Seventh in a series of updates on how the pandemic is informing basic elements of governance.
The extraordinary pandemic-based financial challenges impacting hospitals, health systems and other providers as a result of the Coronavirus (COVID-19) should prompt boards to re-evaluate focus on their duty to monitor the organization’s financial condition. Existing case law provides useful direction on the scope of these duties, particularly during periods of financial distress. There is value to enhancing the engagement of the board’s finance (or similar) committee on solvency matters during this period of crisis.
Of course, the corporation’s business and day to day operational performance are managed under the oversight of the board of directors. More specifically, the board is expected to focus on the integrity and clarity of the company’s financial reporting and other disclosures about corporate performance. The board is also expected to have meaningful involvement in the company’s capital allocation process and strategy, and in reviewing, understanding and overseeing annual operating plans and budgets.
These responsibilities expand as the corporation experiences material financial distress and approaches potential insolvency. Old concepts of “the zone of insolvency” have been rejected by many courts. However, case law does recognize a shift in the identity of to whom the board’s duties run.
Generally speaking, the fiduciary duties of directors of solvent companies run to the shareholders (in the case of for profit companies) and to the corporate mission (in the case of not-for-profit corporations). Should the company become insolvent, however, those duties may be extended to the creditors of the company, as well due to their equitable interests in the company at that point in time. As a result, creditors may be able to pursue derivative claims based on allegations of breach of fiduciary duties owed to the totality of the company’s claimants (including its creditors).
This doesn’t mean, however, that when a company enters insolvency its directors must pursue certain creditor-focused extraordinary actions. Directors are able to act consistent with informed business judgment to pursue corporate strategies that reflect the best interests of all of the residual claimants. In other words, fiduciary duties are owed to the enterprise itself rather than any particular stakeholder.
Of course, the impact of the pandemic has had a disastrous financial impact on hospitals, health systems, physician groups and other providers, arising primarily from the suspension of normal operations due to restrictions on scheduled or non-emergent procedures. In many instances, the steep declines these providers are experiencing in volume and revenue raise questions as to whether they are either approaching insolvency or have actually become insolvent.
Courts have defined “insolvency” under both a balance sheet test and a cash flow test. Under the balance sheet test, a company is insolvent if the sum of its debts exceed the aggregate value of its assets. A company is insolvent under the cash flow test if it is unable to pay its debts as they become due.
Fiduciary issues may arise even in circumstances where the actual or potential insolvency is expected to be only temporary. Creditors may pursue breach of duty claims as long as the insolvency existed at the time of the alleged breach and the plaintiff was a creditor of the company at that time.
In this time of crisis, the board, its finance committee and its financial officers should be alert to the warning signs of insolvency. They should also be particularly attentive to the proper exercise of their fiduciary obligations (including the avoidance of material board-level conflicts of interest) to the extent they could be perceived as damaging to the interests of creditors. It is important to remember that it is difficult to determine when a company may become insolvent, and any cause of action will be brought with the benefit of hindsight.
Case law suggests that a creditor will have a difficult time obtaining judgment on a derivative claim for breach of fiduciary duty during a time when the company was insolvent. But, these claims often follow a notoriously slow pace through the courts. Directors and financial officers should thus be mindful of the old saying that “you may avoid the result, but you will not avoid the ride.” For this and other reasons, proper planning by the finance committee can be critical.