I first want to thank Lisa Fairfax and Gordon Smith for the invitation to guest blog on The Conglomerate. I am a long-time reader but first-time blogger, so this is an exciting opportunity for me. I am a relative newcomer to the academy, having spent almost eleven years in private practice, most recently as a Partner in the Business Restructuring and Reorganization Practice Group at Jones Day. I have been teaching at the University of Nebraska College of Law since 2006.
My interests and scholarship focus on issues at the intersection of corporate and insolvency law. During the next two weeks, I hope to explore some of these issues with you, many of which are implicated by the current economic crisis in the United States. For example, I have spent much time (too much if you ask my family) during the past several months considering a board’s duty with respect to investment decisions and enterprise risk management; the utility of credit default swaps and similar derivative instruments; the impact of investments by hedge funds and private equity firms on distressed companies; and the ability of federal bankruptcy law to address the current economic crisis.
Let me start with a board’s fiduciary duties. As Gordon Smith discussed in a recent post, the likelihood of a board being held liable for excessive risk-taking in investment decisions is highly unlikely, at least under existing applications of the business judgment rule. And perhaps this result is correct and in the best interests of the corporation. After all, boards are not guarantors of corporate success, and their informed, good faith corporate decisions should receive protection under the law.
But if a corporation is insolvent, which arguably many of those caught up in the current economic crisis were at the time of at least some investment decisions, does this fact change the analysis? Should it? In the North American Catholic case, the Delaware Supreme Court suggested in dicta that a board’s fiduciary duty runs to shareholders when the corporation is solvent or nearly-solvent (i.e., in the zone of insolvency) and to creditors when the corporation is insolvent. For insightful and thought-provoking discussions of whether a board’s duties should shift to creditors, see Henry Hu’s and Jay Westbrook’s 2007 article proposing no shift in duties and Doug Baird’s and Todd Henderson’s 2008 article suggesting a contractarian solution.
The business judgment rule rests, in part, on good faith and an absence of conflicts of interest. In the insolvency context, however, these basic assumptions cannot be taken for granted. For example, a board of an insolvent corporation that gives undue weight to equity value in its assessment of investment opportunities arguably is acting in bad faith or, at a minimum, with reckless disregard of its duties. This analysis may turn on considerations similar to those discussed by the courts in the Central Ice Cream and Credit Lyonnais Bank, 1991 Del. Ch. LEXIS 215, cases.
Similarly, conflicts of interest may arise in unexpected ways for directors of insolvent corporations. For example, directors serving on the boards of both a parent corporation and its wholly-owned subsidiary generally do not have disqualifying conflicts of interest because the interests of the parent, as the sole shareholder, and the subsidiary are aligned. Nevertheless, when the subsidiary is insolvent, common directors may have a conflict of interest because their primary duties now run to the corporations’ creditors. The district court in ASARCO LLC v. Americas Mining Corp., 2008 U.S. Dist. LEXIS 71269, recently noted that “the directors of an insolvent wholly owned subsidiary have divided loyalties (between the parent, their corporation (the subsidiary), and the subsidiary’s creditors) and ‘when faced with such divided loyalties, directors have the burden of establishing the entire fairness of the transaction.’”
Directors also may face enhanced conflict-of-interest scrutiny in the approval of compensation, bonuses and other allegedly self-interested transactions when the corporation is insolvent and those transactions potentially constitute fraudulent conveyances under state or federal bankruptcy law. The boards of AIG and Lehman Brothers currently are under the microscope with respect to those issues.
Consequently, boards of insolvent corporations that fail to consider investment risks in light of creditors’ interests, whether because of bad faith, ignorance or unrecognized conflicts, may do so at their own peril. In the current environment, boards of insolvent corporations may have a very difficult time showing that their investment decisions satisfy the entire fairness test. In fact, boards likely will try to defend the numerous breach of fiduciary duty actions bound to be filed both in and outside of bankruptcy first on solvency grounds. A board’s ability to show that the corporation was not insolvent in fact at the time of the decision may allow the board to claim that its duties flowed to shareholders and that its conduct is protected by the business judgment rule. Although corporate stakeholders likely will not benefit from that approach, lawyers, financial advisers and valuation experts certainly will.
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1. Posted by Guest on November 14, 2008 @ 12:03 | Permalink
My reading of the North American Catholic case was that the DE Supreme Court rejected the notion of fiduciary duties owed to creditors, regardless of whether the corporation is insolvent. See Op. at 23-24 (“[W]e hold that individual creditors of an insolvent corporation have no right to assert direct claims for breach of fiduciary duty against corporate directors.”).
