CEOs and owners of businesses filing for Chapter 11 bankruptcy face many tough challenges. In addition to managing the ongoing operations of their businesses under stressful circumstances, navigating complex Chapter 11 proceedings, and properly fulfilling their fiduciary duties towards employees, shareholders, and creditors, they may find themselves exposed to personal liability claims that have arisen out of the bankruptcy process.
The three sources of potential liability that the CEOs of distressed companies may face are:
The three sources of potential liability that the CEOs of distressed companies may face are:
1. Personal guaranties
While personal guaranties are very rarely given by the CEOs of public companies or venture capital-owned companies, it is not an uncommon practice for CEOs of other private companies to provide them relatively often. In such cases, the only way out of a personal guaranty is for the business to pay the debt in full, a proceeding that may bring up additional legal difficulties if the business in question is facing bankruptcy. This is due to provisions in bankruptcy law against preferential transfers, which are payments made to creditors in the 90-day period before bankruptcy is filed, and which are considered to provide those creditors with an unfair advantage over other creditors who have no choice but to wait to receive their payment until after the bankruptcy case has been settled.
Personal liability enters this situation in the following way: most personal guaranties typically come with the provision that, even if the debt is paid in full by the company, the personal guaranty is reinstated if the original payment is later recovered as a preferential transfer. Furthermore, when a creditor holds a personal guaranty from a CEO or another company insider, the pre-bankruptcy period during which payments can be recovered as preferential transfers extends from 90 days to up to an entire year. What this means is that the full value of any preferential payments made during the year leading up to bankruptcy may be recovered directly from the guarantor.
Personal liability enters this situation in the following way: most personal guaranties typically come with the provision that, even if the debt is paid in full by the company, the personal guaranty is reinstated if the original payment is later recovered as a preferential transfer. Furthermore, when a creditor holds a personal guaranty from a CEO or another company insider, the pre-bankruptcy period during which payments can be recovered as preferential transfers extends from 90 days to up to an entire year. What this means is that the full value of any preferential payments made during the year leading up to bankruptcy may be recovered directly from the guarantor.
2. Personal liability for payroll and taxes
Under certain state laws, employees of companies in bankruptcy can sue responsible officers, including the CEO, for unpaid wages, as well as vacation pay, bonuses, and severance payments in some cases. Given that most companies pay their employees in arrears, the total amount of accrued but unpaid salaries can be significant in the event of a sudden company shutdown.
A CEO may also face personal liability for what is known as “trust fund taxes,” which are taxes that the company has withheld or collected on behalf of the government, but has not yet turned over to the government. Examples include taxes withheld from employees’ paychecks or sales taxes collected from customers, but not yet paid to the government. Responsible officers typically have personal liability for these amounts.
The only surefire way to avoid these personal liabilities is to fund payroll and trust fund taxes in cash on a pay-as-you-go basis. Escrow accounts are sometimes used to avoid seizure of funds by unpaid creditors or to prevent the funds in question from becoming part of the bankruptcy estate. If such arrangements are impractical, all is not lost. Most bankruptcy courts permit payroll and trust fund taxes accrued before bankruptcy to be paid in a timely manner, and they have a higher priority than other general unsecured creditors.
A CEO may also face personal liability for what is known as “trust fund taxes,” which are taxes that the company has withheld or collected on behalf of the government, but has not yet turned over to the government. Examples include taxes withheld from employees’ paychecks or sales taxes collected from customers, but not yet paid to the government. Responsible officers typically have personal liability for these amounts.
The only surefire way to avoid these personal liabilities is to fund payroll and trust fund taxes in cash on a pay-as-you-go basis. Escrow accounts are sometimes used to avoid seizure of funds by unpaid creditors or to prevent the funds in question from becoming part of the bankruptcy estate. If such arrangements are impractical, all is not lost. Most bankruptcy courts permit payroll and trust fund taxes accrued before bankruptcy to be paid in a timely manner, and they have a higher priority than other general unsecured creditors.
3. Credit fraud
Another source of personal liability arises out of the actions of a company toward its suppliers and creditors in the period before bankruptcy is filed. Typically, if a company is behind on its payments to a trade creditor, the creditor will seek assurance from the company that payment is forthcoming. However, if a company attempts to placate the creditor by promising payment when, in fact, they have no means to pay, they are entering into dangerous territory. Making a false statement in order to obtain credit or goods against future payment can lead to personal liability exposure, and even to a criminal conviction. In such a case, it makes no difference that the CEO was acting on behalf of the company and not for personal gain. In addition, it can be argued that companies that continue to accept goods from suppliers as they prepare for a bankruptcy filing are misleading their creditors, and that they never intended to pay the debts incurred given that bankruptcy was already imminent.
However, although CEOs may face personal liability for credit fraud, actual cases of this are relatively rare. In the period leading up to a Chapter 11 filing, creditors will typically be conducting business with the company on a cash-on-delivery or similar basis, and the company will usually do its utmost to avoid inducing creditors to increase their aggregate exposure. Both of these behaviors decrease the likelihood of a credit fraud suit, and help to avert the animosity that can arise after a Chapter 11 filing, when creditors may feel misled or abused by the pre-bankruptcy conduct of the company.
However, although CEOs may face personal liability for credit fraud, actual cases of this are relatively rare. In the period leading up to a Chapter 11 filing, creditors will typically be conducting business with the company on a cash-on-delivery or similar basis, and the company will usually do its utmost to avoid inducing creditors to increase their aggregate exposure. Both of these behaviors decrease the likelihood of a credit fraud suit, and help to avert the animosity that can arise after a Chapter 11 filing, when creditors may feel misled or abused by the pre-bankruptcy conduct of the company.