I'm the lunch speaker at the University of Maryland law school's conference on Twilight in the Zone of Insolvency: Fiduciary Duty and Creditors of Troubled Companies, where I'm giving a talk based on my new paper Much Ado About Little? Directors' Fiduciary Duties in the Vicinity of Insolvency. Here's what I plan to say:
As with any relational contract, bond indentures and other long-term debt agreements inevitably prove incomplete. In a world characterized by uncertainty, complexity, and bounded rationality, it cannot be otherwise. Where the bond indenture is silent, should the law invoke fiduciary duties or other extra-contractual rights as gap fillers?
In my remarks today, I want to focus on several aspects of that question. First, I take issue with the framing given the problem by Delaware courts. They have characterized the duties of directors as running to the corporate entity rather than any individual constituency. This approach is incoherent in practice and unsupportable in theory. Instead, courts should focus on whether the board has an obligation to give sole concern to the interests of a specific constituency of the corporation.
I then will briefly discuss the leading argument in favor of imposing fiduciary duties to creditors when the corporation is in the vicinity of insolvency; namely, the notion that shareholders will gamble with the creditor’ money. I conclude that this argument is unpersuasive. It is director and manager opportunism, rather than strategic behavior by shareholders, which is the real concern. Bondholders and other creditors are better able to protect themselves against that risk than are shareholders.
Finally, and perhaps somewhat anticlimactically, I want to suggest that none of this matters very much. Even if the fiduciary duties owed by directors shift in the vicinity of insolvency from shareholders to creditors (or run to both in that setting), the vast majority of board of directors decisions should continue to be insulated from judicial review by the business judgment rule. Because I believe that the rule should apply even to decisions in which the board makes trade offs between the interests of shareholders and creditors (or declines to make such trade offs), the debate arguably ends up being much ado about nothing (or, at least, about very little).
The Law
As Chancellor Allen put it in Katz, “the relationship between a corporation and the holders of its debt securities, even convertible debt securities, is contractual in nature.” [Katz v. Oak Indus. Inc., 508 A.2d 873, 879 (Del. Ch. 1986).] The contract both defines and confines the scope of the corporation’s obligations to its bondholders.
The limited extra-contractual rights of bondholders thus are provided solely by the implied covenant of good faith found in all contracts. According to the leading Katz and [Metropolitan Life Ins. Co. v. RJR Nabisco, Inc., 716 F. Supp. 1504 (S.D.N.Y. 1989)] decisions, moreover, the implied covenant of good faith is constrained by reference to the express terms of the contract. Taken together, these decisions reflect a basic principle, which can be expressed colloquially as “you made your bed, now you have to lie in it.”
Do these rules change when the corporation is insolvent or nearly so? In Credit Lyonnais, Allen famously opined that:
At least where a corporation is operating in the vicinity of insolvency, a board of directors is not merely the agent of the residue risk bearers, but owes its duty to the corporate enterprise.
Technically, Credit Lyonnais does not stand for the proposition that directors of a corporation in the vicinity of insolvency owe fiduciary duties to creditors of the corporation. Instead, Chancellor Allen held that the board of directors of such a corporation “owes its duty to the corporate enterprise.” [Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp., 1991 WL 277613 (Del. Ch. 1991).]
That statement is highly problematic. As to solvent corporations, the law already distinguishes between duties running to the corporate entity and to the shareholders. This distinction is what differentiates direct from derivative shareholder litigation, after all. But if directors already owe some duties to the corporate entity, what changes doctrinally when the corporation is in the “vicinity of insolvency”?
Allen’s highly stylized argument, moreover, conflated issues of pie expansion and pie division. Suppose the board of directors was faced with a true zero sum decision, in which the sole issue is how to divide a static sum between two or more corporate constituencies. For all its detail, Allen’s analysis fails to offer directors any guidance for making that decision.
Hence, it is quite difficult to square Allen’s notion of a duty running to the corporation the proposition that “the Delaware corporate law [should] have stability and predictability.” Two key ambiguities plague the Credit Lyonnais analysis. First, what does it mean to be in the “vicinity of insolvency?” Second, as we have just seen, it is difficult to know what content to ascribe to the duties that arise in that setting. Former Delaware Chief Justice Veasey thus put it quite mildly when he observed that this “is certainly an area where directors of troubled companies and their counsel face particular challenges and need expert counseling.”
In addition to being doctrinally incoherent, the notion that directors owe duties to the corporate entity is inconsistent with the dominant contractarian theory of the firm. Put simply, the board of directors is the nexus of a set of contracts with various constituencies that the law collectively treats as a legal fiction called the corporation. As such, it simply makes no sense to think of the board of directors as owing fiduciary duties to the corporate entity. Indeed, since the legal fiction we call the corporate entity is really just a vehicle by which the board of directors hires factors of production, it is akin to saying that the board owes duties to itself.
In sum, the straightforward duty to shareholders Chancellor Allen set out in Katz thus seems far preferable to the odd formulations espoused in Credit Lyonnais and its progeny.
Will Shareholders Gamble with the Creditors Money?
