The Functioning of Boards of Directors in Light of COVID-19

Boards of Directors in Light of COVID-19:

Duties, Dos and Don’ts, and How to Reduce the Risk of Personal Liability

The outbreak of the COVID-19 (coronavirus) global pandemic has turned the domestic and global markets upside down. The growth and economic prosperity slowed down and nearly halted almost abruptly. The economic and financial damage cuts across industries – starting with the most vulnerable industries – airlines, public transportation, tourism, and severely affecting other industries such as the financial sector, retail businesses, office workplaces, education, oil and gas, sports and pastime and on. Currently, it is too early to assess and calculate the longevity of the pandemic and its magnitude. However, the prospects around the world, at least in the near term, are far from encouraging.

In light of the COVID-10 outbreak, boards of directors of all businesses, publicly traded and privately-owned entities, are required to address the pandemic and its dire effect on the business. In this memo, we outline the appropriate functioning of a board of directors of a business that has been hit by an economic and financial downturn.

A. Slowing Down of the Company’s Cash-Flow

I. General

A typical expression of the economic downturn of the business is a downturn in its cash-flow. A depressed economy translates into lower volumes of sales, services and income generating activity. This calls for managing the company’s cash-flow sensitively. Managements and boards must address the matter closely. They need to categorize and prioritize the businesses’ short term and long-term expenditures and investments.

If the financial situation of the business deteriorates into a crisis, the long-term development needs to take a back-seat in favor of managing the short-term crisis so as to stabilize the business as much as possible and mitigate the damage to the creditors’ recovery (see further below – “Legal Duties of Directors”). Thus, expenses should be examined, and non-core expenses should be reviewed and even curtailed for the time being.

Recommended best practices include:

• • • Receiving updated financial forecasts from company on a weekly or bi-weekly basis.
    • Receiving actual collection and expenditures on a weekly or bi-weekly basis.
    • Reviewing all expenditures and seeking to cut non-core expenses.

II. Dividend Distributions and Stock Repurchases

An important derivative of the downturn of the company’s cash-flow is its dividend policy. Under the Companies Law, 5759-1999 (the “Companies Law”) dividend distributions are a matter within the power and authority of the board. Sections 302 and 303 of the Companies Law forbid any dividend distribution or stock repurchases if the board concludes that there is a reasonable risk that as a result of the distribution the company will not be able to pay its obligations as they become due. This is termed in the statute “the solvency test”. This solvency test is a cash-flow test. To meet this test, the board is required to examine – prior to any resolution of dividend distribution – the existing, and estimate the projected, cash-flow of the company and compare it to its schedule of payments. To the extent the board cannot state that there is no reasonable risk of the company failing to meet its scheduled payments, the board may not declare a dividend distribution. A board that violates this legal requirement, is in violation of its fiduciary duties to the company (section 311 of the Companies Law) and its directors may be sued through a derivative suit initiated by a creditor of the company or by a liquidator thereof and found personally liable.

Given the downturn of the businesses cash-flows, the uncertainty of the development of the pandemic in the foreseeable future and its effect on their projected cash-flows, it is advisable that the boards revisit their current policies of dividend distributions and, if necessary, modify them, in a conservative manner, to reflect the current crisis.

Boards who believe that the current financial state of their company is still strong and wish to declare a dividend distribution accordingly, are advised nonetheless to pay extra attention to the uncertainty of the projected cash-flow of the business in light of the coronavirus pandemic. In this respect, boards ought to: (a) apprise and update themselves on the known state of the pandemic and its projected development; (b) consult with experts concerning the projected economic and financial effects of the pandemic on the industries of their company; and (c) obtain expert financial analysis of the projected cash-flow of their specific business in light of the pandemic.

B.  Shareholders’ Contributions and Loans

One of the sources for corporate finance is controlling shareholders’ contributions (investments or convertible equity) or loans. In times of crisis, when there is a shortage of financing channels, existing commitments of controlling shareholders to finance come into light. It is important that boards act proactively to keep controlling shareholders good on their commitments to finance the company and actually call the funds committed.

It should be noted, that in privately- and closely-held entities controlling shareholders loans are legitimate loans yet are nonetheless susceptible to potential subordination, by the courts, to other creditors of the company. The likelihood of subordination increases where the court finds any wrongdoing by that shareholder, particularly actions that manifest disregard to the rights of other creditors (such as selective, beneficial payments to that shareholder), or thin capitalization of the company (that is, extreme disproportionality between its equity capital and its liabilities, exacerbated by that shareholder’s loan).

