A capital market, corporate law approach to creditor conduct.

• Author: Roe, Mark J.
• Position: II. The Corporate Law Analogue D. Considering a Contractual Trump to Corporate Law Doctrine through Conclusion, with footnotes and tables, p. 85-109

4. Considering a Contractual Trump to Corporate Law Doctrine

   Contractual qualifications to the foregoing analysis, along with a closer look at several additional contractarian considerations, are now necessary. Does the loan contract's terms determine the range of judicial action as to the controlling creditor?

   [T]he efficient ex ante bargain may include terms that look inefficient ex post.... [C]reditors may need to ... have the ability to engage in self-serving behavior that compromises the value of the business as a whole in order to ensure that the shareholders have the right set of incentives in the previous period. (73) But one can take a strong contractarian stance, (74) an approach to which the authors here generally subscribe, and still recognize the great need for a new approach to creditor duties.

   First, contractarian characteristics underlie even aggressive judicial implication of fiduciary duties. Courts that impose duties on controlling creditors still do not deny creditors their contract right to sue and collect on their loan. They rather evaluate a creditor's behavior that is not basic collection activity. The fiduciary-duty courts, however, do not conclude that contractarian deference to straight collection action should extend to when the creditor uses its loan to leverage influence on the firm. That added action, a fiduciary-oriented court could conclude, is not part of the contract. (75) But a full-throated contractarian still might protect the added action (of conditioning waiver on debtor action not explicitly covered by the loan agreement), seeing a creditor's waiver on condition that the debtor take this or that action as a lesser included offense to suing and collecting. But critics of this approach could see the creditor's and debtor's actions as not fully worthy of the same contractarian deference that they would give to straight collection activity, if that conditional waiver transferred value from other creditors to the activist creditor. If the debtor and dominant creditor manipulate the firm or its finances in ways that deeply affect third parties--namely the firm's other creditors--contractarian deference may well not be warranted.

   A second, related consideration is obvious: contracts are often incomplete. Even heavily negotiated loan agreements have open-ended terms or fail to anticipate the consequences of the full range of operational outcomes over the life of the loan. The loan may have a financial covenant that has been violated, and the available remedies may not explicitly include the right to name new management or direct the firm's operations. (76) Indeed, strong contractarians recognize this possibility when they propose "to interpret the duty of good faith as equivalent to a prohibition of opportunistic behavior. Under this view, lenders are entitled to the benefit of their bargain but are precluded from using contractual terms as a pretense for extracting benefits for which they have not bargained." (77)

   Thus, even courts holding the strongest contractarian view of debtor-creditor relations will need to assess the extent to which the controlling creditor's behavior was opportunistic and went beyond what the contract terms permitted. If the contract was clear or if the creditor just did not negotiate for formal rights to control future firm investments in the event of the debtor's default, the case for implying fiduciary duties is not a strong one in our usual business jurisprudence, and recent erosions, analysts argue, should be cut back. (78)

   But consider the possibility that the loan agreement is specific and explicit: "In the event of a default, the creditor may liquidate the firm immediately in a value-destroying fire sale." Or, "in the event of a default, the creditor may name new management, in its sole discretion, to run the company in the creditor's interest." As between that creditor and the debtor, the contractarian view would be that the creditor can engage in even value-destroying creditor actions. (A contractarian, aiming also to maximize social wealth ex post, might hope that merger markets are strong enough that the creditor or the stockholder can sell the firm for a higher value to capture what would be lost in any creditor mismanagement or fire sale, but that is another matter. A contractarian might also hope that, in the face of such a contract, the stockholders and creditors would negotiate a Coasian deal (79) to deploy the firm most efficiently. The doctrinal and business structures we propose in the next Parts are designed in part to facilitate such a Coasian efficient deployment of the distressed firm, even in the face of an ex ante value-destroying contract.)

