In a down market, directors must maintain focus on the fundamentals: state of the business, management, and company liquidity
The corollary to "the more things change, the more they stay the same" is that no one can accurately predict what is going to change next. Economic forecasts range from dire to optimistic, and the march of unexpected events continues without end in sight. Seemingly solid financial institutions have been shaken by unforeseen market conditions; merger and acquisition transactions that appeared certain have fallen apart; and everyone from presidents to Fed chairs are coming under scrutiny and facing criticism. Harsh consequences for behavior that once appeared forgivable is now the rule, not the exception.
In this current period of volatility, directors may be surprised at how quickly a company's fortunes can change. They may find themselves in a difficult situation through no fault of their own or their board's. It is of paramount importance in these circumstances for directors to remember that even in the most uncertain of times, the fundamentals of directorship continue to apply: directors must responsibly oversee company affairs. The business-judgment rule remains the standard for judicial review of their ordinary-course business decisions.
Although well known to most directors, like the Boy Scout motto, it bears repeating: In the broadest sense, it is the responsibility of directors to oversee the affairs of a company and it is management's job to run the day-to-day operations. In times of market uncertainty, there are generally three main areas on which directors should focus their attention: the state of the company's business, the quality and depth of the company's management (including succession planning), and the company's liquidity.
This Year's Model
Paying careful attention to the overall state of the company's business is central to a director's responsibilities. Directors should, in response to changing economic conditions, evaluate the sustainability of the company's business model. For example, the collapse of the subprime mortgage market caused significant collateral damage—some of which was foreseeable and much of which was not—to many companies in different industries. Financially disruptive events may occur with little warning. However, if a company's management and board are aware of potential vulnerabilities arising from changing market conditions and are willing to adapt their business model and strategy, they may be able to reduce their exposure in time to avert a crisis.
Similarly, as economic conditions change, it is important that the board is certain that it has the appropriate management team in place to weather any crisis. Management's qualifications and capabilities should be reassessed in terms of experience, expertise, commitment, leadership ability, and depth. Moreover, the board should make certain that the chief executive officer knows that he or she has the support of the board for the company's strategic direction, if that is the case, or directors should communicate their concerns if there are any differering views on strategic direction.
An important part of this process is making sure that the board hears regularly from the chief executive officer's direct reports so it has sufficient confidence in the entire management team. This should be an important component of the board's succession planning process as well. These matters should be addressed during the board's executive session, which should be on the agenda for each board meeting.
Minding the Store
Once directors have satisfied themselves that the business model and the chief executive officer's strategy continue to be appropriate, and that the current management team is capable of effectively managing the company's current circumstances, directors should be sure they understand the key elements of the company's business performance. Directors should have a clear understanding of how revenue sources might react to changing conditions in the economy in general or their industry in particular. For example, directors should have a general understanding of the company's customer base and whether it is changing in meaningful ways. Directors also should have a good overall sense of the company's operating costs, including labor and goods sold, as well as selling, general, and administrative expenses. Directors should take a broad view of the company's financial and market position in order to be able to ask management about potential vulnerabilities in performance, depending on different economic scenarios.
Board members also need to focus their attention on the company's liquidity. This issue is especially important in today's market environment. A clear understanding of the company's cash flow and credit arrangements, including covenant obligations, is vital. Directors should also be aware of whether the company's business has a seasonal need for cash and be assured that at the point of the company's greatest need for cash, it will continue to have sufficient access to capital to meet the needs of its business. It is important that management can explain what will occur if cash flow is not as strong as anticipated. For example, if a business downturn were to coincide with a peak cash need, how severely would the company's liquidity be affected?
Liquidity and its close cousin, solvency, are key in the merger and acquisition context. The failed purchase of footwear retailer Genesco by its smaller competitor Finish Line is a cautionary tale. Finish Line attempted to acquire Genesco in a highly leveraged transaction. The transaction had no financing condition, but the financing commitment provided to Finish Line was contingent on the solvency of the combined company. Although the strategic transaction appeared to be relatively certain of closing when it was announced, that was no longer the case when, due to a sharp decline in business, the solvency of the combined company was put in doubt.
In the merger and acquisition context, directors should be careful to examine the liquidity and solvency risks, particularly in highly leveraged transactions where financing is at risk, and consider the impact on the company if the transaction is announced, but fails to be consummated.