C. Legal Duties of Directors

I. Duties under the Companies Law

The Companies Law imposes two primary duties on directors and managers of a company: (a) the duty of care and (b) the duty of loyalty. These duties require any director or manager to act reasonably and diligently for the benefit of the company. The directors and managers are expected to enhance the interests of the company and its profitability as a reasonable and capable director or manager would. A central element of the duty of care is to act on an informed basis with respect to any decision-making in the company. A major component of the duty of loyalty is to avoid any conflict of interest between the company and that director or manager.

A company may exculpate, indemnify, or purchase insurance in favor of, its directors and officers against their potential liability for violation of their duty of care, but not for violation of their duty of loyalty.

II. Duty to Mitigate Damage to Creditors

When a company suffers an economic downturn, its officers and directors may be subject to a third and new duty of behavior. This duty is stated in section 288 of the new Insolvency and Economic Rehabilitation Law, 5778-2018, which came into force on Sep. 15, 2019 (“The Insolvency Law”).

Section 288 provides that –

• • • any director or CEO of an insolvent company,
    • who knew or ought to have known that the company is insolvent
    • and failed to take reasonable measures to mitigate the scope of its insolvency,
    • may be personally liable towards the company for the damages suffered by the creditors as a result of his failure to so mitigate.[1]

“Insolvency” is defined in section 2 of the Insolvency Law as either –

• • • • cash-flow insolvency (that is inability of the company to pay its debts as they become due); or
      • balance-sheet insolvency (that is, a negative Net Asset Value (NAV)).

This new duty of section 288 requires a CEO and all directors of a company who is insolvent to address and take into primary consideration the interests of its creditors. The liability encompasses even directors who, at the time, did not actually know of the company’s insolvency, but in the eyes of the court (in hindsight) ought to have known at the time of its insolvency. “Ought to have known” is measured through the standard of a reasonable and diligent director in such circumstances.

Thus, boards should review on an ongoing, constantly updated, and frequent basis the existing and projected cash-flow of the company. A board who finds a problem or expected difficulties with the company’s cash-flow should be mindful of its duty to take measures to mitigate further damages to the creditors. However, this does not necessarily mean to immediately cease any further operations of the company’s business. This duty requires the board to take action and react to the financial situation of the company in manners that are not likely to deepen any deficiency in its NAV. This is an accepted interpretation of section 214 of the UK Insolvency Act.

It should be noted, that section 288 is new in Israeli law. Thus, to date, there is no case law interpreting this section. Nonetheless, the enacting of section 288 drew upon section 214 of the UK Insolvency Act and it relies heavily on its provision. Thus, for purposes of interpretation of section 288 of the Israeli law, it is expected that the courts will look to the comparative case law on section 214 of the UK law.

Alongside the liability, section 288(b) provides certain safe-harbors for CEOs and boards of directors. This subsection provides that a CEO or director shall enjoy a presumption that they took reasonable measures to mitigate the damage to creditors if they exercised any of the following measures:

• • • Obtaining assistance from professionals in corporate reorganization;
    • Negotiating with the company’s creditors in order to reach a debt arrangement;
    • Filing with court a petition for an insolvency proceeding.

The third measure, filing for insolvency proceeding, will be considered if there is no reasonable prospect to salvage the business of the company and manage it without avoiding such a measure. However, to the extent the board believes, based on its informed, rationale, business judgement that there is a reasonable prospect to administer the company successfully outside of formal court proceedings, with the interests of its creditors supreme, it may do so.

For that purpose, it would be wise for the board to seriously consider employing one of the first two safe-harbors. That is, the board may –

• • • equip itself with the hired assistance of professionals in corporate reorganization, or
    • enter into consensual, informal, negotiations with its creditors in order to advance a possible debt arrangement.[2]

It is also suggested to consider a combination of both measures, albeit in a gradual manner. That is, at first obtain the services of corporate reorganization professionals to advise the board and devise the potential business, financial and legal options available to the company under the circumstances. Based on such plans, the board may also engage the creditors, update them on the situation and then jointly consider the possibility and feasibility of a corporate restructuring (debt arrangement).

It should also be noted, that the statute explicitly forbids a company to exculpate or indemnify the CEO or the directors for their personal liability under section 288. The only financial instrument permissible to cover for the CEO or directors’ liability under section 288 is a D&O insurance policy.

III. Dos and Don’ts in Light of Section 288

Below we have compiled a noncomprehensive, bullet format, list of Dos and Don’ts for boards in order to enhance their compliance with their duty to the creditors under section 288 of the Insolvency Law.