2. Posted by Michelle Harner on November 14, 2008 @ 12:53 | Permalink
Thank you for the comment. You identify an important element of the North American Catholic case that often is overlooked--i.e., the court's holding is a limited procedural decision that individual creditors do not have standing to assert direct claims. The court's dicta goes beyond this proposition, however, and suggests that creditors do have the ability to pursue derivative claims for breach of fiduciary duty against the board of an insolvent corporation. See opinion at 20-24. This dicta--even though just dicta--is important because it is the first time that the Delaware Supreme Court has recognized the concept of duty shifting. In fact, the court states that "'[t]he corporation's insolvency makes the creditors the principal constituency injured by any fiduciary breaches that diminish the firm's value.'" So, an individual creditor may not pursue a direct breach of fiduciary duty claim for alleged injuries to its specific interest, but it may pursue a derivative claim on behalf of the corporation for injuries to firm value and, consequently, creditors' collective interests. The Hu and Westbrook article discusses this issue at pages 1343-1345 and may provide additional insight.
3. Posted by Guest on November 14, 2008 @ 13:56 | Permalink
Thanks for pointing out the Hu and Westbrook article. (As a sidenote, the link to the article in the post above doesn't appear to be working.) It looks like Hu and Westbrook attempt to read way too much into one or two sentences of the DE Supreme Court's analysis in the North American Catholic case. Saying that a creditor may assert a derivative claim on behalf of the corporation when the corporation is insolvent is a far cry from saying that a director's normal duties have somehow shifted or altered or that a director owes fiduciary duties to a creditor. Indeed, to say that a director's duties change when a corporation enters insolvency would seem to be inconsistent with the holding and analysis of the rest of the opinion, which stresses the need for certainty and consistency for director duties throughout a corporation's life-cycle. See Op. at 18-19, 23. Hu and Westbrook appear to focus on one sentence from the opinion: "The corporation’s insolvency ‘makes the creditors the principal constituency injured by any fiduciary breaches that diminish the firm’s value.’" Id. at 20. Yet, when read in context with the rest of the Court's analysis, it seems that the better reading is that the Supreme Court was merely saying that creditors are given the right to assert derivative claims when the corporation becomes insolvent because no one else (i.e., underwater shareholders) cares at that point. See id. (“When a corporation is insolvent … its creditors take the place of the shareholders as the residual beneficiaries of any increase in value. Consequently, the creditors of an insolvent corporation have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties. The corporation’s insolvency ‘makes the creditors the principal constituency injured by any fiduciary breaches that diminish the firm’s value.’ Therefore, equitable considerations give creditors standing to pursue derivative claims against the directors of an insolvent corporation. Individual creditors of an insolvent corporation have the same incentive to pursue valid derivative claims on its behalf that shareholders have when the corporation is solvent.”). Importantly, this reading is entirely consistent with the analysis of the Court of Chancery in its decision below, whose judgment the DE Supreme Court affirmed. See Ch. Ct. Op. at 37-38 (“The notion that creditors of an insolvent corporation are permitted standing to maintain derivative claims for breach of existing fiduciary duties on behalf of the corporation is relatively uncontroversial. Indeed, the idea that an insolvent corporation’s creditors (having been effectively placed ‘in the shoes normally occupied by the shareholders—that of residual risk-bearers’) should be granted standing because they are the principal remaining constituency with a material incentive to pursue derivative claims on behalf of the corporation has significant intuitive and persuasive merit.”) (link: http://courts.delaware.gov/opinions/(w5b2fy45xrzhj3qww1eab255)/download.aspx?ID=81170).
4. Posted by Michelle Harner on November 14, 2008 @ 14:28 | Permalink
This exchange is an excellent exploration of the ins and outs of the North American Catholic decision. In my view, the notion of shifting duties is directly tied to the court's discussion of the residual claimant. (The court again referenced this substitution of creditors for shareholders as the residual claimant in footnote 46 of Schoon v. Smith, 953 A.2d 196.) If the creditors are the residual claimants of an insolvent corporation, then the board's risk-taking analysis shifts to some extent as well. As is much discussed in the literature, shareholders generally have a greater risk appetite than creditors. This shift in focus, I think, is consistent with the various decisions of the Delaware Chancery Court discussing a board's duty in the insolvency context.