In Trenwick America Litigation Trust v. Ernst & Young, L.L.P., C.A. No. 1571-N, August 10, 2006 (I don’t yet have an online cite), in a typically insightful opinion, Delaware’s VC Strine held, among other things, that the directors of a subsidiary did not breach a fiduciary duty to its creditors for taking on debt for the benefit of its parent corporation, which owned 100% of its stock, although the parent and the sub eventually became insolvent.
VC Strine basically applied the business judgment rule and refused to find a special duty by the board to the creditors to avoid “deepening insolvency.” In other words, the subsidiary’s board continues to have a duty to the corporation, with the discretion under the business judgment rule to enter into transactions that benefit its sole shareholder, even if these transactions eventually leave its creditors worse off.
Here’s a colorful excerpt:
Delaware law does not recognize this catchy term ["deepening insolvency"] as a cause of action, because catchy though the term may be, it does not express a coherent concept. Even when a firm is insolvent, its directors may, in the appropriate exercise of their business judgment, take action that might, if it does not pan out, result in the firm being painted in a deeper hue of red. The fact that the residual claimants of the firm at that time are creditors does not mean that the directors cannot choose to continue the firm’s operations in the hope that they can expand the inadequate pie such that the firm’s creditors get a greater recovery. By doing so, the directors do not become a guarantor of success. Put simply, under Delaware law, “deepening insolvency” is no more of a cause of action when a firm is insolvent than a cause of action for “shallowing profitability” would be when a firm is solvent. Existing equitable causes of action for breach of fiduciary duty, and existing legal causes of action for fraud, fraudulent conveyance, and breach of contract are the appropriate means by which to challenge the actions of boards of insolvent corporations.
Of particular interest (to me, anyway) is Footnote 75 to the opinion, in which VC Strine responds to Steve Bainbridge’s idea in Much Ado about Little that directors cannot owe duties to the corporate entity, because the entity doesn't really exist:
The judicial decisions indicating that directors owe fiduciary duties to the firm when it is insolvent are not, in my view, at odds with Bainbridge’s fundamental perspective; indeed, they seem to me more a judicial method of attempting to reinforce the idea 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.
This is interesting to me, because it is exactly the approach that I take (with my co-author Kelli Alces) in Directors’ Duties in Failing Firms:
The legal quandary of who should be owed duties in the insolvency scenario disappears . . . in the face of the business judgment rule. It is no more appropriate for courts to interfere with directors’ judgment in the insolvency scenario than at other times. The courts still lack expertise, and liability could still make directors too timid. Indeed, the business judgment rule is arguably more important as the courts face uncertainty as to not only the appropriate course of action but whose interests are paramount. . .
[T]he language about maximizing the “corporate” interest merely confirms the absence of judicial interference in any decision the directors choose to make as long as they avoid conflicts or deliberate harm.
This idea is based more fundamentally on my reasoning in Accountability and Responsibility in Corporate Governance, that directors’ discretion to make decisions on behalf of non-shareholder constituencies, including creditors, is defined by the business judgment rule.
Excellent post.
Posted by: Francis Pileggi | August 16, 2006 at 05:16 PM