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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