Living on the Edge: Fiduciary Duties, Business Judgment and Expensive Uncertainty in the Zone of Insolvency

Article excerpt

Although the extent of Delaware directors' fiduciary duties to creditors during financial distress remains unclear, consensus has begun to develop around the idea that concerns about expansive liability are misplaced because business judgment is typically shielded. This Article contends that to the contrary, the problem remains highly salient because creditors' ability to litigate triggers a staggering set of doctrinal problems and practical costs. It proposes that Delaware courts be explicit that creditors lack standing in the zone of insolvency and articulate a narrow standing doctrine for creditors of insolvent firms alleging fiduciary breach on the basis of zone decisions.

Introduction

Directors of Delaware corporations on the brink of insolvency have owed fiduciary duties to creditors since Credit Lyonnais í. Pathe Communications.1 The terms "brink," "vicinity," and "zone" of insolvency are equivalent. They refer to some period of time when solvent firms are barely so, or very near to insolvency. Although recent jurisprudence about the "zone" has been prolific, Delaware courts have not, strictly speaking, defined the term objectively. They have instead resolved issues related to the label's applicability on a case-by-case basis.

Although both scholars and practitioners have worried about the extent of these duties, consensus has begun to develop around the idea that because the exculpatory provisions of most company charters and the business judgment rule insulate directors from liability for good faith business decisions, concerns about expansive directorial exposure amount, in practice, to "much ado about little."2 Recent Court of Chancery jurisprudence (the Production Resources,3 Trenwick Amenca,4 and North American Catholic Educational Programming Foundation5 ("NACEPF") cases) has clarified that Delaware law does not impose primary or exclusive duties to creditors in the "zone of insolvency" and that directors are entitled to business judgment rule protections for decisions made there. Although little scholarship has treated these particular cases in depth, their director-favorable logic appears to support the growing consensus. In short, judicial deference to business judgment solves the problem.

This Article argues that this understanding is mistaken. It breaks with recent scholarship to contend that even if exculpatory charter provisions and the business judgment rule apply, the problem of duties to creditors in the zone of insolvency remains highly salient for Delaware corporations, their directors, attorneys and financial advisors. The difficulty is that if the law of zone duties provides any handle to creditors - anything more than a shield for directors from liability to shareholders - it dismantles the very incentive structure and directorial discretion which the business judgment rule is meant to protect. Vague, judicially imposed standards generate uncertainty among directors about fiduciary duties, injecting hesitation into financially precarious situations, increasing the transaction costs of risky decisions, and affording particular creditors an enforcement windfall to which their bargain with the firm does not entitle them.

Even if judges ultimately defer to directors' business judgment in creditor and bankruptcy trustee litigation, many of these costs and negative effects have already accrued. Even if currently "there are no cases holding the directors liable simply for getting the balance wrong . . . ."6 there are still cases attempting to do so. Even if the likelihood of business judgment protections for directors means that many creditor cases settle, there are still complaints. Indeed, the mere threat of protracted, costly litigation is likely to interfere with carefully balanced incentive schemes. Most notably, the prospect of judicial intervention may strongly encourage creditors not to contract - and not to pay - to protect their interests, creating an incentive to litigate the matter down the road and a system in which lawsuits, not contracts, become creditors' default enforcement tools. …