Credit Slips

Trenwick--The End of Jaw-Boning

When Credit Slips’ management learned that the Delaware Supreme Court issued a remarkably brief order a couple weeks ago affirming the Chancery Court in the Trenwick litigation, they asked me to reprise my role as guest blogger here. I am, of course, happy to oblige.

Trenwick was the latest in a series of cases at the increasingly congested intersection of bankruptcy and corporate governance. Trenwick involved both breach of fiduciary duty and "deepening insolvency" claims. I won’t belabor the fiduciary duty issues, as I've already discussed them here (you have to scroll to the bottom). Deepening insolvency, on the other hand, warrants a few words. 

The basic idea behind deepening insolvency seems simple: Creditors claim they were harmed when the corporation incurred debt which, rather than salvaging the company, merely prolonged the agony, "deepening" the distress. Instead of losing 75% of their claim, for example, creditors might say that the deepening insolvency "misconduct" caused them to lose 85%. Thus, creditors bring a lawsuit against the managers and others who they believe caused this additional loss. The legal issue is whether and to what extent the courts will give the creditors a remedy if they can prove these facts.

Unlike the closely related question of directors' duties to creditors, there is no obvious predicate doctrine which might guide a court trying to determine how to respond to such a claim. Although most analysts trace deepening insolvency back to the 1983 Schacht case from the 7th Circuit, no one has been able to figure out if deepening insolvency is really a unique cause of action that could be asserted against corporate fiduciaries or professionals, a measure of damages, or both, or neither.

The logical problems with the claim are pretty clear. In many cases, incurring additional debt may actually save the company, but of course you won't know this until it’s too late. Moreover, it is not clear what work this deepening insolvency "doctrine" would do that other doctrines—including breach of fiduciary duty, fraudulent conveyance and good faith—could not already do.

These were certainly the views Vice Chancellor Strine expressed—repeatedly—in his ginormous, 90-page, 25,000+ word Chancery Court opinion in Trenwick, which is what the Supreme Court affirmed--in a mere two sentences. 

In truth, it is not clear why VC Strine bothered to say much of anything in Trenwick. Many of the plaintiff's claims were obviously problematic, including that the plaintiff clearly lacked standing to sue, and the debtor was evidently solvent at all relevant times. As with Gheewalla and some of the other recent Delaware jurisprudence on these issues, the results are probably correct—the curiosity is in the analysis.

Until the Trenwick Supreme Court opinion, it seems the Delaware courts were saying a whole lot more than was necessary in cases that could easily have been resolved with little discussion. Thus, I recently argued in Stanford's Journal of Law, Business and Finance that Delaware courts appeared to be engaged in the "expressive function" of judging. This is just a fancy way of saying that they have been doing a lot of jaw-boning to try to send messages to their audience—lawyers, directors, etc.—about what is and is not acceptable behavior when a firm is in distress.

Trenwick would seem to be the end of this jaw-boning, although there is clearly more that could be said. After all, we should not forget that the net result of cases like Gheewalla and Trenwick will be that Delaware has foreclosed many doctrinal avenues that creditors might reasonably want to pursue against directors and other corporate actors. In fact, contrary to Vice Chancellor Strine’s Chancery Court analysis in Trenwick, it would appear that, in all but extraordinary cases, neither breach of fiduciary duty nor good faith claims will lie in the wake of Gheewalla and Stone v. Ritter.

Perhaps Trenwick means Delaware has said all it means to say on deepening insolvency (and related matters, such as directors' duties to creditors). Perhaps it means they have gotten (or given) the message—and they are going to keep quiet for a while.  Or, perhaps it just means that VC Strine has finally worn the Supreme Court out. Only time--and more jaw-boning--will tell.

Debt to the Future

This will be my final Credit Slips post. I want to thank the keepers (and the audience) for indulging me. I've enjoyed posting here, and hope that it's been useful and perhaps interesting for some of you.

Looking Backwards; Looking Forwards

My first posts were largely backwards-looking, in the sense that they were about a case (Gheewalla) that was flawed in part because it was burdened by the logic of a fairly ancient doctrine (the "trust fund" cases). Indeed, I think problems of financial distress are often backwards-looking:  You lent me a dollar yesterday, which I can (or cannot) repay today. To be sure, we spend a good deal of energy thinking about how much better the future will be depending on the bankruptcy result you're looking for (the debt is paid or discharged). But debts are usually the product of prior behavior.

Which is why a new symposium issue of the University of Chicago Law Review is so interesting. Entitled Intergenerational Equity and Discounting, it is in general about how to calculate the costs and benefits of big decisions today that might have no impact until the distant future. The key example is usually global warming: Most of us are not likely to live to see the moment in the future when there is atmospheric payoff from levying a carbon tax, abiding by the Kyoto Protocols, or whatever else we might do today that saves the planet for later generations.

The authors in the symposium do not generally write in bankruptcy or commercial law (with the exception of Eric Posner), so do not discuss these problems in those terms. But really, what we are talking about is a future debt, an obligation to the distant future, that may be payable today (or in the near future). The problem of intergenerational equity is figuring out how to come up with fair and efficient decisional rules about what that debt and those payments should be.

Speaking of Delaware, or an (Unaccepted?) Invitation to Fraud

I Don't Hate Delaware

After reading my last few posts, you might think I really have a hate on for Delaware. But the truth is I don't. It's just that what the nation's "most important business court" (to paraphrase Vice Chancellor Strine) says and does matters to business lawyers, including those who care about credit and bankruptcy.