• • • Employ a proactive approach of the board
      • Keep a close grip (hands-on) of the corporate business and its development
      • Monitor closely and with high-frequency the evolvement of the COVID-19 pandemic situation and its effect on the corporate business, its employees, suppliers and customers
      • Maintain close and highly-frequent meetings of the board or of its committees (given the Health situation, meetings may need to be held through technological devices)
      • Employ ongoing consultation with professional experts (legal and financial) specializing in corporate reorganization and economic distress – this is a major factor in favor of boards both in Israeli statutory law and UK case law
    • Focus (for the time being) on the short-term survival of the business
      • Focus on the near future cash-flow of the business
      • Identify and mark core assets and less vital ones
      • Consider the employees’ position – contributions to the business and welfare of the employees on one hand; and the costs of compensation and the ability to maintain them at the regular and normal level given the updated financial state of the business on the other hand
      • Keep an eye, nonetheless, on the long haul of the company and what elements does it require
    • Conservative decision-making
      • Chill grandiose investments
      • Apply a cautious approach and decision-making to new business decisions and transactions
      • Review each such decision from the standpoint of the corporate creditors
    • Incurring new financing
      • Attempt to secure fresh financing from shareholders (equity contributions, rights offerings)
      • Try to secure consensual waivers of due payments
      • Beware of obtaining new debt that will further weigh on the corporate liabilities – this may weigh against the board with respect to fulfilling its duty/liability to existing creditors
    • Paying due debts
      • Paying a due debt at the time of insolvency may be sensitive
      • It may constitute a preference of that creditor over others
      • However, to the extent it is essential to keep the company afloat (and avoid a premature insolvency proceeding) – the board, after specific consultation with experts, may approve the payment
    • Selling/Disposing of Assets
      • At times of “red billboards” disposition of the assets should be reviewed very carefully
      • Concerns of “fire sales”, which raise questions of optimizing the recovery for creditors
      • Yet, should be balanced against any available alternatives to handle pressing cash-flow problems
    • Dividend distribution
      • May not be done when cash-flow test cannot be met
      • See in detail above in this Memo
    • Continuous dealing with creditors
      • Consider overall plan for the corporate debt and not only “occasional fire-fighting”
      • Consider possible corporate debt arrangements (debt workouts) – see further below (“Financial Restructuring”)

In addition, as a matter of best practice, it is advisable to respect your creditors and talk to them upfront and frequently. In this respect –

• • • Do not keep them in the dark for long periods;
    • Do not treat your creditors as your adversary – work with them openly.

D. Financial Restructuring (a.k.a. Debt Arrangements) or Asset Realization

A board which recognizes that the company is experiencing difficulties dealing with its creditors – financial creditors, employees, suppliers or customers – and its due payments thereto, should consider initiating talks and negotiations with the creditors for the purpose of restructuring its finances and operational business. A comprehensive workout, especially if it may deleverage the overall corporate debt may be an advisable outcome for both the company and its creditors. Given the potential pandemic related shortage of financing resources, low levels of asset value and the overall slow economy, spreading and deferring payments through future instalments or converting some of the debt into equity may be an adequate measure for struggling businesses. Under the circumstances, restructuring may be preferable over asset realizations, receiverships or foreclosures.

There may be various economic and financial restructuring options and alternatives. Each entails a close and thoughtful planning. Debt restructuring also calls for professional legal planning, as it may be constructed outside or inside the courtroom, with various ramifications to each of these channels. To the extent relevant, we are of course available as experts and professionals to advise and assist in advancing a restructuring.

For additional questions please call Prof. David Hahn at 03-6074463; email: davidh@gkh-law.com.

[1] This cause of action may be brought against the CEO or director by the company’s trustee (in an insolvency proceeding) or by the Superintendent in Insolvency (formerly known as the Official Receiver).

[2] For further discussion on the latter, see below – “Financial Restructuring”.

Gross & Co. (GKH), is one of the leading law firms in Israel, with over 170 attorneys. GKH specializes, both in Israel and abroad, in various fields of law including Mergers and Acquisitions, Capital Markets, Technology, Healthcare and Life Science, Banking, Real Estate, Project Finance, Litigation, Antitrust, Energy and Infrastructure, Environmental Law, Intellectual Property, Labor Law and Tax.

This alert is prepared as an informational service to clients and colleagues of Gross & Co. (GKH) and the information presented is not intended to provide legal opinions or advice. Readers should seek professional legal advice regarding the matters about which they are particularly concerned.