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Gheewalla - What's at Stake?

posted by Jonathan Lipson

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. 

It's Not Unusual

The first set of calls was with our friends at United's Mileage Plus Visa. We had, for many years, used this card when we lived in a city that was served by United Airlines. Since moving to Philadelphia, we have  upgraded to the 7th ring of Hell known as USAirways.  Having no good reason to accrue United miles, we canceled the United card about a year ago. I was thus surprised to receive in the mail a bill from United for the period 4/28/07-5/27/07. They wanted $10 immediately for the "Minimum Payment Due for Credit Access Line" plus $60 (not currently due) for an Annual Membership Fee.

We thus called Visa. A very nice woman named Veronica took our call. After trying to dissuade us from canceling ("no, Veronica, we already canceled"), I asked Veronica why we would have received a bill at all. "Oh," she said, drawing from the Tom Jones Manual of Recommended Credit Collection Practices, "that's not unusual." 

I was so stunned that I momentarily lost the ability to form the next logical question, which would have been something like: "How the %$^*! can you bill me if I am not your %^#$^ing customer?" In the interlude, she dutifully plied us with other card opportunities ("We have cards for lots other airlines."  I could actually hear her smile.). When I finally regained my senses, I asked if there were any miles in the account. After all, if we were still customers, I should still have miles there. "No," she replied hesitantly, "they seem to have been taken back by United."

We could have gone on with Veronica for a while, but she cheerfully agreed to cancel the card and waive the pending charges. She also agreed to send a written confirmation of this. 

All's well that ends well, right? Well, imagine my surprise when we received the cancellation notice--with the following statement: "Although your account currently reflects a $60 balance, pending charges, additional finance charges, and/or fee adjustments may result in a different balance due on your upcoming billing statement." 

My response: "WTF!?!"

So, back on the phone, this time with the computer, which confirmed--despite the letter--that we had no balance. Which was correct, the letter or the computer? I didn't know, so I spoke to another nice woman (this one named Mandy), who assured me that our account balance was actually zero, and we didn't have anything to worry about.

"But why does the letter say we still owe you $60?"

"Oh," she said, "that just goes automatically into the cancellation notice." (I could actually hear her smile, too, which was a little creepy).

This was not the time to lecture Mandy about contract modification, consumer fraud or the 8th ring of Hell known as the Consumer Credit Reporting System. I just asked that she send a letter confirming that we owed nothing, which she promised to do.

This left me wondering: How was it possible to make these mistakes? If they got this wrong, why should we believe anything else they say, in their bills or elsewhere? Or perhaps they didn't get it wrong.  Perhaps it's not unusual because it is, as Credit Slipper Elizabeth Warren has warned elsewhere, part of a larger revenue strategy.

Okay, Maybe Credit Card Companies Are Evil.  So What?

The third call was with a lawyer representing a class of plaintiffs in a consumer fraud suit against a large, public (non-credit-card) company that has been threatening to go into bankruptcy. The lawyer wanted to understand how bankruptcy would affect him and his plaintiffs. The case arose from a protracted--seemingly systemic--pattern or practice of inducing consumers to agree to something under false pretenses. And, while I cannot divulge the name of the company, I can tell you that this is not some aluminum siding schlepper in northern New Jersey. It's a big publicly traded company that you have probably heard of.

When I asked why the company might go into bankruptcy, the attorney said that the company had basically been pillaged by prior management, who had apparently concocted and executed the dubious schemes in question. While they were gone, the plaintiff's lawyers and new management were left to attempt to allocate losses amongst themselves. 

What does this have to do with directors' duties to creditors? It tells me that very sophisticated, well-known, seemingly respectable organizations are nevertheless populated by people who, like most people under the right circumstances, might be greedy, manipulative and, how shall we say this, less than candid. If a credit card company--which is pretty clearly not in bad financial shape--behaves this way, what should we expect of companies that really are in desperate straights? Shouldn't they--or their directors--do exactly what the Delaware Chancery Court suggested in Katz v. Oak Industries: "It is the obligation of directors to attempt, within the law, to maximize long-run interests of the corporation's stockholders; that they may sometimes do so "at the expense" of others . . . does not for that reason constitute a breach of duty."  See Katz v. Oak Indus, Inc., 508 A.2d 873, 879 (Del. Ch. 1986).

We can clearly see shades of this shareholder-maximization norm in Gheewalla:

When a solvent corporation is navigating in the zone of insolvency, the focus for Delaware directors does not change: directors must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owners

Gheewalla, 2007 WL 1453705, at * 7. Since it will usually benefit shareholders to take advantage of creditors, I should expect to spend more time on the phone in the future.

To be sure, this is not a brief in favor of the plaintiffs' bar. If we are to believe recent scholarship, plaintiff's lawyers and their ilk can be every bit as opportunistic as the most craven corporate stewards. Moreover, there is some empirical evidence to suggest that tort-feasing (is that a word?) corporations won't always engage in judgment proofing strategies, like fully encumbering their assets. But, Warren and Westbrook tell us, involuntary creditors frequently populate business bankruptcy cases, and there is no reason to expect this to change. Indeed, if Delaware directors have no reason to fear liability to corporate creditors, and are obligated to exploit them, we should expect to see more of them.

What's really at stake here, then, is the level of opportunism we will tolerate in our corporate directors. In Credit Lyonnais, Chancellor Allen suggested, albeit in dicta, that this was a legitimate concern. Today, we know that so far as the Delaware Supreme Court is concerned, it is not.

Next: Delaware's (unanswered?) invitation to fraud.


I can't go so far in pilloring the Delaware S.Ct. for their decision in Gheewalla. The door is left wide open for a derivative action. Shareholders are normally restricted to this remedy unless they can show specific facts that they were directly defrauded, under traditional recovery principles. Creditors are now added as parties with a legitimate right to bring a derivative action (that is, after all, a very new thing), to whom certain duties are owed.

When we create new causes of action to remedy perceived injury (and that has been done throughout the formation of the common law), we create some serious dislocations in how business is done and how economic decisionmaking is accomplished. Given the difficulties in advising directors and officers of what their range of options should be to avoid a derivative action by creditors, it strikes me as wise of the Delaware S.Ct. to go slow insofar as crafting a direct right of action.

To me, what really needs to happen is for the federal courts to come to their senses about the proper application of in pari delicto when it comes to creditor-driven derivative actions. Fix that problem, and I won't miss not having a direct action for creditors other than those the common law has already constructed.

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