results.

In 2000, the stock market weakens and demand for the company’s services drop. The company’s performance remains positive, although competition has affected earnings, lowering the enterprise value. Covenant defaults arise but are waived by the banks. This concerns the independent director, given the market conditions and continuing weak internal controls. He suggests pursuing strategic alternatives, to which the board reluctantly agrees. An investment banker is retained. Credit and capital markets remain accessible, which the board views as a de-leveraging fallback option, providing a return for investors.

Now being a director becomes more challenging. Are we passing into the zone of insolvency?

The board should question management’s approach: Are we in the right markets? Are we losing position? Do we have business units losing money? Is there enterprise value for the shareholders? Should we pursue aggressive cost reductions? Until now, there was reason to believe that the problems may be temporal. However, “reason to believe” may not be a strong enough defense. All projections must be scrutinized, all strategic pursuits must be cost justified, all system and control gaps must be identified and plugged. As the company deteriorates, a window of opportunity is closing for directors to provide the necessary governance and leadership.

Let’s assume our board does not take these steps. In 2001, revenues drop further, reducing already weakened earnings. Capital markets, once an exit strategy, begin to shut down. The auditors recommend goodwill write-downs, systems and controls begin to break down, new covenant defaults arise and trade debt is stretched to generate cash for debt service.

It’s a miracle! A strategic buyer is identified who will pay $480 million (6.8x) for the company. The buyer sees undervalued intellectual property, significant customer opportunities and unrealized cost savings, to name a few. The offer would be sufficient to pay all creditors, but leave nothing for shareholders. The independent director feels obligated to accept the offer, but is voted down. Barring a sale, the same director urges the board to pressure management to cut costs and is again outvoted, citing the need to ‘maintain critical mass for when the market returns’. This prompts his resignation.

What’s the result? In 2002, the banks force a Section 363 sale of the company for $90 million and the directors are sued by the banks, the sub-debt and the Chapter 7 trustee.

Where did we go so wrong?

Insolvency does not happen overnight. It takes time to develop, to be nurtured and cultivated. Then, before you know it – Wham! Most experts say that if your client thinks they are insolvent, they probably have been for some time!

The fundamental questions remain: What are one’s duties to stakeholders, and what are the priorities once the company has crossed into the zone of insolvency? Once in the “Zone,” have the responsibilities increased, or do they remain the same but apply to a broader constituency? The answer is yes, on all counts!

To put this in perspective, one must define insolvency measurement. Traditional definitions include: whether fair asset value is less than all liabilities; whether debts can’t be met as they come due; or that creditors cannot be reasonably refinanced. The landscape, however, has become complicated with the advance of valuation methodologies and sophisticated ways to proscribe potential value to a business beyond the market value of its assets minus its liabilities. The valuation takes into account such issues as future earnings, macroeconomics, capital markets, credit markets and many other less concrete components. Ultimately, these issues are synthesized into an enterprise value representing what a willing buyer may pay for the company under a set of prescribed (and disclaimed) conditions.

If the going concern value of the business provides sufficient capability to pay off all creditors, then an argument can be made that you have not entered the Zone. Management will value the business as a going concern to determine its worth. This can be self-determining based on management’s intrinsic desire to not fail as well as the need of maintaining one’s compensation. Just think how the private equity board of directors will react to the CEO who opens a board meeting stating that the company is insolvent and must choose a strategy that maintains value for all stakeholders. Big hugs for the CEO all around for his performance? Hardly.

As the example shows, an independent advisor valued the business and even generated a buyer at a value beyond the liabilities. Over time, however, this value deteriorated to a point where creditors were impaired.

How can directors and officers defend their actions? The primary defense is the business judgment rule. Succinctly, culpability is based on the following:

1. Did you do something disloyal in which you benefited at the corporation’s expense?

2. Did you exercise good faith in your affairs on behalf of the company or did you cover up sins?

3. Did you act reasonably in that you did not follow or knowingly ignored the advice of professional advisors, resulting in the company’s loss? In other words, were you grossly negligent or just not smart enough to understand the advice? (Increasingly, outside directors will be expected to provide this perspective, ideally providing a measure of advance warning…if they are prepared to ask the right questions. And, knowing that they will ask will prompt a CEO to consider such questions in advance).

Duty of Loyalty

Let’s talk about each of these questions. The first is corporate loyalty. If you remember the example, our directors voted down the search for a buyer and could be deemed safe in trying to maximize shareholder value. There appeared to be sufficient value, as evidenced not only by their advisor’s analysis, but by the existence of reasonable market conditions. At that time, we are unaware of any compelling reason to suggest the value would subsequently deteriorate.

