A capital market, corporate law approach to creditor conduct.

• Author: Roe, Mark J.
• Position: Introduction through II. The Corporate Law Analogue C. The Creditor Takes Control: Business-Judgment Deference for Nonconflicted Transactions, p. 59-85

The problem of creditor conduct in a distressed firm--for which policymakers ought to have the distressed firm's economically sensible repositioning as a central goal--has vexed courts for decades. Because courts have not come to coherent, stable doctrine to regulate creditor behavior and because they do not focus on building doctrinal structures that would facilitate the sensible repositioning of the distressed firm, social costs arise and those costs may be substantial. One can easily see why developing a good rule here has been hard to achieve: A rule that facilitates creditor intervention in the debtor's operations beyond the creditor's ordinary collection on a defaulted loan can induce creditors to intervene perniciously, to shift value to themselves even at the price of mismanaging the debtor. But a rule that confines creditors to no more than collecting their debt can allow failed managers to continue mismanaging the distressed firm, with the only real managerial alternative--the creditor--paralyzed by judicial doctrine.

The doctrinal difficulty and the potential for creditor paralysis arise from unclear and inconsistent judicial doctrine. Some courts hold that it is the creditor's inequitable control of the debtor that leads to creditor liability. Others rule that the creditor's contract rights go beyond simply suing and collecting, fully allowing the creditor to condition its own forbearance from suing on the debtor complying with the creditor's wishes--even if the conditions are costly to the firm's other creditors. Worse for encouraging positive creditor engagement, the doctrinal standard through which courts shift from protected contract rights to perniciously exercised control is obscure. Leading cases have the same basic facts--sometimes even the same court--but sharply differing results. Creditor control is the key doctrinal metric, but the better metric for judicial focus is the creditor's goal.

Here we show, first, that there is often no on-the-ground, operational difference between these two standards--pernicious control and free-wheeling contract enforcement--and that this lack of sharp difference helps explain why the .judicial results are vexing, contradictory, and costly. We next show how similar problems are dealt with differently in corporate law settings: courts evaluate the questioned transaction but defer to the business judgment of an unconflicted board of directors. Then we show how putting a layer of basic corporate duties--entire fairness for conflicted transactions and business-judgment-rule deferential review for nonconflicted transactions--atop the creditor-intervention doctrines clarifies the creditor-in-control problem and shows us a conceptual way out from the problem. A safe harbor for creditors is plausible--if courts could reduce the extent of creditor conflict for critical decisions--and would both encourage constructive creditor intervention and discourage detrimental, value-shifting creditor intervention.

Finally, we show that modern financial markets yield a practical way out, using this corporate doctrine as the map: modern capital markets' capacity to build options, credit default swaps, and contracts for equity calls provides new mechanisms that, when combined with the classic corporate doctrinal overlay, can better inform courts and parties on how to evaluate and structure creditor entry into managerial decisionmaking. The capital market and corporate doctrine combination can create a doctrinal conduit to better incentivize capital market players to improve distressed firms than the current doctrines regulating creditor conduct.

TABLE OF CONTENTS INTRODUCTION I. THE PROBLEM A. The Doctrinal Contradiction: Creditor Control Versus Contractual Self-Protection 1. American Lumber Versus W.T. Grant 2. Clark Pipe & Supply I Versus Clark Pipe & Supply II 3. Busy Bee Versus American Consolidated 4. Objective Facts Versus Eye-of-the-Beholder Viewpoint B. The Conflicts in Play C. The Operational Problems: The Importance of Getting the Judicial Standard Right 1. Operational Costs of Deterring Capable Creditors from Intervening in Failing Firms 2. Operational Costs to Allowing Excessive Creditor Distortions in Managing Failed Firms II. THE CORPORATE LAW ANALOGUE A. Corporate Law Basics B. The Creditor Takes Control: Entire Fairness Review for Conflicted Creditor Transactions C. The Creditor Takes Control: Business-Judgment Deference for Nonconflicted Transactions D. Considering a Contractual Trump to Corporate Law Doctrine III. A CAPITAL MARKET APPROACH TO REDUCING DISTORTIVE CREDITOR SELF-INTEREST: OLD STYLE A. The Syndicate Leader B. Other Old-Style Ways to Reduce Controlling-Creditor Conflicts 1. Warrants at the Time of Lending 2. Convertible Debt 3. Buying up Proportionate Interests C. The Classic Main Bank System and Its Relevance 1. How the Classic Main Bank System Resembles the Capital Market, Corporate Law Approach 2. How It Differs 3. Why American Banks Could Not Have Become Main Banks IV. A CAPITAL MARKET APPROACH TO REDUCING DISTORTIVE CREDITOR SELF-INTEREST: NEW-STYLE DERIVATIVES A. Equity Options B. Options on Other Debt Layers C. Credit Default Swaps D. Implementation Limits 1. Transaction Costs of the Activist Creditor 2. Creditor Fallback from the Safe Harbor 3. Judicial Limits in Verifying the Quality of the Safe Harbor 4. The Safe Harbor as Infectious Agent E. Hedge Fund Activism F. Similar Situational Conflicts and Solutions CONCLUSION INTRODUCTION

