MY CREDITOR'S KEEPER: ESCALATION OF COMMITMENT AND CUSTODIAL FIDUCIARY DUTIES IN THE VICINITY OF INSOLVENCY.

• Author: Licht, Amir N.

ABSTRACT

Fiduciary duties in the vicinity of insolvency form a notoriously murky area where legal space warps. Courts openly acknowledge that it is difficult to identify its boundaries, and the content of these duties is equally uncertain and inconsistent across jurisdictions. This Article expands the theoretical basis for a special legal regime in virtually or liminally insolvent firms. In addition to the conventional rationale of opportunistic risk shifting, lawmakers should be mindful of managers' tendency to unjustifiably continue failing projects, known as escalation of commitment. Second, this Article addresses the substantive content of a duty to protect creditors, either as in the form of a duty to consider creditors' interest or as the statutory ride against wrongful (or insolvent, or reckless) trading. Specifically, it argues that when these duties are enlivened at the very edge of the zone of insolvency, the mission of directors should transform from entrepreneurial to custodial and should include a trustee-like duty of caution.

TABLE OF CONTENTS INTRODUCTION I. CREDITORS AS AN ENDANGERED SPECIES II. ESCALATION OF COMMITMENT III. CUSTODIAL DUTIES IN THE VICINITY OF INSOLVENCY A. Custodial Duties of Trustees B. Caution and De-escalation in the Vicinity IV. CARING FOR CREDITORS ACROSS COUNTRIES A. The United States B. Canada C. The United Kingdom, Australia, and New Zealand CONCLUSION INTRODUCTION

In several common law systems, creditors of corporate debtors enjoy legal protections beyond what their contracts with those companies afford them. These protections cover both large and small creditors, voluntary and involuntary creditors alike. These protections derive from duties imposed on directors and other corporate fiduciaries by common law or by statute that call for considering and sometimes promoting creditors' interests before the latter take over the company through formal bankruptcy proceedings. This stage is metaphorically described as the "vicinity" or "zone of insolvency."

The vicinity-of-insolvency duties form a notoriously murky area where legal space warps. The contours of this area are fuzzy. Courts openly acknowledge that it is difficult to identify clear guideposts for the threshold at which these duties are enlivened. The content of these duties is equally uncertain and conceptually inconsistent across jurisdictions. At one end of the spectrum, Delaware law denies the legal existence of a zone of insolvency, thus relieving itself--and purportedly, also directors--of the need to consider creditors' interests outside of insolvency. At the other end, Canadian law locates shareholders' and creditors' interests at the same level, assigning neither priority a priori. In this view, creditors constitute one stakeholder constituency among several, including shareholders and employees, whose interests directors should balance. Somewhere in a notional middle ground, the laws of countries like the United Kingdom and Australia struggle to give concrete content to the duty to consider creditors' interest in the vicinity of insolvency.

The goal of this Article is two-fold. First, it expands the theoretical basis for a special legal regime in virtually insolvent or liminally insolvent firms. To explain and justify special fiduciary duties to consider creditors' interests, lawyers usually point to the danger of opportunistic high-risk behavior by managers on behalf of shareholders. I argue that this account may be sound but is nonetheless lacking. In addition to such opportunism, lawmakers should also be mindful of managers' tendency to unjustifiably continue failing projects--a practice known as escalation of commitment. Unlike opportunistic risk shifting, for which empirical evidence is surprisingly sparse, escalation of commitment is an irrational behavior that has been widely documented and studied but has been largely neglected by legal scholars.

Second, this Article addresses the substantive content of the duty to protect creditors where such duties are recognized, either in the form of a duty to consider creditors' interest or as the statutory rule against wrongful (or insolvent, or reckless) trading. I maintain that when these duties are enlivened--arguably, at the very edge of the zone of insolvency, close to actual insolvency--the mission of directors should transform from entrepreneurial to custodial. That is, they should implement strategies that aim to preserve the firm--in working condition, to the extent possible, with a view to resuming regular business--but avoid seeking new projects with a view toward maximizing profits. This could mean that the shield of the business judgment rule may not be available to the same extent as in regular circumstances. The COVID-19 pandemic that swept the globe in 2020 provides a fresh context for this approach and underscores the need to implement such a regime sensibly, with high deference to business decisions even if outside the scope of the business judgment rule.

