The recent settlement in Allegheny Health, Education and Research Foundation (AHERF)¹ relating to the recovery of allegedly misapplied charitable assets, together with the general fragility of the health care finance system, suggests that fiduciaries of health industry companies should be—and are increasingly being advised by sophisticated health care attorneys and financial advisors to be—attentive to "zone of insolvency" issues when they encounter financial distress.²

While compliance with the Sarbanes-Oxley Act³ should make the corporate board more attentive to financial oversight, the "shift" in a director's fiduciary duties (for the benefit of creditors) that occurs when a corporation becomes insolvent is unlikely to be readily apparent to the board (regardless of its diligence). This may be particularly so for the many health industry companies that are not-for-profits with "charitable missions" (i.e., no shareholders) and whose boards are generally composed of community representatives.⁴ Yet zone-of-insolvency concepts, which have been applied to commercial ventures for years, are becoming increasingly relevant to such health industry companies. Unfamiliarity with those duties in the zone of insolvency can create problems for the board and for its creditors. For the benefit of both of those principal constituencies, several important considerations should be noted.

The "Shift"

Corporate law generally provides that the core fiduciary duties owed by a director (e.g., care, loyalty and, for nonprofits, obedience to corporate purpose) undergo a "shift" when the corporation enters the zone of insolvency. At that point, the directors become obligated to act for the benefit of the corporate enterprise as a whole, including not only employees and other constituency groups, but most importantly, the creditors of the corporation. The reason for this "shift" is reasonably simple: Before insolvency, the corporate assets were held for the primary benefit of the shareholders (or, in the nonprofit corporation sense, the charitable mission). Upon the point of insolvency, the creditors assume greater equitable control of the corporation because they are the primary parties that maintain an interest in the assets of the corporation.⁵

Thus, as the corporation approaches the zone of insolvency, the board of directors and non-director officers must be made aware of a number of important questions.

When Does Insolvency Occur?

Obviously, this is the central question. The law suggests two separate standards that may be applied depending on the jurisdiction involved. The "equitable insolvency test" considers a corporation to be insolvent when it is unable to pay its debts as they become due.⁶ The "balance-sheet insolvency test" considers a corporation to be insolvent when its total liabilities exceed its total assets.⁷ A corporation may be considered to have entered the zone of insolvency if it enters into a transaction that leaves the corporation with an unreasonably small capital base, making insolvency reasonably foreseeable.⁸

What Is the Allocation of Duties?

The second question is, once the "shift" in the duties has occurred, are the duties then owed exclusively to the creditors, or there are any residual duties owed to the shareholders/charitable mission? Thus, when considering insolvency questions, the law of the state of the relevant jurisdiction must be reviewed to determine if the directors owe their duties exclusively for the financial benefit of the creditors or its shareholders/charitable mission as well.

What Is the Relevant Standard of Conduct?

Once the question of "exclusivity" is resolved, it will be important to determine the standard of conduct by which the directors will be evaluated. Again, the answer may depend on the jurisdiction. In some states, a "trust"-type standard will be applied, under which a director will be held to a much higher standard of care with respect to his or her business conduct than the corporate law board standards articulated in the Model Business Corporation Act with respect to the duty of care.

In other states, a director's conduct will be evaluated in accordance with the (more benevolent) provisions of the "business judgment rule." Where this standard of care is applicable, directors who make "honest and good-faith judgments in the lawful and legitimate exercise of corporate purposes...without any evidence of fraud, bad faith or self dealing" should have their actions protected even if their judgment is subsequently determined to be incorrect.

The distinction between these two standards is a significant one for directors conscious of their risk in the zone of insolvency. For example, directors subject to trust law standards may be held liable for acts of simple negligence in their performance as director, whereas directors protected by the business judgment rule will be shielded from liability. In addition, trust law may apply a complete ban against self-dealing in all forms, while a business corporation-type approach may authorize a transaction that involved certain types of conflicts of interest as long as safeguards were in place. Third, directors subject to trust law standards may be more limited in their ability to delegate functions than under a business judgment standard.⁹

Conduct that May Create Risk

The courts have provided some guidance on the specific types of director conduct in the zone of insolvency that might give rise to director liability exposure, regardless of the relevant standard case, including (a) manipulation of the assets, properties and liabilities of a subsidiary for the sole benefit of the parent;¹⁰ (b) approval of a transaction that would principally benefit individual directors and not the corporation as a whole;¹¹ (c) forgiveness of debts to an insolvent corporation;¹² and (d) approving loans made by the corporation during its insolvency under less than market rate terms.¹³

It is not difficult to consider other "zone" scenarios in which director conduct could be perceived as conflicting with the duty to creditors; e.g., a decision not to pursue collection of outstanding receivables from creditors, allocation of substantial capital and personnel resources to a major capital project, entry into a new line of business on a speculative basis and entering into a lucrative employment retention arrangement with senior management.