When firms fail, creditors seek to be repaid. Sometimes, however, a creditor does more than simply collect on its breached contract, taking control of the failing firm and dictating the firm's operating decisions and personnel choices with the aim of being repaid, perhaps at the expense of other creditors or of the firm's well-being. When a creditor does so, litigation can readily ensue, after the eventual bankruptcy or before it, with other claimants on the firm asserting that the controlling creditor was liable to those other claimants, or to the firm, if the creditor ran the firm opportunistically for its own benefit.

For now, it suffices to understand two premises here that we demonstrate later: namely that, first, courts have treated substantially identical factual settings differently--sometimes holding creditors liable for a breach of duty but other times absolving them for nearly identical actions under contractarian thinking--and, second, the results and inconsistencies matter. They matter because when a firm fails, a large financial creditor is often the corporate player best positioned to make the needed operational and personnel decisions that will minimize economic loss and reduce the chance that the firm goes bankrupt or closes unnecessarily. But if the creditor is sharply conflicted, then it cannot be trusted to maximize overall value. And, because the applicable doctrines that govern a creditor's acts are both uncertain and not aimed at ameliorating the distressed firm's operational efficiency, the creditor's fear of being caught in an unfriendly legal framework can keep even a nonconflicted creditor far from the firm's operational decisionmaking, for fear of ex post liability. If courts could find, and we believe that they can, a doctrinal overlay that encourages constructive creditor engagement while discouraging value-diminishing engagement, the courts should articulate the doctrine for such a safe harbor.

Thus we have a substantial economic problem that has not yet settled into a suitable legal framework, with the judicially built framework that now exists generating both uncertainty and missed opportunities to restructure weakened firms. This uncertainty arises not just from disagreeing courts unable to settle on correct and consistent doctrine but also from foundational difficulties embedded in the distressed firm's situation. Courts regularly indicate that a creditor can enforce its contract without then bearing much excess fiduciary responsibility, decisions that we examine in Part I. When courts hold that creditor enforcement of its contract is fair game, they typically thereby free the creditor from liability even if the creditor directs or influences the debtor's decisionmaking on operations and finances. Other courts indicate that the contract bars the creditor from controlling the debtor firm with impunity. When the creditor does take control (or as some courts put it, when it takes day-to-day control), it acquires concomitant fiduciary duties, as if it constituted the firm's board of directors--duties that typically lead a court to find creditor liability for unfairly furthering its own interests. When a court does so, it typically orders the controlling creditor's claims to be subordinated in bankruptcy to other creditors' claims, holds the creditor liable to the debtor, or finds the creditor liable to other creditors. We examine instances of these contrasting decisions in Section I.A.

One core doctrinal difficulty is that the existing doctrines do not seek to maximize total firm value. Rather, both doctrines regulate the fairness or the contractual appropriateness of the creditor's conduct, without a sharp view as to whether the doctrines would incentivize better management of the debtor. A second core doctrinal difficulty is that a line separating legitimate contract from pernicious control, the two judicial positions, is difficult to draw. The two positions blur into one another because creditor power, even the power to control the debtor, emanates from the loan contract.

Take many courts' focus on the creditor's having day-to-day control (a characteristic inducing courts to hold the day-to-day controller liable, as we describe in Section I.A): a creditor can enrich itself at the expense of other creditors by inducing a single debtor action. The creditor need not control the firm day-to-day but can, say, force the liquidation of the firm's main factory on a...