A new federal bankruptcy court decision out of Delaware deals with the situation in which the officers and directors of an insolvent subsidiary allegedly looted it for the benefit of the parent corporation. The defendants argued they couldn't be held liable to creditors of the insolvent subsidiary, because they owed their fidicuary duties solely to the parent corporation. The bankruptcy court rejected that argument. In re Scott Acquisition Corp., 2006 WL 1731277 (Bkrtcy. D.Del. 2006), available online here.
It seems self-evident that directors and officers of an insolvent subsidiary corporation shouldn't be allowed to stiff the sub's creditors for the benefit of the parent (let alone for their own personal benefit). Unfortunately, in reaching that perfectly plausible result the court chose to phrase the relevant legal issue as being "whether the directors and officers of a wholly-owned insolvent subsidiary owe a fiduciary duty to that subsidiary." In my article Much Ado About Little? Directors’ Fiduciary Duties in the Vicinity of Insolvency, I explained why so phrasing the issue is an error:
From a doctrinal perspective, this emphasis on fiduciary duties to the corporate entity is essentially incoherent. 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”?
[Focusing on duties running to the entity,] moreover, conflates 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. [The court’s] analysis fails to offer directors any guidance for making that decision. This is so because, in the zero sum case, the value of the corporate entity by definition will be unaffected by the decision. ...
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. … The corporation is not a thing to which duties to can be owed, except as a useful legal fiction. Instead, in contractarian theory, the corporation is thought of as a nexus of contracts. Although this is a very useful and important concept, however, it too is somewhat misleading. After all, to say that the firm is a nexus is to imply the existence of a core or kernel capable of contracting. But kernels do not contract – people do. In other words, it does us no good to avoid reifying the firm by reifying the nexus at the center of the firm. Hence, it is perhaps best to understand the corporation as having a nexus of contracts.
If the corporation has a nexus, where is it located? The Delaware code, like the corporate law of every other state, gives us a clear answer: the corporation’s “business and affairs . . . shall be managed by or under the direction of the board of directors.” 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 owning 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.
Hence, the bankruptcy court should have concluded that the duties of direcors and officers of an insolvent subsidiary run to the creditors of the subsidiary. See Southwest Holdings, L.L.C. v. Kohlberg & Co. (In re Southwest Supermarkets, L.L.C.), 315 B.R. 565, 575-76 (Bankr. D.Ariz. 2004) (holding that "the fiduciary duties become owed to creditors").
BTW, the Southwest Holdings case suggests that "the ordinary business judgment rule no longer applies when the corporation is insolvent." Id. at 575. As a matter of Delaware law, however, this seems clearly erroneous. In Much Ado About Little?, I asked:
What standard of review will a Delaware court ..., assuming arguendo that the creditor is owed some sort of fiduciary duty under Credit Lyonnais? The answer almost certainly is the business judgment rule:
The Credit Lyonnais decision’s holding and spirit clearly emphasized that directors would be protected by the business judgment rule if they, in good faith, pursued a less risky business strategy precisely because they feared that a more risky strategy might render the firm unable to meet its legal obligations to creditors and other constituencies.
In other words, 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 block quotation is taken from Leo Strine's opinion in Production Resources Group, LLC v. NCT Group, Inc., 863 A.2d 772, 788 (Del. Ch. 2004). See also Angelo, Gordon & Co., L.P. v. Allied Riser Communications Corp., 805 A.2d 221, 229 (Del. Ch. 2002) (“My preliminary view is that, even where the law recognizes that the duties of directors encompass the interests of creditors, there is room for application of the business judgment rule.”).