CAUTION: YOU ARE ABOUT TO ENTER THE ZONE OF INSOLVENCY
CAUTION: YOU ARE ABOUT TO ENTER THE ZONE OF INSOLVENCY
In recent years, there has been a lot of discussion, particularly among officers and directors of small to medium size companies concerning what is commonly referred to as the “Zone of Insolvency.” What does it mean? How can it impact decisions made by officers and directors? What considerations should/must be considered? This article explores these issues and offers some thoughts on what officers and directors can or may do when they find themselves in the “Zone of Insolvency.”
What is insolvency? There are two tests for insolvency that are recognized. The first is the balance sheet test - whether a company’s liabilities exceed the fair market value of its assets. The second test is called the cash flow test – whether a company is able to pay its debts as they become due in the ordinary course of business. A small to medium size company may find themselves in these “zones” a number of times throughout their existence. The analysis frequently arises when seeking conventional, institutional financing. If a company falls within these tests but is about to close on financing they will likely fall outside the Zone of Insolvency upon closing. However, being outside the Zone of Insolvency is a fluid concept and a company can easily fall back in at any time. So, care must be taken at all times when making decisions which may or will affect the financial stability of a company.
What happens when a company falls within the “zone”?
Once a company falls within the “Zone of Insolvency” care should be taken by its officers and directors such that it actions constitute those which would be “reasonably” expected of a company of its size and type under the attendant facts and circumstances. Actions taken may also be impacted by the location in which the company originates and/or operates. For example, in Delaware, directors of an insolvent company act as fiduciaries owing an appropriate level of care and loyalty to both creditors and shareholders. Creditors in many instances will be entitled to bring a derivative action against a board of directors for breach of such duties but may not be entitled to sue the directors themselves and the “business judgment rule” – i.e., whether the actions taken were in the best business judgment of the company – will apply.
What steps should be taken in the “zone”?
There are steps that directors and officers should take (or not take) when the company is in the Zone of Insolvency. As an initial matter, they should not incur ANY liability after they have knowingly entered into the Zone of Insolvency. This may mean curtailing payroll, contract or vendor costs. It could also mean taking steps to reduce costs – reasonable measure to try and extricate the company from the zone. Creditors may need to be notified that the company is having financial difficulties and that the company has and will be taking steps to reduce further liability and is working toward a plan to exist the zone. Further steps that may be considered at the executive level might include:
Assess the company’s status and prospects for the future
Consider engagement of outside professionals to evaluate whether the company is, in fact, in the Zone of Insolvency – allowing the officers and directors cover in the event an issue arises in the future and/or allowing for an analysis of reasonable steps that may be taken to exit the zone
Evaluate capital improvements that should be discontinued
Assess intellectual property and whether and to what extent it may have enterprise value
Assess creditor obligations by type – secured versus unsecured – and priority, including options for modifying payment terms
Exit unprofitable areas of investment or business
Evaluate leases of real and personal property
Consider refinancing of debt options
Consider request for modified and advantage payment plans with vendors
Consider equity infusion
Consider discontinuing funding of pension or other profit-sharing vehicles
Identify possible purchasers of all or part of the business
Conduct focus groups within key areas of the business
Make sure all federal, state and local taxes are current – avoid potential involuntary liens being placed against assets
Conserve and reserve cash – defer discretionary bonuses, maintain ability to make payroll and pay statutory obligations, i.e., payroll, sales and ad valorem taxes
Keep all management and key operational employees in the loop – but make sure information is kept on a “need to know” basis at a key level until critical decision and actions have been determined and are in play
Conduct or commission a liquidation analysis of the business in the event a liquidation or insolvency proceeding becomes necessary or fund-raising options present themselves
Document decisions at the board level – try to reach consensus among board members
In any business situation, legal and business professionals should be consulted to help the company handle or extricate themselves from the Zone of Insolvency. While it is not a place any business wants or desires to find itself, it is also a place in which a company can observe and learn. Taken prompt, positive, practical and reasonable steps to avoid, handle and exit the Zone of Insolvency will lead to positive and worthwhile creditor and lender relationships going forward while doing nothing will only worsen and already difficult situation.