Should a Director of a Company in Crisis Resign?

 

SHOULD A DIRECTOR OF A COMPANY IN CRISIS RESIGN?

Written By:
Sarah M. Olson
James L. Baillie
Fredrikson & Byron, P.A. (Minneapolis, Minnesota)

Recently, Fredrikson & Byron sponsored a seminar in Minneapolis for clients and friends of the firm on “DIRECTOR & OFFICER DUTIES BEFORE AND DURING CRISES: What Directors and Officers Need to Know to Plan For and Manage Insolvency and Other Company Challenges.” The authors of this article served as moderator and panelist, respectively. During a preparation session, the panelists had a lively discussion about how to respond when directors ask if they should resign when a crisis arises. Given the divergent viewpoints, the topic was added to the presentation, where it generated another spirited discussion. The panelists, who have decades of experience individually, offered a number of different perspectives drawn from their experience. Later legal research showed that while the authorities are sparse, the case law and commentaries are consistent with the experience of the panelists.

Mark Sheffert, principal of Manchester Companies, has served on more than 50 company boards, and has been an advisor to more than 100. He was named an Outstanding Minnesota Director and awarded the Outstanding Director - Lifetime Achievement Award by the National Association of Corporate Directors, and was recently inducted into the Minnesota Business Hall of Fame. Mark generally advises directors that they ought not resign. The problems that the company is now experiencing happened on their watch. Rather than resigning, this is the time to become even more active: step up, be more involved and be more aware of their fiduciary duties to try and solve the problems facing the company. It is a time to hold officers to their duties, get more and better information, and obtain and rely on professional advice. 

Jim Baillie, senior member of the Bankruptcy Department at Fredrikson & Byron, with more than 45 years of bankruptcy experience, supported this view. He opined that, in his experience, when people later look back at the crisis they tend to blame the directors who resign (it can be taken as an admission of a previous lack of attention), rather than those who stayed involved and tried to fix the problem.

John Stout, head of the Corporate Governance Group at Fredrikson and recent Chair of the Corporate Governance Committee of the ABA Section of Business Law, was quick to offer a competing consideration and raise the enthusiasm of the discussion. When he helps a board through a crisis, he tries to guide them to becoming an active and effective board, and part of this can mean getting rid of the dead wood. He noted that certain people are not cut out to deal well with crises, and it may be better to replace them with new directors who have the skills to deal with the situation at hand. John also reminded the panel and audience that the action of resigning may in itself have fiduciary duty ramifications. The directors may need to be separately advised. The professional advising the company should make clear that the only advice being offered is for the company itself and not for individual directors, whose interests may be inconsistent.

Jim also reminded the audience that once a company enters a court-supervised proceeding, such as a chapter 11 bankruptcy case, the directors should be safer as to future actions and decisions. The company should be advised by competent counsel, important decisions will be very visible and often negotiated with the other stakeholders, and—most significantly—the actions will be blessed by a court order.

Jim also raised the topic of D&O insurance in chapter 11 cases. The topic should have been addressed before the filing, but if not, the question will arise as to whether a court order is necessary to renew D&O insurance or buy a “tail,” and whether estate funds can be used to pay. Some years ago, the bankruptcy court in the Baldwin-United Corporation case addressed a similar question: whether funds of the bankruptcy estate could be used to meet the company’s indemnification obligations by paying the legal fees of directors who were named as defendants in securities actions alleging misconduct during their terms as directors. In re Baldwin-United Corp., 43 B.R. 443 (S.D. Ohio 1984). The debtor argued that the use of funds should be approved because the company needed to keep its directors, and would not be able to if it did not comply with the indemnification provisions in its bylaws. The court determined that the funds could not be spent as to the former directors—that those directors who resigned did not get the benefit of the indemnification (notably, the Baldwin-United court commented that the problem may have been avoided had the company had D&O insurance). Jim suggested that a similar outcome may result if a court determination was made regarding whether estate funds may be used to renew D&O insurance or purchase a tail. One potential ally of a debtor seeking to pay for continued D&O insurance coverage or indemnification may be the creditors’ committee. A committee may want coverage to be maintained and may support a motion to pay ongoing premiums, as claims against D&O insurance policies could be a major source of recovery by unsecured creditors.