Recommended Action Items

Health care financial managers and their advisors should consider a series of steps to better position the board of directors and the corporation to address issues associated with the zone of insolvency.

1. Consistent with the principles set forth in the Sarbanes-Oxley Act, provide clear, precise "plain English" financial reports and related disclosure to the board of directors, to better enable it to identify when the financially distressed corporation may enter the zone of insolvency. Confirm in corporate governance policies and executive employment agreements the obligation of senior management to advise the board regularly on financial condition.
2. Incorporate reference to the "shift" in director duties in the zone of insolvency into any corporate/board document or policy that sets forth the board's core fiduciary duties.
3. For health care systems with multiple subsidiaries and operating entities, treat (as appropriate) intra-system financial arrangements as "loans" from the parent to the affiliate to enhance the ability of the parent to be treated as a legitimate creditor of the affiliate in the event of the latter's bankruptcy or other similar condition.
4. When in the "zone," the board should pay particular attention to the financial impact of proposed corporate transactions and in that regard consider retaining a financial advisor to opine on the fairness of any such transaction.¹⁴
5. Boards of nonprofit health care corporations approaching or within the "zone" should adopt specific protections to assure that donor-restricted funds will not be used in an inappropriate manner (e.g., used in an unrestricted manner toward operation).
6. In situations where a nonprofit board is faced with a zone of insolvency conflict between duties (e.g., where a business decision might benefit creditors but be inconsistent with the charitable mission), it may be appropriate to consult the state attorney general before any decision is made.¹⁵

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Footnotes

¹ Terms of the settlement are disclosed in a public announcement by the Pennsylvania Attorney General, dated Jan. 16, 2002. Return to article

² See, e.g., "Pa. Hospital Files for Chapter 11," Modern Healthcare, Sept. 9, 2002. Return to article

³ See Peregrine, Horton and Libby, "The New 'Corporate Responsibility' Law: How it Affects Health Care," BNA's Health Law Report, Aug. 22, 2002. Return to article

⁴ A majority of health care providers in the United States are still not-for-profit corporations whose charters describe or are subject to their "charitable mission." That charitable mission may be and increasingly has been enforced by the attorney generals of the respective states. See Manhattan Eye, Ear & Throat Hospital (MEETH) v. Spitzer, 715 N.Y.S. 2nd 575 (Sup. Ct. 1999). See, also, Peregrine, Schwartz, Burgdorfer and Gordon, "The Fiduciary Duties of Healthcare Directors in the 'Zone of Insolvency,'" AHLA's Journal of Health Law, Spring, 2002, Vol. 35, No. 2. Return to article

⁵ See, e.g., Geyer v. Ingersoll Publications Co., 621 A.2d 784 (Del. Ch. 1992), aff'd. in part and rev'd. in part, No. 97C7934, 2000 U.S. Dist. 276, at 1* (N.D. Ill. Jan. 11, 2000). Return to article

⁶ See, e.g., Califano, Thomas A., "A Shift in Fiduciary Duties: When a Corporation Approaches Insolvency, Its Directors Owe Responsibilities to Creditors," Nat'l. L.J., Sept. 17, 2001, at B16. Return to article

⁷ See, e.g., Geyer v. Ingersoll, supra. Return to article

⁸ Brandt v. Hicks, Muse & Co. Inc., 208 B.R. 288, 302 (Bankr. D. Mass 1997). Return to article

⁹ Reference in this general regard should be made to the seminal decision, Credit Lyonnais Bank Nederland N.V. v. Pathe Communications Corp., No. 12510, 1991 Del. Ch. LEXIS 215 (Del. Ch. Dec. 30, 1991). Return to article

¹⁰ Federal Deposit Ins. Corp. v. Sea Pines Co., 692 F. 2d 973, 977 (4th Cir. 1982). Return to article

¹¹ Wieboldt Stores v. Schottenstein, 94 B.R. 488, 509 (N.D. Ill. 1988). Return to article

¹² First Options Inc. v. Polonitza, No. 88-C-2998 1990 WL 114740, at *4 (N.D. Ill., July 31, 1990). Return to article

¹³ Clarkson Co. v. Shaheen, 660 F.2d 506 (2d Cir. 1981). Return to article

¹⁴ See, e.g., In re Allied Riser Corp., C.A. No. 19298 (Del. Ch. Jan. 30, 2002). Return to article

¹⁵ The authors wish to generally credit Peregrine, Schwartz, Burgdorfer and Gordon, authors of "The Fiduciary Duties of Healthcare Directors in the 'Zone of Insolvency,'" in the preparation of this article. Return to article

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