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Directors of Private Company Found Liable in Bankruptcy Suit

The responsibilities and liabilities of officers and directors of private companies may have been significantly expanded by a recent ruling by Judge Robert W. Street in the federal district court (Manhattan).

Trace International Holdings, described as the personal holding company of Marshall S. Cogan, declared Chapter 7 bankruptcy. The bankruptcy trustee sued Cogan and the company's directors for breach of fiduciary duty. The court held that Cogan had a duty not to engage in self-dealing, so the directors had a duty to prevent self-dealing from happening. Cogan was found liable for $44 million, but if he does not pay, various directors and officers of the company could be individually liable for amounts ranging from $21 to $38 million. The bankruptcy trustee can seek payments from all liable parties, but can collect no more than $44 million.

The acts of self-dealing cited by the judge included Cogan's unilaterally borrowing and failure to repay millions from the company, increasing his compensation unilaterally and without regard to his fiduciary responsibility; illegally arranging loans for his wife, secretary and other corporate executives, approval of $4.2 million in dividends to preferred shareholders when the company was insolvent, paying his daughter $430,000 over four years to write a cookbook, which produced no revenue (Mr. Cogan at one time owned New York's famous 21 Club restaurant), paying Cogan's wife $1,000 a week for over three years and spending $108,000 to produce a film entitled The Life of Marshall Cogan.

The judgment serves as a warning to directors and officers of private companies that they can be held personally liable for failing to manage their businesses properly, according to Harvard Law School professor, Elizabeth Warren. This case invites scrutiny of officers and directors when private companies are in bankruptcy.

Creditors of bankrupt private companies can use this precedent to look to the directors and officers for recovery of damages caused by mismanagement, said attorney John P. Campo, who represents the bankruptcy trustee.

The problems facing the defendants in the case were further complicated by the company's directors and officers (D & O) liability insurance. While the company had $50 million of liability coverage, $10 million had already been spent on defense costs. Moreover, Reliance Insurance, which wrote $20 million of the company's coverage, was itself in liquidation.

In addition to providing extra-vigilant oversight if a company is in bankruptcy, boards of private companies should consider the following in fulfilling their fiduciary duties:

  • Review and approve chief executive compensation, particularly increases in compensation when the company is experiencing financial difficulties.
  • Have clear policy and procedures in place to review loans from the company to related parties.
  • Review compensation to family members of the owners/managers.
  • Review and approve any dividends paid to holders of preferred or common stock.
  • Review D & O insurance coverage regularly, including consideration of the companies from which coverage is purchased.
 

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