There are other pertinent issues related to D&O insurance coverage and indemnification obligations that may affect a director’s decision regarding whether to resign. John Ratelle, Vice-President at Marsh McClennan, had already provided an overview on D&O insurance, including the key point that the time to buy the right amount of coverage is before the actions that give rise to claims. Another time to take a close look at coverage is when a crisis arises. Directors considering resigning due to a crisis should want to know: does the company have an ongoing duty of providing a defense or indemnification if they resign? Will it have the funds to do so? Will renewals of coverage or the purchase of tail coverage apply to them? Will they be able to buy tail coverage for themselves individually? These practical concerns may affect a director’s decision regarding resignation.

So did research support the experience and judgment of the panelists?

Generally, yes. It showed that an analysis of the appropriateness of a director’s resignation during a time of crisis is a fact-specific inquiry; while resignation may be appropriate in certain circumstances, it can be a breach of fiduciary duties in other situations, so it may be a risky proposition. 

As explicitly provided in many state statutes governing corporations, directors may free themselves of their fiduciary duties to a company by resigning, and have a right to resign. See, e.g., Minnesota Business Corporation Act, Minn. Stat. § 302A.221; see also, e.g., Gerdes v. Reynolds, 28 N.Y.S.2d 622, 651 (N.Y. Sup. Ct. 1941). A director’s right to resign and the appropriateness of the resignation, however, are qualified by fiduciary obligations. Gerdes, 28 N.Y.S.2d at 651. As a result, the act of resignation itself may constitute a breach of fiduciary duties in certain circumstances. For example, directors would breach their fiduciary duties by resigning “if the immediate consequence would be to leave the interests of the company without proper care and protection.” Gerdes, 28 N.Y.S.2d at 651 (holding that directors—who were also the controlling shareholders—violated their fiduciary duties by selling their stock at an inflated price and then resigning en masse and electing successors designated by purchasers, who then wasted the company’s assets).

In one case that helpfully illustrates this concept, the directors discovered that the company’s CEO (who was also Chair of the board) had been stealing assets of the company for 18 months. After being “stonewalled” in their investigation, the directors resigned. Shareholders filed a derivative lawsuit, claiming the directors breached their duty of loyalty for failing to exercise reasonable oversight over the company and its activities. Delaware Judge Leo Strine, Jr.—currently the Chief Judge of the Delaware Supreme Court—denied the directors’ motion to dismiss, opining that it may have been a breach of fiduciary duty on the part of the directors to simply resign upon discovering the theft, instead of causing the company to sue. As the judge noted, the directors’ resignation effectively left the company “under the sole dominion of a person [the CEO] they believe has pervasively breached his fiduciary duty of loyalty.” In re Puda Coal Stockholders’ Litigation, C.A. No. 6476-CS (Del. Ch. Feb. 6, 2013).

In a similar case, auditors discovered a $130 million cash transfer out of the company that was previously unknown to the board. A shareholder suit triggered an investigation by the board’s audit committee, but the investigation was abandoned when management failed to pay the incurred fees. The independent directors resigned, and then faced claims for breach of fiduciary duty. The judge denied the directors’ motion to dismiss, stating that the resignation itself may have constituted an abdication of their duties, because they should have instead stayed to ensure that a meaningful investigation was conducted on behalf of the company. Rich v. Chong, C.A. No. 7616-VCG (Del. Ch. April 25, 2013).

Given the practical and legal issues that can arise following a director’s resignation during a crisis, the risks of resigning likely outweigh any perceived protection. As an article by one group of commentators—including Martin Lipton, a leading New York attorney and expert on corporate governance—concluded:

Each crisis is different and it is difficult to give general advice that will be relevant to any particular crisis without knowing the facts involved. That said, in most instances when a crisis arises, the directors are best advised to manage through it as a collegial body working in unison. While there may be an impulse to resign from the board upon the discovery of a crisis, directors are best served in most instances if they stay on the board until the crisis has been fully vetted and brought under control.

Martin Lipton et al., White Papers and Memos, Some Thoughts for Boards of Directors in 2009, Wachtell, Lipton, Rosen and Katz (Cheetah) (Dec. 2008).