Managers' fiduciary duties in financially distressed corporations: chaos in Delaware (and elsewhere).

• Author: Campbell, Rutheford B., Jr.

1. INTRODUCTION II. POSITIVE ANALYSIS OF CORPORATE FIDUCIARY DUTIES A. In Normal or Solvent Periods B. In Periods of Insolvency and Its Vicinity 1. Insolvency 2. Vicinity of Insolvency C. Bankruptcy Court's Interpretations of Managers' Duties Before Bankruptcy: Weiboldt Stores, Inc. v. Schottenstein D. Duties of Corporate Managers in Bankruptcy Case III. PRESCRIPTION A. The Normative Justifications for Shareholder Wealth Maximization 1. Criterion for Efficiency Analyses of Corporate Governance Regimes 2. Shareholder Wealth Maximization and the Efficiency Criterion B. Fiduciary Duties in and near Insolvency 1. Normative Justifications for the Shift of Duty upon and in the Vicinity of Insolvency 2. Critique of the Shift in Duties C. The Exception: Manager Fiduciary Duties in Bankruptcy IV. CONCLUSION I. INTRODUCTION

   The inherent conflict between creditors and shareholders (1) has long occupied courts and commentators interested in corporate governance. (2) Creditors holding fixed claims to the corporation's assets generally prefer corporate decision making that minimizes the risk of firm failure. Shareholders, in contrast, have a greater appetite for risk, because, as residual owners, they reap the rewards of firm success while sharing the risk of loss with creditors. (3)

   Traditionally, this conflict is mediated by a governance structure that imposes a fiduciary duty on the corporation's managers--its officers and directors--to maximize the value of the shareholders' interests in the firm. (4) In this traditional view, officers, and directors serve as agents of the shareholders and thus are charged with a fiduciary duty to maximize the value of the principals' ownership interests. Under this model of corporate governance, managers are not agents for the company's creditors and thus owe no fiduciary duty to act in the best interests of creditors. (5)

   For the most part, this traditional model of corporate governance has dominated corporate law. (6) Over recent years, however, a number of courts have suggested or held that these normal fiduciary duties of corporate managers may change when firms move into and through periods of deepening financial distress.

   Courts have staked out at least four separate periods as a company moves across a spectrum from financial solvency to bankruptcy. The first period along the spectrum is the normal or solvent period for the corporation. (7) Next is a period when the corporation is not yet insolvent but is close to insolvency. Sometimes this period is called the "vicinity of insolvency" or the "zone of insolvency." (8) Next, as conditions continue to deteriorate, is a period in which the corporation is insolvent but has not yet filed for bankruptcy. (9) Finally, the fourth period commences when the corporation files a bankruptcy petition and, we assume, begins reorganization under Chapter 11. (10)

   While generally across this time spectrum courts define fiduciary duties as an obligation to maximize some "value," the question of whose value is to be maximized in any given period is uncertain. Three possible beneficiaries of managers' value maximization obligation have emerged from the cases. The beneficiaries may be: (1) shareholders; (2) creditors; or (3) the "corporation", which should be interpreted as some combination of corporate stakeholders. The cases hold or suggest that the obligation of corporate managers in normal or solvent periods is to act in the best interests of shareholders (11) but that the duty changes to an obligation to act in the best interests of the corporation once the firm enters the vicinity of insolvency. (12) As the firm's financial distress deepens and it passes out of the vicinity of insolvency and into actual insolvency, cases suggest or hold that the obligation of managers becomes a duty to maximize the interests of creditors. (13) Finally, when the company enters bankruptcy and is operating under Chapter 11, the cases hold or suggest that the obligation is to maximize the total interests of creditors and shareholders as a whole. (14)

   This line of cases is rife with uncertainties. Defining the perimeters of the periods is often difficult. An obligation to act in the best interests of the "corporation" raises the question of which of the corporate stakeholders or constituencies (e.g., employees, the community) are included in the "corporation." Is the obligation of corporate managers to act in the best interests of the preferred constituency (e.g., creditors) unbending, or is it permissible for managers to pursue a path that benefits a non-favored constituency (e.g., shareholders) at the expense of the favored constituency (e.g., creditors)? If managers are permitted to pursue such a path, is there a limit on the extent of the permissible sacrifice managers may visit on the favored constituency?

