Academic journal article Vanderbilt Law Review

Managers' Fiduciary Duty upon the Firm's Insolvency: Accounting for Performance Creditors

Academic journal article Vanderbilt Law Review

Managers' Fiduciary Duty upon the Firm's Insolvency: Accounting for Performance Creditors

Article excerpt


A corporation's managers1 generally owe a fiduciary duty to the corporation and its shareholders.2 Legal scholars interpret this duty as requiring the managers to maximize shareholder value.3 When a firm IMAGE FORMULA8

is solvent, the obligation to maximize shareholder value tends to give managers an incentive to deploy firm assets efficiently-that is, in a way that maximizes total value.

When a firm is insolvent, however, the duty to maximize shareholder value could lead managers to take actions that reduce the value of debt more than they increase the value of equity and therefore reduce total value. Accordingly, a number of courts have held that upon a firm's insolvency, managers owe a fiduciary duty not only to shareholders but also to creditors.4

The courts have yet to clearly articulate how managers of an insolvent firm should balance the interests of shareholders against those of creditors. However, economically oriented legal scholars addressing this issue have argued that managers of an insolvent firm should have a duty to maximize the sum of the values of all financial claims (both those held by shareholders and those held by creditors) against the firm.5 Put differently, an insolvent firm's managers should maximize the total financial value of the firm, not just the value of its equity.6 We call this view the "financial value maximization" ("FVM") approach.

To be sure, an insolvency-triggered fiduciary duty to maximize the financial value of the firm would be difficult to enforce. Thus, one might argue that even if courts were to impose an FVM duty on managers of insolvent firms, that duty would have little effect on managers' behavior. Whether or not it would affect managers' behavior, however, FVM is considered to be the conceptually correct approach to managers' fiduciary duty upon their firm's insolvency.7 IMAGE FORMULA10

This Article demonstrates that the FVM approach is, in fact, conceptually flawed. Proponents of FVM conclude correctly that when a firm is insolvent, efficiency requires that the interests of shareholders and creditors should be equally weighted: $1 of shareholder value should be treated the same as $1 of creditor value. However, supporters of FVM overlook the fact that an insolvent firm is likely to have two types of creditors: (1) "payment creditors"parties owed a fixed cash payment, which have a financial claim against the firm; and (2) "performance creditors"-parties owed contractual performance, which have a claim for performance against the firm.8

The FVM approach, which creates a duty to maximize solely the financial value of the insolvent firm, requires managers to take into account the effect of their actions on payment creditors and to ignore their impact on performance creditors. From an economic perspective, there is no justification for treating the interests of these two types of creditors differently. Indeed, as we explain, the requirement to maximize the financial value of the insolvent firm regardless of the effect on performance creditors might obligate managers to take steps that harm performance creditors more than they benefit payment creditors and shareholders and therefore are inefficient.

We identify two potential distortions that may arise under the FVM approach. First, managers seeking to maximize the financial value of an insolvent firm might have an incentive to inefficiently underinvest in the firm's ability to perform its contracts, reducing the likelihood that the firm will be able to meet its contractual obligations. Second, in certain situations, managers might have an incentive to choose to breach value-creating contracts that the firm could perform.

Neither of these distortions would arise under the FVM approach if the firm were solvent. If a solvent firm cannot (or chooses not to) perform a contract, the firm is forced to pay the injured party full monetary damages for breach, which reduces the firm's financial value by that amount. …

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