You might  expect the same to be true for the Delaware legislature. So, for example, when Delaware enacted its  "Asset Backed Securitization Facilitation Act" ("ABSFA") in 2002, you can understand why Delaware lawyers would say that Delaware is the "jurisdiction of choice" for securitization transactions. Given that ABSFA gave the securitization industry almost everything it wanted, you might expect the industry (and its transactions) to flock to Delaware, which was presumably the legislature's goal in enacting the law in the first place. 

Yet, it appears that hasn't happened. Rather, it appears these transactions continue to be governed by New York law. This is fascinating, since Delaware's ABSFA should be very attractive, both to the securitization industry and to those who may be less savory. This is because, read literally, it would immunize these transactions from virtually any judicial scrutiny. Read fairly, it would sustain transactions even if they were intentional fraudulent conveyances. You can't get much more certainty than that. And, at least ostensibly, certainty was a central quest for the industry in seeking ABSFA.

Gheewalla - What's at Stake?

The past two posts have been about what's wrong with the Delaware Supreme Court's opinion in the Gheewalla case, which holds that directors of distressed corporations have little in the way of fiduciary duties to creditors. I pointed out a variety of flaws and gaps in the case. 

But just because a case is wrong, doesn't mean it matters. Courts get things wrong all the time, and we adjust. So, perhaps a more important question than "what's wrong with Gheewalla" would be "what's at stake?"

If you've read my last posts, or anything else I've written about this, you'll know that the only constituency that seems to me to have legitimate normative and economic concerns about Gheewalla will be involuntary creditors of distressed corporations. These creditors axiomatically cannot protect themselves contractually, and I am not persuaded that the legal architecture of bankruptcy and creditors' rights--in particular, priority and fraudulent conveyance doctrine--will do much to protect them from directorial opportunism, either. 

But this assumes both that involuntary creditors are, in fact, vulnerable, and that corporate directors would exploit this vulnerability. If a few recent telephone calls are any evidence, there may be reason for concern. 

Gheewalla Gaps

The last post labored on about flaws in Gheewalla, the Delaware Supreme Court's recent opinion on directors' duties to creditors. This post discusses some gaps created by the case.

Recall that  Gheewalla tells us that directors of the distressed (insolvent) firm are, for unarticulated reasons, still fiduciaries for corporate creditors in a derivative sense. This presumably means that any suit by the creditor will be in the name of the corporation, and any recoveries will go to the corporation, to be shared by all corporate constituents. But this leaves at least four gaps in the law.

Gap 1--How Does this Work?

The first gap involves the procedural rules that apply to derivative suits in Delaware. Rule 23.1 of the Delaware rules of procedure requires that shareholders first make "demand" on directors before they will have standing to sue in the corporation's stead.

Fine, but what does this mean for creditors? The statue says nothing about creditors--only shareholders. Does this mean it simply does not apply? If not, then what sort of procedural predicates must occur for a creditor (or class of creditors) to pursue the derivative claim?

Vice Chancellor Strine chided counsel in Production Resources because they "ha[d] not burdened [him] with input" on this question. Prod. Res. Group, L.L.C. v. NCT Group, Inc., 863 A.2d 772, 795-96 (2004). I can see why. It would be nice to know.

Gheewalla-Palooza (or, Delaware to Creditors: Drop Dead)

A Few Words About My Few Words

Before rolling into the blog-jam, I want to thank the keepers of Credit Slips both for setting up this site, and for permitting me to squat here for a week. I also want to thank Professor Pottow for his very generous introduction.

Since there has not yet been a discussion here of the recent Gheewalla decision--and because I want to promote a forthcoming article on it--I am going to devote the first few posts to some flaws and gaps in the decision, which is the Delaware Supreme Court's first substantive utterance on directors' duties to corporate creditors.

Gheewalla-Palooza

After many years of speculating and handwringing among lawyers and academics, the Delaware Supreme Court has finally told us what sort of duties directors of distressed Delaware corporations owe to corporate creditors: None, really. 

Gheewalla holds that directors of a distressed corporation owe no direct duties to creditors, and at most only derivative duties when the firm is actually insolvent. N. Am. Catholic Educ. Programming Found., Inc. v. Rob Gheewalla, _ A.2d _, 2007 WL 1453705 (Del. May 18, 2007) aff’g 2006 WL 2588971 (Del. Ch. Sept. 1, 2006). As I will discuss in this and the next post, derivative duty claims as currently envisioned by Delaware are unlikely to have much force. Thus, net-net (as the accountants might say), Delaware is really telling us that directors have little to fear from creditor duty suits.

The Gheewalla decision has been greeted with a mix of relief and self-congratulation. Lawyers that advise directors of distressed Delaware firms now have at least the appearance of clarity on the murky challenges created by cases like Credit Lyonnais and Production Resources, which suggested (although did not actually hold) that under certain circumstances directors might be liable in a direct fiduciary capacity to creditors when a firm is in distress (i.e., "insolvent" or its "vicinity," whatever that means). See Credit Lyonnais Bank Nederland, N.V. v. Pathe Commc’ns Corp., No. 12150, 1991 Del. Ch. LEXIS 215 (Del. Ch. Dec. 30, 1991); Prod. Res. Group, L.L.C. v. NCT Group, Inc., 863 A.2d 772 (Del. Ch. 2004). For their part, Professors Bainbridge (here and here) and Ribstein have engaged in a virtual high five, satisfied that they have halted the creep of a doctrine could have had the unseemly effect of benefitting creditors at the expense of directors.

What no one seems to have paid much attention to, however, are some odd flaws and gaps in the Supreme Court's decision. While I think the result of the decision is correct in the sense that this creditor--if the plaintiff even was a creditor--had no fiduciary claim, these flaws and gaps are troubling. I will blog today about the flaws, and thereafter about the gaps and what's really at stake.