As California Business Bankruptcy blogger Bob Eisenbach notes, the Delaware Supreme Court's recent decision in North American Catholic Educational Programming, Inc. v. Gheewalla (copy of the opinion available at Bob's website) held, in pertinent part, that:
- When the corporation is in fact insolvent, creditors have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties; and
- Even when the corporation is insolvent, creditors have no right to assert direct claims for breach of fiduciary duty against the directors.
It's a very interesting result. In my article, Much Ado about Little? Directors' Fiduciary Duties in the Vicinity of Insolvency, I pointed out that there is substantial support in the case for the proposition that "Once the corporation is actually insolvent, the directors owe fiduciary duties to the firm’s creditors." See FDIC v. Sea Pines Co., 692 F.2d 973, 976-77 (4th Cir. 1982) (stating that “when the corporation becomes insolvent, the fiduciary duty of the directors shifts from the stockholders to the creditors”); Henderson v. Buchanan (In re Western World Funding, Inc.), 52 B.R. 743, 763 (Bankr. D. Nev. 1985) (holding that when a “corporation is insolvent” the fiduciary of directors “run to creditors”); Geyer v. Ingersoll Publications Co., 621 A.2d 784, 787 (Del. Ch. 1992) (observing that “when the insolvency exception does arise, it creates fiduciary duties for directors for the benefit of creditors”).
As Vice Chancellor Leo Strine held in Production Resources Group, LLC v. NCT Group, Inc., 863 A.2d 772, 790-91 (Del. Ch. 2004), “When a firm has reached the point of insolvency, it is settled that under Delaware law, the firm’s directors are said to owe fiduciary duties to the company’s creditors. This is an uncontroversial proposition ….” As such, Strine recognized the possibility that creditors of an insolvent corporation could not only sue derivatively on behalf of the corporation but also could bring direct claims of breach of fiduciary duty.
The Delaware Supreme Court rejected Production Resources, overturning what everyone thought was settled law, to hold that:
individual creditors of an insolvent corporation have no right to assert direct claims for breach of fiduciary duty against corporate directors. Creditors may nonetheless protect their interest by bringing derivative claims on behalf of the insolvent corporation or any other direct nonfiduciary claim, as discussed earlier in this opinion, that may be available for individual creditors.
Notice, BTW, that the holding is limited to individual creditors. But what if the class of creditors as a whole was injured and sought to bring a class action?
In any case, what do we make of this as a matter of policy?
As I explain in Corporation Law and Economics, the logic of allowing creditors of an insolvent corporation to bring fiduciary duty-based claims rests on the fact that:
... insolvency is a paradigmatic final period situation in which the market constraints characteristic of repeat transactions are inoperative. In addition, because a common outcome of bankruptcy reorganization is the effective elimination of existing shareholders and the issuance of equity in the post-reorganization firm to bondholders, the effect of insolvency is to render bondholders the de facto residual claimants.
These arguments would seem to support both derivative and class actions. Moreover, the court's explanation for its holding is unpersuasive. Justice Holland explains:
Recognizing that directors of an insolvent corporation owe direct fiduciary duties to creditors, would create uncertainty for directors who have a fiduciary duty to exercise their business judgment in the best interest of the insolvent corporation. To recognize a new right for creditors to bring direct fiduciary claims against those directors would create a conflict between those directors’ duty to maximize the value of the insolvent corporation for the benefit of all those having an interest in it, and the newly recognized direct fiduciary duty to individual creditors. Directors of insolvent corporations must retain the freedom to engage in vigorous, good faith negotiations with individual creditors for the benefit of the corporation.
I can understand the logic of disallowing suits by individual creditors. Once the corporation is insolvent, the residual claimants are the unsecured creditors as a class. You don't want to give a single creditor leverage to cut a better deal for itself at the expense of the class. But Holland's argument makes a different claim. First, he says directors must act for the benefit of the corporation. This is reification, however. As I explain in Much Ado about Little? Directors' Fiduciary Duties in the Vicinity of Insolvency, "in the zero sum case, the value of the corporate entity by definition will be unaffected by the decision. As such, it is the directors’ duties running to specific constituencies, rather than the entity, which are implicated in this setting." I also argued that:
... the notion that directors owe duties to the corporate entity is inconsistent with the dominant contractarian theory of the firm. The insistence that the firm is a real entity is a form of reification—i.e., treating an abstraction as if it has material existence. Reification is often useful, or even necessary, because it permits us to utilize a form of shorthand—it is easier to say General Motors did so and so than to attempt in conversation to describe the complex process that actually may have taken place. Indeed, it is very difficult to think about large firms without reifying them. Reification, however, can be dangerous. It becomes easy to lose sight of the fact that firms do not do things, people do things.
In other words, the corporation is not a thing to which duties to can be owed, except as a useful legal fiction.
