Fiduciary Duties During Insolvency –

NEW YORK – You’re sitting on the board of the 15th wireless company in a market with room for only 10 companies. To top it off, the product is stuck in beta, and your biggest customer just shut down. Sound like fun? Probably not, but hopefully it’s not a familiar situation.

Venture capitalists who act as portfolio company directors serve several masters in the best situation. However, when insolvency rears its head, they also must deal in the interests of the company’s creditors.

“Your responsibility is to pay the creditors first,” said Jonathan Bell, shareholder in Greenberg Traurig LLP. “But, you really want to make sure the shareholders get paid.”

The courts test insolvency in a handful of ways, but regardless of the balance sheet, fiduciary responsibilities shift facing the imminent inability to pay the bills – for example, when the financing strategy falls through or the receivables get strung out.

Directors get in trouble by making transactions favorable to related parties, such as paying directors large consulting fees, approving dividends or allowing stock redemption during troubled times.

While bankruptcy provides some shelter, directors should proceed cautiously and make sure the company pays the premiums on the directors’ and officers’ insurance.

Most corporations purchase D&O policies for their board members, because this area of corporate practice exposes personal assets, typically of a high-net-worth individual, according to Mike Wiebe, senior vice-president at Marsh & McLennan.

However, Richard Couch, chairman of Diablo Management Group, warned about needling over the letter of the law. VCs have to act quickly and intuitively if they are going to save the company. If everybody starts fighting over the assets, the game is over.

“[In a recent turnaround case, the board] stopped talking to operating guys and started talking to lawyers,” Couch said. “That deal saw its probabilities of a turnaround cut in half just because of the conversations that were taking place.”

Michael Littenberg, corporate partner at Schulte Roth & Zabel LLP, said most creditors may not be inclined to sue. Most likely, lawsuits will only come from large creditors like major vendors and consultants, but even some large creditors chose not to sue because the lawsuit may hurt their chances to attract future customers. Creditors are also only likely to sue those directors with deep pockets or insurance policies.

VCs should understand their fiduciary responsibilities, consult their counsel often and know their D&O policies. The consequences of fiduciary indiscretion include defending a lawsuit, personal liability, increased D&O insurance premiums and tarnished reputations.

“I tell all the venture capitalists, you make money on new deals, you don’t ever make money on what’s behind you,” Couch said.