Don’t Wait to Wind Down ‘Zombie’ Subsidiaries
This article first appeared in CFO.
As businesses grow, their legal entity organizational charts often grow as well. While subsidiary entities are created for specific purposes, there may come a time when they no longer serve those purposes. It is not uncommon for a company to have a subsidiary in its organizational structure that is, for all intents and purposes, a “zombie” or “walking dead ” — operationally inactive and financially insolvent, but still in existence from a legal standpoint. Private equity funds often face the same issue with companies in their portfolios.
There are several options available to a company or fund to deal with and dissolve entities that have no ongoing value. One is bankruptcy, which has its benefits but also drawbacks. The expense, “look back provisions” under Chapter 5 of the Bankruptcy Code, potential claims against officers and directors, and long timelines driven by the Bankruptcy Code requirements can cause a seemingly simple attempt to “bury” a company into an administrative nightmare. Typically, the best course of action is to wind down and dissolve a corporation under state law.
Given the economic challenges caused by the COVID-19 pandemic, more businesses will be experiencing financial distress. Bankruptcy is not always the best or even a viable option — and neither is biding time.
Reasons to Be Proactive
Inactive subsidiaries and portfolio companies continue to incur costs and pose legal risks as they remain in a state of limbo. Entities that fail to remain in good standing may incur penalties in some states. Tax returns need to be filed. Outstanding tax liabilities will continue to accrue interest. Portfolio managers who served as passive officers and directors may be unaware of lurking claims that could arise against them. Additional creditors may surface over time. The IRS provides a checklist of steps that need to be completed to close a business. As the IRS states, “Closing your business can be a difficult and challenging task.”
As long as a corporation exists, whether it is active or not, there are risks that it will incur additional liabilities over time — some of which may become liabilities of the parent company or fund and certain executives of the corporation.
The Steps Involved
Corporate dissolutions are done according to state law. For example, in Delaware, a corporation can be dissolved through a process that takes place outside of court (a non-safe harbor dissolution) or one that involves court supervision (a safe harbor dissolution). As you might expect, the court-supervised process tends to be more costly and time-consuming but offers more protection for shareholders, officers, and directors against creditor claims.
While every state’s laws are different, corporate dissolutions often take place without any court supervision. In some instances, however, the dissolution process may be overseen by a court at an interested party’s request. For instance, in California, a court may take jurisdiction over the winding up of a corporation upon petition of: (i) the corporation; (ii) shareholder(s) holding at least 5% of the outstanding shares; (iii) any shareholder of a close corporation; or (iv) three or more creditors. Even if a request is made, a court may decline to accept jurisdiction.
In short, because every state’s laws vary, the decision to dissolve under state law, file for bankruptcy, or pursue some other alternative for winding up a corporation’s affairs will depend on individual facts, circumstances, and governing law. As opposed to a bankruptcy, a wind-down tends to be a good option when a corporation has relatively few creditors and a low likelihood of future contingent liabilities (such as environmental or product liability issues).
If it is determined that the dissolution of a subsidiary or portfolio company under state law is the right path forward, the state statute will provide the appropriate road map. Typically, outside advisers will be tapped, including a consultant and legal counsel, to help navigate the process. A consultant may serve in one of several roles, including a trustee for a wind-down trust established to administer assets and liabilities, as a board member, or as an adviser to the board during the wind-down process.
In some cases, to the extent permitted by an entity’s organizational documents, it may be advisable for other board members or managers to resign to limit potential personal liability exposure during the wind-down.
However, even after a company’s control has transferred to a new board or fiduciary under a wind-down, the former executives may remain exposed to various legal claims or personal liability. If a court supervises a wind-down, a consultant can serve as a receiver or assignee under an assignment for the benefit of creditors to oversee the process and serve as an intermediary between the court and the company.
The Timeline
The specific steps involved in the wind-down process vary by state but generally involve:
- Internal Approvals: A corporation’s bylaws typically outline the procedures required to dissolve the corporation, and state law may include additional requirements. Generally, a board resolution and shareholder approval are required to move forward.
- Compliance with Government Requirements: When a company is being dissolved, a certificate of dissolution must be filed with the secretary of state or other appropriate state office. The IRS and state must also be notified, and a final tax return must be filed to obtain tax clearance to pave the way for the dissolution.
- Collecting Debts and Settling Claims: As part of the dissolution process, the corporation will collect outstanding debts and resolve outstanding claims.
- Liquidating and Distributing Assets: The assets that remain after paying corporate debts, such as manufacturing equipment and intellectual property, will be liquidated and distributed to shareholders. In some cases, a reserve will be established to satisfy unknown or contingent claims.
- Administrative Tasks: There are often other minor administrative tasks, from dealing with insurance issues to the closing of accounts, that require attention before a wind-down can be wrapped up.
It is rarely a good idea to keep an operationally inactive company on the books. Rather than waiting for an unwelcome surprise from the IRS relating to an unpaid tax liability from years past, or an unknown creditor petitioning a court to force a dissolution or involuntary bankruptcy, it is far easier and less costly be proactive.
Given the economic challenges caused by the COVID-19 pandemic, more businesses will be experiencing financial distress. Bankruptcy is not always the best or even a viable option — and neither is biding time.