Chancellor Allen’s justification for the Credit Lyonnais dicta rests in large part on the notion that limited liability creates incentives for shareholders to prefer higher risk projects than would the firm’s creditors. Because shareholders do not put their personal assets at jeopardy, they effectively externalize risk to creditors.
Although this discrepancy in risk preference is present even in solvent corporations, it becomes especially pronounced when the corporation is insolvent or in the vicinity of insolvency. Under those conditions, the shareholders may well be inclined to recall Will Roger’s famous aphorism: “It's not so much the return on my money that concerns me as much as the return of my money.” Because the corporation is on the edge of a liquidation or reorganization in which the shareholders are likely to receive neither a return on their investment nor, more importantly, the return of their investment, they now have an incentive to cause the corporation to engage in particularly high risk ventures. If the venture pays off with a substantial return, they may be able to at least recoup their initial investment in the corporation. If the venture fails, they have lost nothing. Creditors thus bear the entire risk associated with such ventures.
The Credit Lyonnais decision thus is justified as being necessary to prevent the shareholders, “who were about to wind up with nothing,” from taking “an unreasonable gamble with the money that would have otherwise gone to the creditors upon the dissolution of the firm.”
Unfortunately for the proponents of Credit Lyonnais, the argument suffers from two major flaws. First, creditors could protect themselves ex ante either by negotiating contractual limitations on corporate behavior, such as restrictions on the types of projects in which the firm may invest, or by negotiating for a share of the up-side, such as through the use of convertible debt securities, or by charging a higher interest rate. In this way, voluntary creditors pass on the risk of default to the shareholders, even in a system of limited liability.
Second, the shareholder-gambler argument has traction only with respect to firms in which the shareholders exercise effective control. As such, it has no application to publicly held corporations, which are characterized by a separation of ownership and control. Instead, the shareholder incentive argument applies only to closely held corporations or quasi-public corporations in which there is a controlling shareholder. And, of course, it is in precisely such firms where the costs of bargaining between shareholders and creditors will be low enough to allow the latter to negotiate ex ante particularized protections.
In the true public corporation, with no controlling shareholders, power to decide whether the firm invests in particular high risk projects rests in the hands of the board of directors and its subordinate managers. It is not clear that managers will necessarily favor either the interests of shareholders or creditors:
A manager tainted by the company's financial problems might prefer to take high risks because only they could lead to returns sufficiently high to restore the manager to favor. On the other hand, a manager whose job and company are not in immediate jeopardy might prefer investments with risks that are lower than those preferred by the company's investors. [Lynn M. LoPucki & William C. Whitford, Corporate Governance in the Bankruptcy Reorganization of Large, Publicly Held Companies, 141 U. PA. L. REV. 669 (1993).]
If agency cost economics teaches us anything, however, it causes us to suspect that at least some managers will put their own interests ahead of those of either shareholders or creditors at least some of the time. As such, the real risk present when a public corporation is in the vicinity of insolvency is that of managerial opportunism rather than strategic behavior by shareholders.
Which Constituencies Can Help Themselves?
In contractarian theory, fiduciary duties are viewed as gap fillers by which courts resolve disputes falling through the cracks of incomplete contracts. In particular, fiduciary duties come into play when corporate directors and officers seek to appropriate quasi-rents through opportunistic conduct unanticipated when the firm was formed (and, accordingly, not dealt with ex ante by contract).
The shareholder’s investment in the firm is a transaction specific asset, because the whole of the investment is both at risk and turned over to someone else’s control. In contrast, many corporate constituencies do not make firm specific investments in either human capital or otherwise. Because the relationship between such constituencies and the corporation does not create appropriable quasi-rents, opportunism by the board is not a concern for them.
Relative to many nonshareholder constituencies, moreover, shareholders are poorly positioned to extract contractual protections. Unlike bondholders, for example, whose term-limited relationship to the firm is subject to extensive negotiations and detailed contracts, shareholders have an indefinite relationship that is rarely the product of detailed negotiations.
The dispersed nature of stockownership, moreover, makes bilateral negotiation of specialized safeguards especially difficult.
Accordingly, we can confidently predict the majoritarian default that would emerge from the hypothetical bargain. Shareholders will want the protections provided by fiduciary duties, while bondholders will be satisfied with the ability to enforce their contractual rights, which is precisely what the law provides. Credit Lyonnais thus threatens to give bondholders a windfall for which they have not bargained.
Does it Matter?
So much for theory. Let’s turn to practicalities. Does any of this matter? My guess is: Not very much.
Consider the facts that were at issue in Katz. Oak Industries was in deep financial trouble, having experienced unremitting losses for the previous 45 months. The common stock’s market price had fallen from $30 to $2 per share and Oak’s debt traded at substantial discounts to par. In hopes that an infusion of new equity capital would turn things around, Oak entered into an agreement with Allied Signal, pursuant to which the latter would purchase certain of Oak’s assets for $160 million in cash and also would invest an additional $15 million in Oak by purchasing newly issued common stock and warrants.
