What Happens to the Board of Directors Under Corporate Bankruptcy?

by Jayne Thompson

Boards of directors owe fiduciary duties to their organization’s shareholders. In other words, they must act in the shareholders' best interests. If a corporate bankruptcy looms the board's actions are determined by the need to protect those invested in the company's success. How well or poorly it does this, and how it deals with questions about why the company went bust, usually determine what happens to the board.

Director Duties

Company directors owe duties of care and loyalty to their organization. They must act reasonably, in good faith and in the best interests of the shareholders. If they exercise their business judgment according to those standards, interested parties may not parse their business decisions. This rule safeguards directors from personal liability even if their decisions have adverse consequences.

The Insolvency Zone

The same principles apply when insolvency threatens. However, the directors must now consider the interests of the organization's other stakeholders, including its creditors. Courts in some states hold directors liable to creditors for breach of fiduciary duty if they don't act in a way that allows the company to service its debt.

Keep Calm and Carry On

Directors in the insolvency zone must quickly take stock of the situation while balancing the potentially competing interests of shareholders and creditors. Conducting a thorough financial review and seeking professional help are now the primary concerns. Directors should avoid resigning because those who quit rather than engage themselves in the bankruptcy proceedings are generally viewed as being in derogation of duty. If state law and the company's bylaws allow, investors can call a shareholders’ meeting and replace the board if they so choose.

Fiduciary Foul-Up

'Business as usual' is not an option for companies in the insolvency zone. Directors who don't consider whether continuing to operate hurts one or more stakeholders are at risk of breaching their fiduciary duties. While turning to previous investors or even fellow board members for a capital injection may be tempting, the board might find itself on the wrong side of a lawsuit if doing so violates conflict-of-interest laws and policies.

Liability Line

Directors who deliberately misrepresent the company’s financial position expose themselves to liability lawsuits. Those who make business decisions without full knowledge of the facts may also be sued for breaching their fiduciary duties. Other causes of action include failing to act where the board has a clear duty to do so, or placing personal interests before the organization's.

Going Under

If the worst happens and the company goes under, bankruptcy law determines what happens to the board. Under Chapter 7 bankruptcy the company goes out of business and the directors are out of a job. The bankruptcy trustee pays the company's debts in federally mandated order: bankruptcy costs, secured creditors first, then unsecured creditors and finally shareholders. Directors stand in the same line as everyone else. Chapter 11 bankruptcies reorganize the business to get it back on track. In this scenario, the board stays on the job but a court must approve all significant business decisions.

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