   The difficulty of the full contractarian view even here, in an unusual setting of contractual explicitness on control, is not that it would permit the creditor to liquidate or name new management, against the debtor's objections, but that the creditor could be enabled to do so in the face of objections from the firm's other creditors. True, if other financial creditors lent to the debtor after examining the loan agreement with the control-and-liquidate covenants--that is, if they were themselves fully contracting creditors, with knowledge of the prior deals--then the contractarian view would bind those informed, subsequent creditors. But vis-a-vis a wide range of other creditors-many preexisting creditors and most tax claimants, as well as many trade creditors, tort claimants, and consumer creditors--the explicit contractarian framework fits poorly. These creditors in the aggregate can be substantial for a firm. Think of many small tort claimants in the mass tort cases that drove firm after firm that dealt with asbestos into bankruptcy. Think of tax, consumer, and supplier claims on typical businesses. Such claims have figured prominently in major cases, such as American Lumber, (80) Clark Pipe & Supply II, (81) and W.T. Grant. (82)

   In these three settings, pure deference to an incomplete contract, or to waivers of defaults in exchange for operational concessions, would work erratically in maximizing value. Too many creditors are not party to the relevant contract.

   In principle, these contractarian issues could arise elsewhere in the life cycle of the firm--contracts are always incomplete, some creditors do not fully negotiate contracts, bilateral contracts have third-party effects on other creditors. But these difficulties are more acute when the firm is insolvent or nearly so.

   Regardless, for the reasons already discussed, the current state of judicial doctrine--contrasting day-to-day control against creditor enforcement of its contract protections via conditional waivers and hoping that such a distinction is real--provides poor guidance. We need a new approach.

   3. A CAPITAL MARKET APPROACH TO REDUCING DISTORTIVE CREDITOR SELF-INTEREST: OLD STYLE

   The theory is clear: if a court could find an unconflicted creditor, it could accord business-judgment deference to a creditor's business decisions in influencing a failing firm. The problem is practical, in that such a lack of conflict, or even a substantial lessening of conflict, seems hard to achieve. Worse yet, traditional financial structures and traditional bank regulation have largely impeded such structures from emerging in the United States.

   But the unconflicted creditor-in-control is not as far-fetched as it might at first seem, in light of the new finance of options and derivatives, and against the background of the concomitant rise of new financial players. First, though, we will consider how old-style finance could have been adapted, albeit with much transactional and regulatory difficulty, to the theory.

1. The Syndicate Leader

   Consider a firm with a traditional lending syndicate and stockholder-managers but with no other major players in the capital structure. Trade creditors are few, and back taxes have been paid. The firm's capital structure initially consists of just the creditors and stockholders.

   The firm defaults, and creditors do more than seek to be repaid: they seek to replace management and influence operating decisions. This setting occurred in the well-known Farah Manufacturing controversy (83) and is instructive here. There, the lending syndicate forced out old management after a bitter labor strike and secondary boycott of the debtor, put a managerial change clause into its loan agreement (i.e., barring any managerial change to which the creditors objected), used the managerial change clause to wedge its preferred managers into place, and induced managers to liquidate major parts of the firm's operations. (84) The new managers made disastrous operating decisions that cost everyone in the firm dearly. (85) When the original equity holders eventually regained control of the firm, they had better operating results, and they sued the banks on several theories of lender liability. (86)

   If the firm had a bleak future when the creditors originally seized control, a liquidation sale of the useless machinery was operationally sensible. If the bank-appointed managers intended their decisions to be profit maximizing, however, and if the controlling creditors who appointed those managers lacked conflicts, then business-judgment judicial deference to the decisions could have been appropriate. But given the deep conflicts of interest of the creditors, no such thinking emerged in the Farah Manufacturing litigation. (87) Nor, given the lending syndicate's structure, should it have.

   How then could the Farah creditors have not been conflicted? If they owned the same proportion of equity that they were owed on their loans, then the debtor-creditor conflict would have approached zero. But the lenders were just about the firm's only creditors, so a proportional equity interest for them would have required them to own nearly all of it. This was not possible short of a full-scale bankruptcy and reorganization.

   But consider...