It is worth noting that, in the zone of insolvency, directors' obligations may shift from the company's shareholders to the company's creditors, depending on which state law applies to the circumstances. Under Delaware law, when a company is insolvent, the board's priority potentially shifts to encompass the interests of creditors. This is an area that is highly dependent on specific factual circumstances, and directors of a company facing potential insolvency should seek expert legal counsel in determining the parameters of their duties.
Directors should always focus on succession planning, but a challenging economic environment increases its importance. If a company experiences a downturn at the same time that the chief executive officer (or another key member of management) exits without a clear successor, it will be difficult for the board and the remaining management team to effectively deal with the challenges facing the company. As directors are considering contingencies, they should be mindful of the succession plan and whether it continues to be appropriate in light of changing circumstances, both internal and external.
Need to Know
Reporting and information systems are the enemies of liability. Directors' fiduciary duties do not change with market conditions, nor does the applicability of the business-judgment rule. The degree of vigilance required of a director changes, depending on the circumstances a particular company is facing. Directors should pay close attention to market conditions and think carefully how trends or events affect the company's business and strategy. As long as directors act on a fully informed basis, in good faith, and in the manner they reasonably believe to be in the best interests of the company, their ordinary-course business decisions will receive the protection of the business-judgment rule. In cases where the traditional business-judgment rule applies, directors' decisions are protected unless a plaintiff is able to carry its burden of proof in showing that a board of directors has not met its duty of care or loyalty. In Delaware, it is clear that directors will only have liability in their oversight role in exceptional circumstances, such as when directors utterly fail to implement any reporting or information system or controls; or when directors implemented such a system or controls, but consciously failed to monitor or oversee its operations, thus disabling themselves from being informed of risks or problems requiring their attention. In either case, imposition of liability requires showing the directors knew they were not discharging their fiduciary obligations.
In light of recent cases, directors should actively seek information that will make them "fully informed," which is the key principle at the core of the duty of care. To be fully informed, directors need to give due consideration to relevant materials and engage in appropriate deliberation. A director's conscious disregard of his or her responsibilities to the company—either through knowingly making decisions without adequate information and deliberation or through systematically ignoring a known risk—will not satisfy the legal requirement to act in good faith and on a fully informed basis.
In this context, it is the responsibility of the directors to request information they need to make a fully informed decision, as well as the obligation of the management team to provide sufficient information. In turn, directors are entitled to rely on members of management and other experts in making their decisions. Moreover, directors should not hesitate to ask the board's advisers for advice as to whether the information provided to them is sufficient for them to make a decision.
In the current litigious environment, it is important to ensure companies have up-to-date indemnification arrangements in place for board members and that companies have purchased adequate director and officer liability insurance polices.
All of these arrangements should be reviewed on a regular basis to ensure that directors have the fullest coverage available to them so they are protected against the risk of personal liability for their actions as directors. While director and officer liability insurance polices have become more expensive, they are generally available in most cases and should be purchased. Retentions and exclusions in insurance policies should be carefully studied, so directors understand where they have protection and where they do not. Directors also should request information about the financial strength of the companies providing different layers of the insurance coverage.
In addition, directors should consider the impact of a bankruptcy of the company on the availability of director and officer liability insurance. It is important to focus on how rights are allocated between the company, on the one hand, and the directors and officers, on the other hand, who may be claiming entitlement to the same aggregate dollars of coverage. In order to eliminate any ambiguity that might exist as to directors' rights to coverage and reimbursement of expenses in the case of a bankruptcy of the company, many companies have decided to purchase separate supplemental insurance policies covering the directors and officers individually (often known as "side-A" coverage) in addition to their standard policies. In the case of a bankruptcy, this will be money well spent.
Board directing is an active pursuit. Directors should satisfy themselves periodically that the company is pursuing the right strategic direction, that business and liquidity are sufficiently stable, and that management is prepared for contingencies in both its specific industry and the economy generally. If there are no storm clouds on the horizon for a particular company, there is no need to schedule additional board meetings or seek the advice of outside consultants simply because economic conditions are uncertain. That said, directors should stay in contact with management between board meetings, particularly when external events occur that could potentially affect the company's business and strategy. Directors may request information from management between board meetings and offer counsel to the chief executive officer or other members of management as appropriate for their particular company. In a volatile business climate, directors should be active, not passive, in exercising their oversight responsibilities.
It is important to note that, absent any substantial reason to believe that the company's management is not providing appropriate information or that management is ignoring "red flags," directors are entitled to rely on management's reports, advice, and decisions.