The Article proceeds as follows. Part I addresses the role of creditors as corporate stakeholders and its legal implications for directors' duties to promote the company's interests. Next, it briefly reviews the problem of anti-creditor opportunism and presents the possibly bigger problem of escalation of commitment. Part II sets forth the custodial duties in the vicinity of insolvency. Part III provides a comparative analysis of creditor-oriented duties in several common law jurisdictions and examines how these jurisdictions could implement a custodial approach. Part IV concludes.

1. CREDITORS AS AN ENDANGERED SPECIES

   The common wisdom in corporate finance and corporate law points to conflicts of interest between shareholders and creditors and notes that the latter are vulnerable to abuse by the former. These tensions are often described as an "agency problem," and the resulting losses are sometimes called "agency costs of debt." These are misnomers, however. Unlike managers, who are agents for the company and indirectly for shareholders, shareholders do not stand in the same position vis-a-vis creditors as agents or fiduciaries of the latter. (1) There is no mission or project that creditors entrust to shareholders, and shareholder-appointed managers do not work for or on behalf of creditors. It is more accurate therefore to refer to "opportunistic behavior" by shareholders through company managers and to the detriment of creditors in the Williamsonian sense--namely, by exploiting transaction costs of contract formation, information asymmetry, vulnerability due to specific investment, etc. (2)

   To see the source of creditors' vulnerability, consider a basic setting, in which shareholders appoint managers to operate the firm for profit and enjoy limited liability such that creditors have recourse only to the company's assets, the company being a separate legal entity. (3) This setting assumes that only property law and contract law apply (i.e., no fiduciary duties); the shareholder-manager agency problem is assumed away for convenience. (4) Several mechanisms could then be utilized to make creditors bear non-priced business risk after the credit terms--particularly, the interest rate--have been set. Assuming that higher business risk is accompanied by higher expected returns, when the company is virtually insolvent shareholders enjoy the upside of increased risk without being fully exposed to its downside, which is borne by the creditors.

   The literature identifies three major risk-shifting mechanisms: asset dilution, claim dilution, and asset substitution. (5) Asset dilution involves siphoning value away from the company, either legitimately (e.g., through dividend payouts) or illegitimately (e.g., through self-dealing, also known as "tunneling"). (6) When creditors seize a company upon default and insolvency, the remaining assets do not match the risk they bargained for. Claim dilution works similarly to diminish the scope of the collateral available to creditors upon default, but instead of depleting the company's assets it increases its liabilities by taking on more debt--again, beyond what the creditors have envisaged and priced. Finally, asset substitution stands for post hoc changes in the firm's line of business--specifically, by entering into higher-risk-higher-return projects. In the now-less-likely event that those projects succeed, shareholders will gamer the higher rewards, while creditors become more likely to end up with whatever scraps that remain in the company upon liquidation.

   The effect of all of these mechanisms is the same--namely, exploitation and frustration. However, because risk shifting as described above is rather straightforward, most creditors realize its prospects and take measures to hedge against it by adjusting credit terms. There is ample evidence that, beyond setting interest rates in line with foreseeable risks, resourceful creditors design loan contracts (debentures) to accommodate particularly pertinent risks with appropriate covenants, security interests, and so forth. (7) Moreover, participants in certain debt markets appear to identify and price such covenants and penalize corporate debtors for breaching these obligations, thus providing incentives for optimal contracting and compliance. (8) In fact, there is surprisingly little evidence that corporate debtors can successfully engage in opportunistic risk shifting to extract value from creditors. The available empirical evidence relates largely to publicly traded debt instruments. While there is evidence for increased risk taking, (9) evidence for risk shifting is sparse. Such risk shifting appears to take place only in limited circumstances. (10) In summary, while risk shifting may not be a myth, its actual severity is unclear at this stage.

   The persuasive power of the risk-shifting account is so compelling that lawyers have bought whole-heartedly into it. This is especially the...