Health Care Enters the Zone of Insolvency

Journal Issue

Oct 2002

Column Name

Journal HTML Content

The recent settlement in Allegheny Health, Education and Research Foundation
(AHERF)<a href="#1" name="1a">1</a> 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.<a href="#2" name="2a">2</a>

While compliance with the Sarbanes-Oxley Act<a href="#3" name="3a">3</a> 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.<a href="#4" name="4a">4</a> 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.

<h3>The "Shift"</h3>

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.<a href="#5" name="5a">5</a>

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.

<h3>When Does Insolvency Occur?</h3>

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.<a href="#6" name="6a">6</a> The "balance-sheet insolvency test" considers a corporation to be
insolvent when its total liabilities exceed its total assets.<a href="#7" name="7a">7</a> 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.<a href="#8" name="8a">8</a>

<h3>What Is the Allocation of Duties?</h3>

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.

<h3>What Is the Relevant Standard of Conduct?</h3>

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.<a href="#9" name="9a">9</a>

<h3>Conduct that May Create Risk</h3>

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;<a href="#10" name="10a">10</a> (b) approval
of a transaction that would principally benefit individual directors and not the
corporation as a whole;<a href="#11" name="11a">11</a> (c) forgiveness of debts to an insolvent corporation;<a href="#12" name="12a">12</a>
and (d) approving loans made by the corporation during its insolvency under less than
market rate terms.<a href="#13" name="13a">13</a>

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.

<h3>Recommended Action Items</h3>

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.

<ol>
<li>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.

</li><li>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.

</li><li>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.

</li><li>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.<a href="#14" name="14a">14</a>

</li><li>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).

</li><li>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.<a href="#15" name="15a">15</a>

</li></ol>

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Terms of the settlement are disclosed in a public announcement by the Pennsylvania Attorney General, dated Jan. 16, 2002. <a href="#1a">Return to article</a>

<a name="2">2</a> See, e.g., "Pa. Hospital Files for Chapter 11," Modern Healthcare, Sept. 9, 2002. <a href="#2a">Return to article</a>

<a name="3">3</a> See Peregrine, Horton and Libby, "The New 'Corporate Responsibility' Law: How it Affects Health Care," BNA's Health Law
Report, Aug. 22, 2002. <a href="#3a">Return to article</a>

<a name="4">4</a> 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 <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Eye, Ear & Throat Hospital (MEETH) v. Spitzer, 715 N.Y.S. 2nd 575 (Sup. Ct. 1999)</a>. 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. <a href="#4a">Return to article</a>

<a name="5">5</a> See, e.g., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Ingersoll Publications Co., 621 A.2d 784 (Del. Ch. 1992)</a>, aff'd. in part and rev'd.
in part, No. 97C7934, 2000 U.S. Dist. 276, at 1* (N.D. Ill. Jan. 11, 2000). <a href="#5a">Return to article</a>

<a name="6">6</a> 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. <a href="#6a">Return to article</a>

<a name="7">7</a> See, e.g., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Ingersoll, supra.</a> <a href="#7a">Return to article</a>

<a name="8">8</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Hicks, Muse & Co. Inc., 208 B.R. 288, 302 (Bankr. D. Mass 1997)</a>. <a href="#8a">Return to article</a>

<a name="9">9</a> 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). <a href="#9a">Return to article</a>

<a name="10">10</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Deposit Ins. Corp. v. Sea Pines Co., 692 F. 2d 973, 977 (4th Cir. 1982)</a>. <a href="#10a">Return to article</a>

<a name="11">11</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Stores v. Schottenstein, 94 B.R. 488, 509 (N.D. Ill. 1988)</a>. <a href="#11a">Return to article</a>

<a name="12">12</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Options Inc. v. Polonitza, No. 88-C-2998 1990 WL 114740, at *4 (N.D. Ill., July 31,
1990)</a>. <a href="#12a">Return to article</a>

<a name="13">13</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Co. v. Shaheen, 660 F.2d 506 (2d Cir. 1981)</a>. <a href="#13a">Return to article</a>

<a name="14">14</a> See, e.g., In re Allied Riser Corp., C.A. No. 19298 (Del. Ch. Jan. 30, 2002). <a href="#14a">Return to article</a>

<a name="15">15</a> 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. <a href="#15a">Return to article</a>

<hr>

</td>
<td valign="top" width="125">

Journal Authors

Harold L. Kaplan

Journal Date

Tuesday, October 1, 2002 - 12:00

Bankruptcy Rule

2002