Allied Signal conditioned the deal on a restructuring of Oak’s existing debt to be effected via a tender offer in which Oak would buy back some debt at a premium over the debt’s then current market price but at a discount to par. Debt holders accepting the offer would be obliged to execute exit consents authorizing indenture amendments eliminating various protections, including all financial covenants. Without the amendments, Allied Signal was unwilling to enter into either the equity investment or asset purchase.
Assume Oak was in the vicinity of insolvency at the time the restructuring plan was approved by Oak’s board of directors. A creditor sues the board alleging breach of the Credit Lyonnais fiduciary duty. The creditor argues that the deal was structured to disadvantage creditors to the shareholders’ benefit.
What standard of review will a Delaware court apply on these facts, assuming arguendo that the creditor is owed some sort of fiduciary duty under Credit Lyonnais? The answer almost certainly is the business judgment rule.
So long as the board of directors is independent and disinterested and otherwise satisfies the preconditions for application of the business judgment rule, the court will abstain from reviewing the merits of the board’s decision. The rationale for applying the business judgment rule in this context follows in part from the same policy considerations we’ve already discussed:
Creditors are often protected by strong covenants, liens on assets, and other negotiated contractual protections. The implied covenant of good faith and fair dealing also protects creditors. So does the law of fraudulent conveyance. With these protections, when creditors are unable to prove that a corporation or its directors breached any of the specific legal duties owed to them, one would think that the conceptual room for concluding that the creditors were somehow, nevertheless, injured by inequitable conduct would be extremely small, if extant. Having complied with all legal obligations owed to the firm's creditors, the board would, in that scenario, ordinarily be free to take economic risk for the benefit of the firm's equity owners, so long as the directors comply with their fiduciary duties to the firm by selecting and pursuing with fidelity and prudence a plausible strategy to maximize the firm's value. [Production Resources Group, LLC v. NCT Group, Inc., 863 A.2d 772, 790 (Del. Ch. 2004).]
In addition, and perhaps more importantly, however, application of the business judgment rule follows necessarily from the basic architecture of corporate governance.
The business judgment rule operationalizes the intuition that fiat— i.e., centralization of decisionmaking authority—is the essential attribute of efficient corporate governance. As Nobel laureate economist Kenneth Arrow explains, authority and accountability cannot be reconciled:
If every decision of A is to be reviewed by B, then all we have really is a shift in the locus of authority from A to B and hence no solution to the original problem. [Kenneth J. Arrow, The Limits of Organization (1974).]
The business judgment rule prevents such a shift in the locus of decision-making authority from boards to judges. [See my article, The Business Judgment Rule as Abstention Doctrine]
Judicial abstention from merits review of board decisions has several critical advantages. First, judges necessarily have less information about the needs of a particular firm than do that firm’s directors. A fortiori, judges will make poorer decisions than the firm’s board. In addition, while market forces work a sort of Darwinian selection on corporate decision makers, no such forces constrain erring judges. As such, rational shareholders might prefer the risk of managerial error to that of judicial error.
Second, the firm’s residual claimants do not get a return on their investment until all other claims on the corporation have been satisfied. All else equal, the residual claimant—whether it be a shareholder or, in insolvency, a creditor—therefore will prefer high return projects. Because risk and return are directly proportional, however, implementing that preference necessarily entails choosing risky projects. Board decisions rarely involve black-and-white issues, however; instead, they typically involve prudential judgments among a number of plausible alternatives. Given the vagaries of business, moreover, even carefully made choices among such alternatives may turn out badly. Unfortunately, both residual claimants and judges will find it difficult to distinguish between competent and negligent management. By virtue of the hindsight bias, bad outcomes are often regarded, ex post, as foreseeable ex ante. If bad outcomes result in liability, however, managers will be discouraged from taking risks.
The critical point for present purposes is that nothing in the preceding précis of the rationale for the business judgment rule depends on the question “to who are directors accountable?” There will be an unavoidable tension between authority and accountability whether directors owe duties to the shareholders, the creditors, the entity, or some combination thereof. Allowing courts to review the merits of board decisions will inevitably shift some aliquot of the board’s authority to courts whether such review is triggered by shareholders, the creditors, the entity, or some combination thereof.
Accordingly, absent a disabling conflict of interest on the part of the board, the business judgment rule should be the standard of review whether fiduciary litigation is brought by shareholders, the creditors, the entity, or some combination thereof.
Conclusion
In sum, the zone debate is mostly much ado about nothing. Or, more precisely, about very little. In the vast majority of cases, the business judgment rule will preclude judicial review regardless of whether suit is brought by shareholders or creditors. In some cases, the business judgment rule may not apply, but suit will be derivative in nature and any recovery will go to the entity regardless of whether suit is brought by shareholders or creditors. As a result, the only cases in which the zone of insolvency debate matters are those to which the business judgment rule does not apply, shareholder and creditor interests conflict, and a recovery could go to directly to those who have standing to sue. In those cases, moreover, there is a strong policy argument that creditors should be limited to whatever rights the contract provides or might be inferred from the implied covenant of good faith.
