Minimizing Directors’ Liability When Raising Capital

Commonly, a publicly held corporation will go to the public markets in order to raise capital. Unfortunately, directors’ risk of liability can be substantially increased when a company is raising capital. This is particularly the case if any of the lenders or investors in a particular capital raise are unhappy with what has become of their investment.

When things turn out as planned, and the investors or lenders are either paid back or their investment is worth substantially more than their initial outlay, there is rarely any litigation. However, if for some reason the stock tanks, or if the capital raise was achieved through some sort of loan transaction and the debt doesn’t get repaid, the chance of litigation increases substantially and the directors may be at risk.

Avoiding Risk

The following are some examples of capital-raising transactions leading to increased directors’ risk.

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  1. The company files for bankruptcy shortly after capital is raised.

    Risk: As hard as this may be to believe, there have been plenty of instances wherein a company goes into some form of bankruptcy shortly after having successfully raised money in order to pursue its business strategy. Of course, there can be extenuating circumstances to the bankruptcy that can mitigate directors’ liability (such as natural disaster, sudden labor strike, etc.).

    If, however, there is no outside cause that brought about the bankruptcy filing, you can be pretty sure that a lawsuit will soon follow. The litigants would probably claim that the directors were aware, or should have been aware, of factors that made the loan or investment unsound.

    Remedy: In the first instance, if there were some sort of natural disaster or calamity (earthquake, hurricane, fire), the risk to directors would be greatly diminished. The most obvious risk in this situation would be that the company did not maintain adequate insurance against such a disaster. If that were the case, then there could be some directors’ exposure.

    However, in the second instance, where there was no outside factor that brought about the bankruptcy, the directors would surely be exposed. To eliminate this exposure the directors would have to be extremely proactive in overseeing any fund-raising by the corporation. They should also assure themselves that the funds raised would either be repaid (in the case of a loan) or would give the investors a good return for their money. If the directors were actively engaged and voted against such this fund-raise, there would obviously be no problem.

  2. The company does not pay the debt incurred as agreed.

    Risk: Here again, the directors would be exposed to a lawsuit and liability. The creditors would be sure to say that the directors should have known that the conditions of the debt instrument (loan) would not be met. The lawsuit would assume that the directors read the loan instrument and in some fashion either approved it or allowed it to be signed without their formal approval. In either case, there would be risk to the directors.

    Remedy: The remedy in this case is quite similar to the remedy described above. That is, the directors should be actively involved in any major borrowing by the corporation and should provide as much input and guidance as possible. Such involvement would surely mitigate directors’ risk.

  3. The company’s stock nosedives and doesn’t recover in the short run.

    Risk: If, after raising money through the issuance of stock, the company’s stock price swoons, certainly there would be exposure to directors. A lawsuit would likely claim that the directors should have known that something untoward would happen to the stock and to the value of the new investors’ holdings. Litigants would do all that they could to prove that the directors were asleep at the switch.

    Remedy: No one can accurately predict what will happen to a company’s stock. However, if the stock plummets shortly after the raise, the directors have some explaining to do. If the cause were beyond their control, they shouldn’t have a problem.

    The best way to insulate against this type of risk is to be a very proactive director and to question the reasons for a capital raise and the “promises” made in order to gain the capital. If the promises made were reasonable and there were high hopes that the company’s stock would recover, this fact should be quickly communicated to investors.

A General Remedy

Besides being proactive, the directors should be assured that their legal counsel is highly competent and deeply experienced. With such counsel on your side, the chances of a retaliatory stockholders’ or borrowers’ suit are greatly reduced. Directors should meet often with corporate security counsel and ask probing and meaningful questions.

Actually, with the right counsel, your questions will be answered before you even have a chance to ask them. Competent counsel strives mightily to protect the company’s and the directors’ interest and to communicate relevant risks to directors.

Finally, as a backstop for you as a director, insist on adequate directors’ and officers’ (D&O) insurance. Hopefully, you’ll never need it. Good luck!

Theodore F. di Stefano is a founder and managing partner at Capital Source Partners, which provides a wide range of investment banking services to the small and medium-sized business. He is also a frequent speaker to business groups on financial and corporate governance matters. He can be contacted at [email protected].

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