sary financial documents needed for and
during a bankruptcy filing, allowing the
owner to remain focused on business
operations.
business to the "zone of insolvency" (de-
scribed further below) has an important
effect on the duties of the directors.
The duty of loyalty requires directors
and officers to perform their duties in
good faith and in a manner that they
reasonably believe to be in the best
interests of the company. The duty of
loyalty generally mandates that the
best interests of the corporation and
its shareholders take precedence over
any interests possessed by a director,
officer or controlling shareholder and not
shared by the stockholders generally.
The duty of care requires directors and
officers to act with the care an ordinarily
prudent person in a like position would
exercise under similar circumstances. A
director or officer who fails to exercise
appropriate diligence may violate the
duty of care, even if such officer or
director did not realize any personal
gain from the transaction at issue.
However, directors (as well as officers)
are generally protected by the "business
judgment" rule from liability arising from
negligent acts (as opposed to intentional
or grossly negligent misconduct).
a company is in the "zone of insolvency."
A company is insolvent when its liabili-
ties exceed its assets. Most courts appar-
ently presume a business is on the brink
of insolvency if the questioned action by
the directors would or reasonably could
render the corporation insolvent in fact,
or that there is the risk that creditors will
not be paid.
insolvency," directors and officers owe a
fiduciary duty to shareholders. Directors
of an insolvent corporation have a
fiduciary duty to creditors. It is unclear
the directors' duty to shareholders. The
duty has been described as the duty as
to protect the contractual and priority
rights of creditors. If directors cause
their business to incur debt they may
be in breach of duties enforceable by
creditors if, for example, the directors
cause the business to incur unnecessary
debt to or for the benefit of shareholders
or otherwise divert assets from legitimate
business uses.
only option
ruptcy is the only option, for most busi-
nesses there are typically two types of
bankruptcy that are relevant: a Chapter
7 liquidation and a Chapter 11 reorga-
nization. While Chapter 7 and 11 filings
are normally voluntary (i.e. the company
makes an affirmative decision to file),
they may be involuntary and forced on a
business which is delinquent in payment
of its creditors.
A business should only consider a
Chapter 7 liquidation if the business is
going to cease to operate. The purpose of
filing a Chapter 7 is to wind up a busi-
ness and put the final liquidation of the
assets in the hands of a trustee.
Unlike in a Chapter 7, in a Chapter
11 management of the business re-
mains in place as a debtor in possession
("DIP"). No trustee is appointed unless
the DIP has engaged in inappropriate
conduct or other fraudulent acts, in which
event a trustee might be appointed. A
Chapter 11 is very flexible; it allows a
company to either liquidate under the
control of the DIP, sell the assets or reor-
ganize. More often than not, management
(often with professional assistance) is in a
better position than a trustee to maximize
the return on the asset liquidation.
The bankruptcy code has a priority
scheme for the payout of creditors as
follows: secured creditors, administra-
tive creditors (which include the cost of
the bankruptcy, wages, taxes, deposits
on goods not delivered and certain other
items), unsecured creditors and finally,
equity holders.
is sent to creditors by the bankruptcy
court indicating both that the company
has filed a Chapter 7 bankruptcy and
whether or not assets are available for
distribution. In the event that assets
are available for distribution, creditors
may file claims in the bankruptcy case
and receive a pro rata distribution of
the assets available. All of the assets of
the company are delivered to a Chapter
7 trustee whose responsibility it is to
conduct the liquidation and disposition
of the assets.
A Chapter 11 is a business reorga-
nization. The purpose of a Chapter 11 is
to allow a business which is financially
distressed to get a breathing spell and
an opportunity to modify its financial
structure.
Upon the filing of a Chapter 11
bankruptcy, a separate estate, referred to
as a bankruptcy estate, is created. At this
point, the books and records of the busi-
ness are started anew as of the date of
the bankruptcy filing. Any assets created
by sales occurring post petition become
part of the bankruptcy estate.
In most Chapter 11 cases, a creditors'
committee is appointed. The creditors'
committee is usually between three and
seven of the largest unsecured creditors
of the company. The creditors' commit-
tee's role is to monitor the operations of
the Chapter 11 company. The company's
management will usually keep the com-
mittee closely involved in the decisions
that company makes, and on occasion
the company and the committee may dis-
agree, in which event the disagreement is
resolved by the court.
If the Chapter 11 company has a pre-
existing secured loan, then bankruptcy
law requires that the lender either con-
sent to, or the court approve, the use of
"cash collateral" during the course of the
Chapter 11. "Cash collateral" is the pro-
ceeds generated from the security held
by the lender. Receivables generated
from inventory security held by a lender
are "cash collateral." The company is not
allowed to use the cash generated from