The three sources of potential liability that the CEOs of distressed companies may face are:
1. Personal guaranties
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
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
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.