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The Financially Troubled Company

The Venture-Backed Company Running Out Of Cash: Fiduciary Duties And Wind Down Options

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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 with a refresher on the fiduciary duties of directors and officers of 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.
  • Follow this link for more on the key 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 whether it 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 circumstances at hand.

Legal Options For A Wind Down. When the board decides that the company needs to wind down, options range from an informal approach all 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 could become 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 following is 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. Follow this link for more details on corporate dissolution.
  • 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. Follow this link for a an in-depth look at the ABC process.
  • Chapter 7 bankruptcy: A Chapter 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 the bankruptcy 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. Business operations often continue and funding them and the higher cost of the Chapter 11 process 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. Follow this link for a discussion of how a Section 363 bankruptcy sale in the right circumstances can maximize value for creditors and shareholders.

Conclusion. When a company’s cash is running out and investors have decided not to provide additional financing, the board may conclude that a wind down is required to fulfill fiduciary duties and maximize value. The discussion above is a general description of certain wind down options. Determining whether any of these paths is best for a particular company is fact-specific and dependent on many factors. Be sure to get advice from experienced corporate and insolvency counsel when considering wind down or other restructuring options.

The Financially Troubled Company

You Say You Want A Dissolution: An Overview Of The Formal Corporate Wind Down

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Winding Down. If a corporation’s board of directors decides that the business needs to be wound down, there are a number of legal paths to consider. Determining the best approach is fact-dependent, and the corporation and its board should get legal advice before making a decision. Sometimes a bankruptcy filing is needed, either a Chapter 11 reorganization (perhaps to complete a going-concern sale) or a Chapter 7 liquidation bankruptcy (in which a trustee will be appointed to liquidate the business). In other cases, an assignment for the benefit of creditors might be a good choice.

A Delaware Corporate Dissolution. This post takes a high-level look at another, often simpler option: the corporate dissolution.  It assumes that the business is a Delaware corporation, since many corporations incorporate there. The laws of the state of incorporation govern the dissolution process, so it’s important to remember that the process described below will differ if the business is incorporated in another state.

Why A Corporate Dissolution? Corporations typically choose to do a corporate dissolution when they don’t need bankruptcy protection (and prefer to avoid filing bankruptcy) but want to have the corporation formally wound down. The dissolution process can be less expensive than other alternatives, particularly when litigation or disputes over claims is unlikely.

  • When properly conducted, a dissolution can bar late claims against the corporation and provide directors with protection from personal liability to claimants.
  • Unlike a bankruptcy filing (but similar to an assignment for the benefit of creditors), a dissolution requires shareholder approval; that often makes it a better fit for privately held corporations.
  • A dissolution typically requires at least one director to supervise the process and at least one officer to manage the wind down and liquidation, although some professional firms will step into those roles.
  • Corporations often elect to dissolve at a point when they anticipate being able to pay creditors in full and return some funds to shareholders or, if they are insolvent, find their creditors generally to be cooperative. If the corporation has a bank or other secured creditor, it helps if they are willing to work with the corporation to liquidate the assets without a foreclosure.

A Corporation In Dissolution. Under Delaware law, once the dissolution commences the corporation is no longer permitted to operate as a normal business. Instead, as the Delaware statute provides, the corporation continues only “gradually to settle and close their business, to dispose of and convey their property, to discharge their liabilities and to distribute to their stockholders any remaining assets, but not for the purpose of continuing the business for which the corporation was organized.” The corporation is allowed up to three years to complete the dissolution process; if more time is required, a request has to be made to the Delaware Court of Chancery (although a corporation in dissolution remains in existence, without having to go to the Chancery Court, to complete lawsuits that are pending when the three year period expires).

Key Aspects Of A Dissolution. To give you a sense of the process involved, below is a list of some of the main steps in a dissolution. However, please note that important details go beyond the scope of this post. Examples include special voting procedures that may be required if preferred stock has been issued, possible alternatives to the claims process, establishing reserves for claims, payment of the costs of the liquidation, winding down subsidiaries, and the impact of foreign affiliates. It bears repeating: a corporation considering a dissolution should get legal advice on all aspects of the process.

With that caveat, a dissolution generally involves the following:

  • Board approval of a decision to dissolve and adoption of a plan of liquidation;
  • Shareholder approval of the dissolution and plan of liquidation in requisite majorities as provided under the corporation’s then-current Certificate of Incorporation;
  • Filing of a Delaware Annual Franchise Tax Report and payment of franchise taxes, including a partial-year final franchise tax report;
  • Filing a Certificate of Dissolution with the Delaware Secretary of State’s office;
  • Timely reporting to the Internal Revenue Service of the dissolution;
  • A formal claims process, with at least 60 days notice to potential claimants of the dissolution and deadline to file claims, together with publication of the notice in required newspapers;
  • Review of filed claims, with appropriate offers to claimants or rejections of claims;
  • Resolution of any lawsuits, including any timely-filed by claimants whose claims the corporation rejected;
  • Liquidation of remaining corporate assets in accordance with the plan of liquidation;
  • Preparation and filing of all final tax returns;
  • Withdrawals or surrender of qualifications to do business in other states; and
  • Final distributions to creditors and, if funds remain, to applicable shareholders.

Conclusion. In the right situation, a dissolution can be the best approach to formally wind down a corporation’s business and corporate existence. As with all corporate governance matters, however, the corporation’s board and management should get legal advice tailored to the corporation, its business, and creditors, and guidance throughout the dissolution process.

 

Image courtesy of Flickr by JBrazito