Zone of insolvency conference

This post started as a live-blog, but I've revised the post to make it a bit more coherent.

I'm at the University of Maryland School of Law conference on director duties in the "zone of insolvency"  (what we affectionally refer to as "The Zone").  Also attending are corporate bloggers Gordon Smith and Steve Bainbridge.  Recall that my theory is that the standard business judgment rule takes care of this issue.

The following are brief summaries and comments on many of the talks.  No warranties as to accuracy -- there is no substitute for reading the papers, many of which are here.

Russ Silberglied, Richards, Layton and Finger says, among other things, that Vice Chancellor Strine "held" in his Production Resources opinion that fiduciary duties are owed to creditors.  I think this is wrong.  How to tell?  The case would not have come out any differently if the Vice Chancellor had said the opposite. The case involved the creditors' right to sue on a corporate claim.  This does not require any decision one way or the other on duties to creditors individually.  The Vice Chancellor was explicitly agnostic on the latter issue.

Jonathan Lipson, Temple, sees fiduciary duties in the zone of insolvency as an aspect of the "expressive function of law." This would be consistent with my view that the cases supposedly espousing this duty are dicta, not holdings.  The problem with Lipson's view is that I'm not sure what the courts are "expressing" in these cases, since they're all over the lot on what directors can do.  This is as it should be -- it's consistent with directors' broad discretion under the bjr.

Royce de R. Barondes, Missouri had several interesting ideas.  Among them: an options perspective on the problems of a duty of care to creditors; the fact that shareholders can approve conflict transactions doesn't itself require that they be the exclusive beneficiaries -- though it may make sense to at least make them the default beneficiaries. 

On the latter point, I would add that there's a potential issue as to whether shareholder-directors are conflicted if they act for shareholders, affecting entire fairness review.  I would say no -- because this would in effect impose a fiduciary duty to creditors, which as I argue doesn't exist.  If it did exist, when would arise under this rationale?  When the directors own any stock?  When their jobs are subject to shareholder control?

Larry Hamermesh, Widener, raises an interesting question arising under Vice-Chancellor Strine's Production Resources opinion:  if, as he says, 102(b)(7) can limit the creditors' claim, what about an LLC in which the firm can opt out of fiduciary duties entirely, at least in Delaware?  I think the answer is clear: it would apply, making any duties default.  This would be a powerful reason to use LLCs and other partnership entities if courts were really serious about "zone" duties.

Carl Metzer, Goodwin Proctor, discussed how a possible duty to directors might and should affect director conduct on the ground. Some of this involves simply "acknowledging" creditor interests, exploring alternatives, etc.  Some involves avoiding obvious problems whether or not there's a fiduciary duty to creditor, including avoiding insider transactions. The question remains whether all this affects what directors actually do on the margin.  I'm sure it does, which is one reason why it's important that the courts be clear here about business judgment rule protection for these decisions.

Roger Lane, Greenberg Traurig, discussed the position of the plaintiff's lawyer, who wants to allege all possible claims. From the chancery court's perspective, it is trying to act as a court in equity. [Does this mean the Delaware supreme court will approach this issue differently?] He expects to see a resurgence of this theory because of all the subordinated debt floating around.  Therefore, there will be "a lot of quasi-derivative claims."  The most interesting issue, he says, is whether there can be such a thing as a direct creditor claim, the issue left open in Production Resources. He then discussed some specific fact scenarios that raise this issue.

There was also some discussion of whether creditors really can fill all gaps by anticipating everything? [Can any contract do this?  Does that mean fiduciary duties in all contracts?] Interestingly, panelist Mark Grovic (U of M School of Business) suggested that these very sophisticated creditors can anticipate a lot.

William Callison, Faegre & Benson, expressed skepticism about zone of insolvency fiduciary duties -- e.g., when are we in the zone?  what are the duties? what are the implications for unincorporated firms?

Mark Grovic handles early-stage venture capital firms. He makes the point that he agrees with the outcomes of the cases -- judges are getting to the right results, whatever the reasoning. He says that the insolvency definition is particularly difficult because most of his companies have negative equity in some sense, but may have lots of opportunities for financing. With respect to preferred stock, there's a spectrum of financing.  [And those complications are another reason for not second-guessing board decisions to favor one particular interest or another.]