   These shifting duties and the accompanying uncertainties cause problems for managers attempting to live up to their legal obligations. Even more important to us, however, is the pernicious impact that such confusion has on the pricing of capital and the allocation of risks among investors. When shareholders and creditors contribute their capital to a corporation, they price their investment and shape the terms of their contract in part by reference to fiduciary duties and the extent to which they are the beneficiaries of managers' fiduciary obligations. (15) Confusion and complexity respecting the matter of whose value in what period managers are obliged to maximize make it nearly impossible for investors--shareholders and creditors--to price the capital they contribute to the corporation and to allocate the risk of loss in corporate transactions to the most efficient bearer of that risk. (16)

   The purpose of this Article is twofold. First, we offer a positive analysis of the fiduciary duties of managers, as corporations move along the time spectrum from solvency to Chapter 11 reorganization. While, certainly, we are unable to clarify entirely the mess that courts have created, we believe that we are able to offer guidance regarding the present state of the law and how the law is likely to evolve on these important matters.

   In the second part of the Article, we offer our prescription for corporate managers' fiduciary duties, as corporations move along the time spectrum from solvency to bankruptcy. Our view is that the fiduciary obligation of corporate managers should be uniform across the pre-bankruptcy period, changing only at the point the company enters into Chapter 11. Our prescription is informed by simple economic concepts. Our view is that clear and efficient default rules are of the utmost importance, since such rules will protect the expectations of the parties, respect their pricing, and thus facilitate an efficient allocation of the risk of loss in financial transactions.

2. POSITIVE ANALYSIS OF CORPORATE FIDUCIARY DUTIES

   1. In Normal or Solvent Periods

      In normal times--before a company enters bankruptcy or otherwise gets itself in a situation of financial distress--the fiduciary duties of corporate managers are often articulated by reference to the best interests of "the corporation." (17) Notwithstanding such language, it is generally conceded that corporate managers are under a duty to act in the best interests of the company's shareholders, (18) a duty that is often stated in terms of an obligation to maximize shareholder wealth. (19)

      A corollary of this fiduciary duty to act in the best interests of shareholders is that corporate managers owe no fiduciary duty to the corporation's creditors (20) or any other non-shareholder constituency, such as employees. (21) Duties to creditors (and other non-shareholder constituencies) are purely contractual in nature, (22) except for discrete legal duties imposed on the corporation (and its managers), such as duties to refrain from paying excessive dividends to shareholders (23) or engaging in fraudulent transfers. (24)

      To illustrate these basic points, consider an example roughly based on the RJR-Nabisco case. (25) Target is acquired in a highly leveraged acquisition. It is an all cash deal at a price that amounts to a large premium over Target's market price. Shareholders as a whole are better off as a result of the acquisition. The additional leverage, however, causes a significant loss in the market value of Target's credit instruments.

      Target's managers who facilitate this acquisition appear to be acting consistent with their obligation to maximize the wealth of Target's shareholders. It does not matter that part of Target shareholders' gain came at the expense of the company's creditors. Managers owe no broad fiduciary duty to act in the best interests of creditors. (26) Target's creditors' protections come only from the covenants in their indenture and from the extra contractual protections found in discrete legal rules of the kind mentioned above. (27)

      The foregoing discussion and example show that corporate managers' fiduciary duty to shareholders is defined in terms of the duty to maximize the total wealth of shareholders considered as a whole. There is, however, a second component to the fiduciary duty of corporate managers, and that is a duty to refrain from facilitating wealth transfers detrimental to any portion of the shareholders. (28) Even if a transaction increases shareholder wealth considered as a whole, managers breach their fiduciary duty by facilitating a transaction that transfers wealth from any group of shareholders (minority shareholders, for instance) to other shareholders (majority shareholders, for instance) or to non-shareholder constituencies.

      This rule can be illustrated by an example based roughly on Weinberger v. UOP, Inc. (29) Assume that Parent owns a majority interest in Subsidiary and that the managers of Subsidiary, who are nominees of Parent, facilitate a merger of the Subsidiary into Parent in which minority shareholders of Subsidiary are frozen out at...