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The potential for individual liability for officers and directors arises as more venture-backed companies become distressed and face the prospect of insolvency. The ability of officers and directors to analyze and resolve competing responsibilities to company shareholders and creditors is further complicated by the potential, under some state wage laws, for personal liability for officers and directors for unpaid employee wages. This article focuses on two areas of potential personal liability for officers and directors: Potential personal liability of officers and directors under state wage payment statutes for the nonpayment of employee wages; and Potential personal liability of officers and directors for breach of fiduciary duties owed to creditors of the distressed company. This article also addresses the inherent conflict between the obligations for officers and directors and provides some strategies for identifying and addressing these competing responsibilities. I. POTENTIAL LIABILITY OF OFFICERS AND DIRECTORS UNDER STATE AND FEDERAL WAGE PAYMENT STATUTES Under the Fair Labor Standards Act (FLSA), the federal law governing the payment of wages, the definition of “employer” has been interpreted to include individual officers and directors that are either personally involved in payroll decisions or in a position to be aware of such decisions. Accordingly, under the FLSA, individual officers and directors of both solvent and insolvent companies have been held responsible for the company’s inability to meet its payroll obligations. In addition to the federal law, each state has its own wage payment laws governing the payment of wages by employers to employees. There are three critical elements of each state law: The definition of “employer;” the definition of “wages;” and the penalties prescribed for an employer’s failure to pay earned wages to employees. DEFINITION OF EMPLOYER Many state wage laws are worded either explicitly or implicitly to include officers and directors in their definition of the term “employer,” thereby creating potential personal liability of officers and directors for the nonpayment of employee wages. It is important to look at the text of each state’s wage law and the case law surrounding it to determine who will be considered an “employer.” In some states — Colorado, for example — mere status as an officer of a company is enough for personal liability to attach. In many states, however, including Delaware, Illinois, Massachusetts and Texas, the broad definition of “employer” has been interpreted to include only those officers who are personally involved in the actions leading to the nonpayment of employee wages. In states, such as California, with statutes that mirror the FLSA definition of “employer,” state agencies responsible for interpreting and applying the state’s wage laws have attempted to adopt the FLSA definition of “employer” in order to hold individual officers and directors liable for nonpayment of wages. In some states, the definition of “employer” also includes “agents” of the company. This raises the question of whether outside directors of a company could be considered “agents.” Under general agency principles, the board and its directors do not act as agents of the company unless they are involved in day-to-day operations. In the case of many venture-backed companies, however, outside directors are often very actively involved in management decisions, particularly in times of financial distress, as they attempt to exert more control over the company in an effort to protect their investment. Under such circumstances, outside directors may find themselves potentially liable for unpaid employee wages under wage laws that include “agents” in the definition of “employer.” DEFINITION OF WAGES The definition of “wages” also varies among the state wage laws. All states include all earned regular and overtime wages in the definition of wages. Most states also include earned but unused vacation and Paid Time Off (PTO) as well as vested and determinable commissions and bonuses. A minority of states includes other benefits as well. Severance payments established in executive employment agreements are also included in the definition of “wages” in many states. Under these employment agreements, severance payments often involve substantial payments to departing employees ranging up to 24 months of salary and benefits that must be paid out to the departing employee. Accordingly, in evaluating potential liability for unpaid employee wage claims, companies must identify all outstanding severance obligations and determine whether such amounts would be treated as “wages” under the relevant state statute. PENALTIES In all of the state statutes we examined, an “employer” who fails to make timely payment of wages is liable for the full amount of the “wages” unlawfully withheld. In addition, statutory penalties can include fines and criminal penalties. II. POTENTIAL LIABILITY OF OFFICERS AND DIRECTORS FOR THE BREACH OF FIDUCIARY DUTY TO CREDITORS The primary duties of the officers and directors of a solvent company are the duties of care and loyalty to the company and its shareholders. When the directors fulfill these duties, they are usually protected from personal liability. However, officers and directors of an insolvent company also owe fiduciary duties to creditors, and are under a heightened duty to maximize value in connection with the inevitable break up of the company. In fact, it is likely that even being in the zone of insolvency is sufficient to trigger these fiduciary duties to creditors. Although there are several different tests to determine insolvency, it is often