Grovic pointed out that if any of these interests want protection, they should take board seats. Moderator Jim Hanks of Venable wondered whether these directors have different duties from shareholder-representative directors. Larry Hamermesh pointed to Frank Partnoy's paper about many "breakpoints" among the many  types of capital contributers.  When do the fiduciary duties kick in?
Grovic said that this can be resolved by focusing on blocking rights. When the directors do have to take a position, then they have to act in the interests of the "entity."

Grovic talked about managing for stakeholders.  He said that to the extent you're not focusing on shareholder value you're not doing a good job. (See my discussion of this issue.)

Fred Tung, Emory (on the first panel after lunch) and the immortal Steve Bainbridge, who made the keynote speech, can be lumped together because essentially they both first explained whether as a matter of finance directors should have duties to creditors, and then conclude that it doesn't matter because of the business judgment rule.   

My comment on both: the business judgment rule shouldn’t be an endpoint of the analysis, but rather the starting point.  This is all about, not what directors should do, but what courts can and should do – a jurisprudential matter.  As discussed in my article, this affects the scope of the bjr (broad) and the scope of corporate debtors’ fiduciary duties (narrow). Steve suggests that we should put a "stake through the heart of Credit Lyonnais. I propose that we should understand Credit Lyonnais:  it does not impose a fiduciary duty on directors near insolvency.

Simone Sepe (Yale) focuses on what rule will get to the right contracts.  He concludes that we need a clear rule, unsullied by a good faith duty.

Gordon Smith, Wisconsin and Conglomerate asked how all this applies to venture capital firms.  He responds that fiduciary duties come down to creditors’ inability to protect themselves. I disagree -- it comes down to whether courts can and should supply that protection. Gordon focused on preferred shareholders. He observed that “board protection and staged financing obviates the need for fiduciary protection.” I agree, but again it’s not important: the question is whether the courts should act even if the protection is incomplete.

Alan Schwartz, Yale, began by pointing out that society wants firms to maximize social wealth, which means giving control rights to those with the best incentives – equity during solvency, but not necessarily during insolvency. At that point control possibly should shift to the creditors – which in effect is what fiduciary duties to creditors would do. If directors are in a conflict situation, fiduciary duties will apply. So if duties exist, boards will change their behavior. 

My response: This depends on whether directors are really in a conflicts situation.  That, in turn, depends on whether there’s a fiduciary duty to creditors.  One problem with such a duty is that boards can’t live with uncertainty, so in reality, pursuant to legal advice, they will convert a fiduciary standard into a rule.  This is really an aspect of the jurisprudential problem – that is, courts can’t come up with a rule on fiduciary duties to creditors that provides the proper incentives.

Schwartz put this all in the context of what contracts we want.  Among other things, he suggests a problem with banning ipso facto clauses, which effectively limits the kind of renegotiation that can occur near and in insolvency. In general, I think that Schwartz and Sepe provide a very useful contracting perspective on this issue.

The final panel concerned comparative and international perspectives on duties to creditors near insolvency: Reid Feldman, Kramer, Levin, Paris, Andreas Engert, University of Munich; Hanno Merkt, Freiburg; Donna McKenzie-Skene; Pamela Huff, Blake Cassels & Graydon, Toronto.  All provided interesting information, but by this time in the day I found myself unable to add value.

Update:  Gordon Smith has more comments. I join in thanking Rich Booth, the conference organizers.  Apologies to Steve Bainbridge for not saying more about his thoughtful talk, which is must reading for those who want to understand the problems involved in shareholder/creditor conflicts near insolvency.  My paper, and therefore comments, focused on the separate problems of what courts can and should do about these problems.

Comments

[Russ Silberglied]

Larry, glad to see that the one comment on my talk was that I was wrong...Joking aside, for purposes of the blog record, I'll defend my position as follows: the sentence that I directly quoted from the opinion appears just after a sentence from the Vice Chancellor indicating, essentially that "everything I said before this sentence was dicta, and now I am getting to the issue". In that sentence, he explicitly says that fiduciary duties are owed to creditors upon insolvency in fact. Then he goes on to refuse to dismiss the breach of fiduciary duty counts of the complaint. With respect, your reading posits that he "could" have reached this result without resting his rationale on the duty to creditors, but the fact is he did not. Or at least that is my view.

I greatly enjoyed the opportunity to debate with you both Thursday night and Friday. I hope our paths will cross again soon.

[Larry Ribstein]

It was a very stimulating talk, and I agreed with most of it. On this specific point, I think we just have different definitions of holding and dicta.