February 3, 2015
By Michael H. Torkin, Sullivan & Cromwell LLP
The U.S. corporate default rate currently is below historical averages, hovering slightly below 2008 pre-crisis levels. Restructuring professionals, however, are cautioning that a rising interest rate environment, exacerbated by the Fed’s reduction in fiscal stimulus, could lead to a softening of the ongoing robust multiyear credit cycle. In addition, it has been reported that the Department of Treasury’s Office of the Comptroller of the Currency has “suggested” to a number of U.S. institutional lenders that they begin to more closely scrutinize credit standards – focusing on reigning in issuances of covenant-light high yield debt as well as tightening leverage ratios. If credit tightens, leveraged companies that have successfully accessed traditional credit markets could face significant challenges.
Directors of a leveraged company should begin to consider the implications of not being able to access traditional debt markets on appropriate terms. This concern is particularly acute for companies with near-term debt maturities, prior difficulty achieving financial projections, a declining EBITDA forecast and/or capital funding needs reliant on low interest rates. This note highlights the initial steps, questions and concerns typically facing a director in this new environment.
LiquidityLiquidity is consistently the single biggest driver of the restructuring process. Management teams that begin to explore restructuring possibilities and strategic alternatives sufficiently in advance of short-term liquidity concerns are best positioned to navigate away from a value detracting or uncontrolled restructuring process. Management should adequately educate the board on interim liquidity levels (quarterly or semi-annually). The board needs appropriate visibility and room to pivot if a challenging refinancing environment should ensue. Faced with pre-bankruptcy restructuring options, a director should consider carefully the risks associated with incurring additional pre-bankruptcy financing including its implication on the company’s ability to incur additional secured financing should a bankruptcy filing ultimately be in the best interests of the company.
Importantly, a director should expect the unexpected. What might appear to be a fourth quarter refinancing could be accelerated significantly if the company’s auditors take a conservative view with respect to the company’s refinancing risk. An auditor’s refusal to issue an unqualified audit could require immediate refinancing of funded debt to avoid defaults or costly waivers.
Restructuring ExpertiseA thoughtfully developed record that evidences the board’s consideration of its restructuring advisors’ advice is a powerful defense should the board ultimately be sued for alleged breaches of fiduciary duty arising from an unexpected liquidity crisis. Seasoned restructuring advisors, including financial advisors, investment bankers and counsel understand the tempo of the restructuring process, how to work constructively with management, when and how to approach key constituents and importantly, how to develop an effective and robust record of the board’s deliberation and assessment of strategic alternatives. If possible, it is emerging best practice for a director with particular subject matter expertise to review the advisors’ work more thoroughly than other directors.
Remaining on the Board?Some directors question whether to resign from the board before or during the restructuring process. Although time commitments increase dramatically for board members in the period leading up to a restructuring, in most situations it is advantageous to remain on the board. For example, in bankruptcy it is customary for continuing directors (as opposed to directors who resign before or midway through the process) to receive releases and exculpation from the debtor and other parties that consent, usually the principal stakeholders involved in the restructuring.
Many times board members are appointed or sponsored by significant stakeholders, including creditors from a prior restructuring that continue to hold restructured paper or stock. It can be important for any director who could be perceived as closely connected to a principal stakeholder to ensure full disclosure to the board of any perceived conflict and potentially to recuse him or herself from matters that directly impact negotiations or recoveries. The circumstances merit careful consideration in advance, and in certain situations a special committee of independent directors will be established, which will engage separate counsel.
Communication Strategy and Public DisclosureIf a decision to restructure becomes more certain, it is essential to ensure an appropriate communication and disclosure strategy is in place. For all companies, there is a practical business-interfacing concern – trade credit is highly sensitive to adverse disclosure. Additionally, for a reporting issuer, the board, together with counsel, should carefully evaluate the company’s SEC reporting and disclosure posture. A board could be criticized for not creating sufficient market awareness of the company’s potential need to restructure.
Zone of InsolvencyIf management begins to raise issues regarding the company’s liquidity profile, ability to generate sufficient cash flow to meet current liabilities, or potential for near-term covenant defaults, the board should heighten its scrutiny of and approach to decision-making.
In most jurisdictions, a director of a solvent corporation owes fiduciary duties exclusively to the corporation and its shareholders. Under Delaware law, most decisions a director will make are protected by the business judgment rule, other than in the context of related party transactions, the adoption of defensive measures, or the sale of corporate control, each of which are subject to differing and heightened standards. A court should not second guess a director’s business decision with respect to most matters, and a director should not be found to have breached its fiduciary duty to the corporation or its shareholders for good faith business decisions that prove unsuccessful.
As the corporation approaches insolvency, under Delaware law, a director’s duty continues to be to maximize the value of the corporation, as a whole, for the benefit of all stakeholders, with duties running to stockholders. Once the corporation is insolvent, creditors have standing to sue the board derivatively for breaches of fiduciary duty. This legal nuance should prove irrelevant for a board that continues to take steps to maximize value for the corporation.
Best practice includes: developing a robust record demonstrating diligent preparation for, and frequent attendance and active involvement at, board and committee meetings; making the decision-making process transparent; scrutinizing management projections and assumptions; seeking and considering the advice of outside experts; and canvassing and pursuing strategic alternatives.
D&O ProtectionSeveral factors implicate the structure, scope and amount of D&O insurance, including: the amount of the company’s funded debt; whether the company is public or private; and the nature and risk of the company’s assets and business. In the lead-up to a restructuring, or in advance of near-term concerns about a company’s ability to refinance or repay its debt, a director should review the structure, breadth and nuances of the company’s D&O policy. Specifically, the borad should review the policy as it relates to issues that arise in a restructuring context. There are three provisions/features that warrant specific consideration: the structure of Side A coverage; the limitations on the insured versus insured exclusion; and the duration of the imbedded tail.
As a company embarks on a restructuring initiative, best practice suggests that the board develop a “zone of safety” to ensure it has the appropriate freedom to make the best decisions to maximize corporate value. Understanding personal protections, assembling a team of first-class and independent experts, and beginning as early as possible to ensure a sufficient runway to implement the restructuring are essential.
If a chapter 11 restructuring is likely, there are a number of additional issues the board should consider. Each situation has its own opportunities and challenges and counsel should be consulted early to highlight and address issues and assist the board when exploring options and developing a record of robust director oversight.
About the Author
Michael is a partner at Sullivan & Cromwell LLP. He specializes in restructuring & special situation matters. Michael represents debtors in Chapter 11 reorganizations and out-of-court restructurings. He also advises private equity and hedge funds in connection with distressed transactions and special situation investments. Michael routinely advises boards of directors of financially distressed companies on fiduciary matters. He can be reached at [email protected]