As VC Strine summarized my argument in footnote 75 of Trenwick America Litigation Trust v. Ernst & Young, L.L.P. 906 A.2d 168 (Del.Ch. 2006):
In an incisive article and a thoughtful blog comment, Professor Bainbridge is critical of jurisprudence that expresses the view that directors owe fiduciary duties to the corporation itself, rather than a particular constituency of the corporation. See Stephen M. Bainbridge, Much Ado About Little? Directors' Fiduciary Duties in the Vicinity of Insolvency (forthcoming 2006), available at http://ssrn.com/abstract=832504; Duties of Directors of Insolvent Corporations, http://www.professorbainbridge.com/2006/07/duties_of_direc.html (July 26, 2006). When a corporation is solvent, Professor Bainbridge believes that fiduciary duties are owed by the directors to the stockholders. Bainbridge, Much Ado, at 5-6. When a corporation is insolvent, he accepts the notion that the directors owe their fiduciary duties to the creditors, because the creditors are now the residual claimants. Id. at 15. That does not mean, however, that Professor Bainbridge believes that all claims against directors of insolvent corporations are direct claims belonging to the creditors individually. To the contrary, he recognizes that if the directors of an insolvent firm commit a breach of fiduciary duty reducing the value of the firm, any claim belongs to the entity and that creditors would benefit from the recovery derivatively, based on their claim on the firm's assets. Id. at 38; Duties of Directors of Insolvent Corporations. Supporting his view that owing fiduciary duties to a firm is an unhelpful concept, Professor Bainbridge relies heavily on the idea of the corporation as a nexus of contracts to which it is silly to think duties can be owed. See Bainbridge, Much Ado, at 21 n. 94, n. 96 (citing to Henry Hansmann, The Ownership of Enterprise 18 (1996) and Stephen M. Bainbridge, The Board of Directors as a Nexus of Contracts, 88 Iowa L.Rev. 1 (2002)). His concern is that telling directors that they owe fiduciary duties to a “nexus of contracts” provides no concrete objective against which to measure their conduct; thus, he favors clarity that the directors' obligation is to maximize returns for the corporation's residual claimants, who in the case of insolvency, are its creditors.
Which is precisely why creditors ought to be allowed to bring a class action when the class of creditors identified as the new residual claimants of the insolvent corporation are injured directly by a breach of the fiduciary duties that are now owed them. As Strine further observed in Trenwick:
Because, by contract, the creditors have the right to benefit from the firm's operations until they are fully repaid, it is they who have an interest in ensuring that the directors comply with their traditional fiduciary duties of loyalty and care. Any wrongful self-dealing, for example, injures creditors as a class by reducing the assets of the firm available to satisfy creditors.
Second, Holland's explanation for his holding includes a rather odd reference to the "directors’ duty to maximize the value of the insolvent corporation for the benefit of all those having an interest in it." Is stakeholderism rearing its ugly head here? In Trenwick, Strine suggests that directors of an insolvent corporation retain the right to exercise discretion "about how generous or stingy to be to other corporate constituencies."
For the reasons laid out in Much Ado about Little? Directors' Fiduciary Duties in the Vicinity of Insolvency, I completely agree with Strine's conclusion that "the business judgment rule protects the directors of solvent, barely solvent, and insolvent corporations, and that the creditors of an insolvent firm have no greater right to challenge a disinterested, good faith business decision than the stockholders of a solvent firm."
But for the reasons also laid out therein, I reject the notion that the board has fiduciary duties to the entities or to any other constituency other than the residual claimant:
Standards that require the directors to balance the interests of multiple constituencies, shading between them from case to case, ... deprive directors of the critical ability to determine ex ante whether their behavior comports with the law’s demands, raising the transaction costs of corporate governance. The conflict of interest rules governing the legal profession provide a useful analogy. Despite many years of refinement, these rules are still widely viewed as inadequate, vague, and inconsistent—hardly the stuff of which certainty and predictability are made.
Second, absent clear standards, directors will be tempted to pursue their own self-interest. Directors who are responsible to everyone are accountable to no one. In the foregoing hypothetical, for example, if the board’s interests favor keeping the plant open, we can expect the board to at least lean in that direction. The plant likely will stay open, with the decision being justified by reference to the impact of a closing on the plant’s workers and the local community. In contrast, if directors’ interests are served by closing the plant, the plant will likely close, with the decision being justified by concern for the firm’s shareholders, creditors, and other benefited constituencies.
For more on the case against stakeholderism, see Chapter 9 of my Corporation Law and Economics.
So the Delaware Supreme Court got it two-thirds right. They're right that creditors of an insolvent corporation should have standing to sue derivatively. They're right that individual creditors should not be able to sue individually for breach of fiduciary duty (although they're right for the wrong reasons). If they meant to hold that individual creditors of an insolvent corporation may not bring a class action for breach of fiduciary duty on behalf of the relevant class of creditors, however, they got it wrong. Fortunately, Holland's phrasing of his holding leaves open the possibility that the Court could still recognize the latter result.