In the second year, this argument falters. The value of the company deteriorated because of capital markets constriction as well as operating performance erosion. Our investment banker found a buyer whose purchase price would repay all creditors, but with no shareholder return. Does this mean the sale should have been pursued? Not necessarily. Again, the board has not tried to use the company’s assets to generate personal gain. One could argue it was reasonable to assume that capital markets could strengthen and operating performance could improve.

However, there is a potentially fatal flaw here: the directors did not take action to stabilize or mitigate the operating performance. Remember, the board voted against a cost reduction strategy so they could be in a position to benefit from future opportunities.

This does not mean all companies whose markets are shifting must cut costs lest they be deemed insolvent. This decision must be made with specific attention on excess liquidity in the business and its ability to weather downturns. But smart managers are constantly pruning their organizations and trying to maintain agility so they will not be in need of wholesale change at any given point. This means constantly reviewing SKUs, product lines, operating units and distribution channels to optimize profitability.

Now, we move to 2001, when a reasonable person could believe it would be impossible to recover all the creditors’ money, let alone shareholder value. Here, we see an all too common phenomenon: senior management and directors have nothing more to lose since their investment is gone. They will gamble on luck or a lightning strike returning some benefit to them. This is what we call swinging for the fences with someone else’s bat and ball. At this point, one would hope that D&O premiums are paid and competent counsel hired.

Duty of Good Faith

The second measure of the business judgment rule is the duty of good faith. Did you act in good faith or did you lie and cheat or cover up for others that did the same? Did you have access to knowledge about the performance of the company and did you cover it up? In our example, there is no direct evidence of fraud or that the board acted in bad faith. However, the board had repeated warning signs of the systems and control failures and management’s apparent incompetence. This could create the basis for a multitude of sins that were either covered up or ignored.

In our example, this argument would be difficult to sustain. But there are boards that have breached this duty by virtue of a cover up. Take the example of a closely held business where the founder appoints cronies to the board. Over time, the founder hands responsibility to his son, who does not possess the same entrepreneurial savvy, but revels in the trappings of his ascendancy. While the board retains loyalty to the founder and supports the next generation’s failings, they are potentially creating personal liability for not acting responsibly.

Duty of Reasonableness

Finally, the duty of reasonableness can be complicated. Obvious breaches include a board ignoring outside counsel’s opinion that an activity will likely result in legal action against the company. The activity commences and ultimately results in significant lawsuits against the company. In more subtle situations, an investment banker might render a valuation that provides the board with apparent value to justify continued business operations. However, a year later, the same banker re-evaluates the business, takes into account marketplace changes and provides a value that now put the creditors in harm’s way.

While the banker has not provided specific advice and recommendations, the results of the analysis suggest that the creditors may no longer receive full value for their debts. In addition, the enterprise does not have sufficient working capital to weather an industry downturn and has not embraced efforts to address critical operating problems. Now, the board is treading on thin ice.

Conclusion

What is the good news for directors and officers? There is no law against business failure, but demand is increasing within the law for diligent purposeful action and prohibition on attempts by directors to allow themselves or officers to benefit personally. In the near term, we should expect to see an increase in D&O litigation surrounding business failures. The most visible activity will result from claims against directors over not having protected all stakeholders, while pursuing the hopes and dreams of investors. Keep in mind the following guidelines:

Duty of Loyalty: Personal gain at the expense of your stakeholders results in liability.

Duty of Good Faith: Don’t cover up your sins or those of your management team. Once issues are identified, disclosure and remediation can help avoid liability.

Duty of Reasonableness: Take reasoned and prudent action in the face of adversity to help avoid liability.

In this era of heightened corporate governance, directors must be well advised of their responsibilities and the consequences of their actions - and inactions. Remember the business judgment rule means that you should use good business judgment and focus on business fundamentals. Directors must monitor more than shareholder value: They are responsible for assuring that management operates on sound business principles, generates not only earnings and sustainable positive cash flow, and acts deliberately to press management for change when appropriate.

The independent board will not shrink due to a lack of qualified candidates, but it will become increasingly challenging to find independent directors willing to sign on for hazardous duty. The properly governed and advised board will continue to perform its mission – not only corporate vision but corporate vigilance and oversight. This will continue to provide the kind of visibility, intellectual challenge and psychic benefits for which independent directors enlist.

Michael J. Epstein

Michael J. Epstein is a Director and shareholder of TRG. He advises companies in a wide range of industries, including high technology, manufacturing and distribution, retail and financial services, and has served as Crisis COO, CFO and Chief Restructuring Officers, as well as financial advisor to bank syndicates and creditors’ committees. He has developed and implemented operational and financial restructuring plans both out of court and in Chapter 11 cases and has served on public and private boards of directors.