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The Role of the Board of Directors in a Turnaround
By Mark W. Sheffert
June 2001

Our firm has worked with over 250 organizations, many of them public companies in crisis, and oftentimes the actions and attitudes of the board of directors during a turnaround surprise us. When a company gets into trouble, the first thing many directors want to do is jump ship --- they want to resign because they feel that with the equity gone from the company, they are no longer responsible to the shareholders. It’s been our experience that many directors don’t realize that they have other fiduciary responsibilities and that the board of directors has an important role to play in a turnaround.

Rather than jumping ship, directors need to dive in to the company during times of trouble.

First of all, the board is responsible for protecting and preserving whatever shareholder value is left, especially when management has been either the direct or indirect cause of whatever led to the trouble. Managers have to make decisions that may or may not be compatible with the interests of shareholders. For example, the board
needs to step in to determine where the buck stops for legal infractions, halt a failed strategy when managers seem to have personal interests in supporting it, address the poor performance of managers when they are reluctant to do it among themselves, and acknowledge that employees have lost confidence in management. Even if management is acting responsibly during a crisis, the board of directors must remain actively involved to
assure shareholders that management is doing so.

Secondly, in certain circumstances, such as in a crisis situation, the fiduciary responsibilities of a board of directors is broadened to duties beyond the company and its shareholders. If a company is insolvent or if the board of directors approves a transaction that might reasonable lead to its insolvency, then the directors have a
fiduciary duty to the company’s creditors plus their duties to the shareholders. In addition, if a board of directors authorizes a transaction that results in a change of control, the courts have ruled that directors must receive on behalf of its shareholders the best value reasonably available. In these instances, courts have examined the decision of the board of directors and their decision-making process to ensure that this result is reasonably achieved.

Directors should also possess certain personal qualities that are crucial during a crisis. At all times, the three main qualities expected of directors are independence from management, the capacity for objective judgement, and commitment to shareholder value. However, most companies at some time or another will run into trouble of some kind, and the ability of directors to utilize these qualities to effectively handle trouble is especially important. Directors should be so independent of management and capable of objective judgement, for example, that they are able to make the tough decisions required when real trouble happens. This is especially important when the crisis requires dealing with management, as is often the case, and may even be the management team and / or executive that the director has chosen.

Just as importantly, directors should take their responsibilities seriously, be committed and engaged in their duties, and take the time and give of the energy required. Independence, judgement, and attention to detail can mean the difference between slight trouble and a serious crisis.

The leadership abilities of directors are also important during a turnaround. Troubled companies have one goal --- to survive --- and directors must possess the courage and leadership needed to guide their companies through the crisis. In the initial crisis and then in managing the turnaround plan, time is of the essence and swift action
is imperative. Directors must be able to act quickly and decisively. They must shift their gears from strategic oversight to focusing on short-term survival. The focus of directors during a turnaround should be on survival, action, and solving problems; their decision-making should be quick and decisive; and their involvement must be direct.

For instance, in a severe turnaround my firm will hold weekly meetings with our client’s board of directors where we give detailed updates as to the progress on the turnaround plan, any new problems we’ve uncovered, and what we will do next. This isn’t the level of detail and decision-making that most directors are accustomed to, but it is required of them during a turnaround.

Directors are also responsible for avoiding situations that can lead the company down the path into trouble. Managing a turnaround is not easy, and it’s best to not have to go through it in the first place.

To that end, directors should insist that the company has internal systems in place to ensure legal compliance, credible and timely financial reporting, and the supply of necessary information to monitor performance and vital financial trends. Being disciplined in these areas will not only help companies avoid trouble, but if trouble does
strike, these systems will help directors make decisions more quickly and able to rely more on facts and less on personal judgement.

The courts are moving toward making the insistence on these internal systems a requirement. In a recent case in Delaware, the court told directors that they have a duty not only to monitor the business and affairs of the corporation, but also to assure that management establishes appropriate information and reporting systems While the court recognized that the appropriate details should be left to business judgement, it emphasized that directors have a role in overseeing compliance to laws and regulations by ensuring that compliance systems exist and function properly.

A frequent source of trouble during a crisis is the proper handling of layoffs, because companies in a financial crisis are often forced to layoff employees. Congress passed the Worker Adjustment and Retraining Notification Act (the WARN Act) in 1988, but many directors are still unfamiliar with the responsibilities required of them when planning an employee layoff. The purpose of the WARN Act is to provide employees and communities a period of time to adjust to mass layoffs and plant closings. If a business employs 100 or more employees (part-time employees are excluded unless all employees together work at least 4,000 hours per week including overtime), it is required to provide at least 60 days advance notice to the affected employees of a plant closing or mass layoff.

A plant closing is defined as the permanent or temporary shutdown of a single site of employment if the shutdown results in a loss of employment during any 30-day period for 50 or more employees (excluding part-time employees). A mass layoff is defined as a reduction in work force resulting in employment loss at a single site of employment during any 30-day period for (1) at least 33 percent of the employees and affects 50 or more employees or (2) 500 or more employees.

There are additional WARN Act details that can apply to a company and which may affect how a company can reorganize during bankruptcy, so if directors find themselves in that situation they should consult with an experienced bankruptcy attorney.

In addition, new rules by the Securities and Exchange Commission and the leading stock exchanges during the past several years emphasize the responsibilities of directors to oversee the audit process. The rules require that companies adopt and disclose the audit committee’s charter and that the charter specify that the outside
auditor report to the board, not to management, through the audit committee. Furthermore, the annual proxy statement must include a written report from the audit committee and a disclosure statement about the independence of the audit committee members. Following these rules and ensuring the independence of the audit committee will help directors avoid trouble.

Directors should go beyond the oversight of compliance systems and financial reporting to also oversee management’s strategies, business plan, and the market assumptions from which they are built upon. By understanding these key financial assumptions, competitive factors, and market trends, directors will be in a better position to effectively judge management’s strategies and business plan and to provide ongoing
measurement of performance. Directors who are actively engaged in their company’s strategies and business plan are also more likely to spot trouble earlier and deal with failures when they are in their infancy.

Few companies have been able to avoid life-threatening or near life-threatening trouble at some point in their history. Trouble seems to be inevitable, for many reasons including human nature, the pressures to meet the short-term high expectations of Wall Street, the ever-changing competitive marketplace, and the difficulties of management to grow with a growing organization. But if the board of directors is properly informed of their role during a turnaround and takes its responsibilities seriously, that can often make the difference between long-term success and failure.

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