hard to pinpoint when fiduciary duties to creditors arise. The conservative approach to complying with fiduciary duties to creditors is to assume that a company is in the zone of insolvency if there is any substantial doubt. Once it is determined that a company is in the zone of insolvency, officers and directors are charged with a fiduciary responsibility of protecting the interests of creditors based on an “informed business judgment” standard of care. This usually involves taking appropriate actions designed to maximize payment of the company’s outstanding creditors. Officers and directors who fail to carry out this responsibility may be subject to liability for breach of fiduciary duty. For example, a claim of breach of fiduciary duty may arise when officers and directors favor the interests of shareholders over creditors, engage in insider transactions, prefer one creditor over another creditor with an equally valid claim (make a “preferential payment”), or continue the business longer than is justified, thereby “wasting” the remaining corporate assets. III. COMPETING INTERESTS The desire to minimize personal liability for unpaid employee wage claims may compete with the officers’ and directors’ fiduciary responsibilities to the other creditors of the company. In the case of an insolvent or potentially insolvent company, employees with wage claims simply become additional unsecured creditors. Officers and directors cannot assume that directing a distressed company to make “preferred” payments to employees in order to avoid potential personal officer and director liability is an appropriate solution. Under such circumstances, employees may have a statutory “priority” that will allow a company to pay out a portion of the employee wage claims ahead of other unsecured creditors. For example, under federal bankruptcy law, employees are currently entitled to a priority claim over other unsecured creditors of $4,650 for certain employee wage claims. Should the amount owed the employee exceed $4,650, the employee can only recover the remainder by filing a claim with the bankruptcy court as an unsecured creditor and, if the applicable state wage statute permits, instituting legal action against the individual officers and directors of the Company. The extent, if any, to which employee wage claims have a priority over the claims of other unsecured creditors is dependent on applicable state or federal law and the type of liquidation proceeding that the company has chosen to pursue. A careful examination of the relevant state statutes is necessary to determine the extent of any such employee priority. In the event that the amount paid out to any individual employee exceeds the allowable statutory priority, the excess payment is voidable and, in some circumstances, may be viewed as a breach of the fiduciary duty of the officers and directors to other creditors. The trustee or assignee may seek to recover the excess payment from the employee and the officers and directors who authorized such a payment may be subject to a personal claim for breach of fiduciary duty. IV. BEST PRACTICE POINTERS Assess potential liabilities under the various state wage payment statutes. This includes a legal analysis of existing employment contracts, vacation policies, bonus programs, commissions programs, severance payment policies and any other forms of compensation that may accrue. Remember to pay special attention to governing law provisions in the employment documents. This assessment of potential liabilities will be a highly factual inquiry. Given the possibility of individual liability of officers and directors under state wage payment statutes, explore whether such claims would be covered by the company’s directors’ and officers’ liability policy. This will be a policy specific inquiry. Many policies do not cover employment practices claims, or coverage may exclude wage related claims. Consider the effect of any indemnification provisions relating to directors and officers in the certificate of incorporation or the company’s bylaws. Although the company is likely obligated to indemnify its directors and officers, remember that bankruptcy may render the company unable to fulfill that obligation. Consider options that will minimize the accrual of unpayable wages. Some of these options may include a reduction of pay rates, temporary shutdowns (for example, closing down every other Friday), a salary for stock exchange, changes in vacation policy, leaves of absence or a reduction in force. (Note that many of these options have other significant legal ramifications that should be explored thoroughly before implementation.) Recognize actual or potential insolvency sooner rather than later and observe the expanded fiduciary duties to creditors to avoid liability for the breach of those duties. In making payments to employees during actual or potential insolvency, be sure to comply with priority limitations. On a going forward basis, consider adding insolvency of the company to the definition of “cause” in any employment agreement so that insolvency will not trigger severance payments. The Cooley Godward LLPEmployment and Labor Group provides clients with guidance regarding human resources policies and procedures, day-to-day preventive advice, and litigation and dispute resolution services in all areas of employment law. The Employment and Labor group also works closely with the firm’s Compensation and Benefits Group and Immigration Group to ensure that clients’ complex employment needs are efficiently addressed, and to assist clients in remaining competitive. The main number for the firm’s Palo Alto, Calif., office is (650) 843-5000.

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