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.

Gheewalla Flaws

At least four things about Gheewalla don't quite add up.

1.  Why an Opinion?

First, as with so many Delaware decisions on directors' duties to creditors, it is not clear why an opinion issued on these questions at all. It is, for example, not clear that the plaintiff was even a creditor, or that the corporation was in the "zone" of insolvency. Rather, the plaintiff essentially asserted contingent claims regarding the corporation's failure to repurchase spectrum. But, at least under Delaware's standards, it is not clear that the plaintiff would have qualified as a "creditor" (it would have under the broader definitions in the Bankruptcy Code or the fraudulent transfer statutes, but they did not apply). Moreover, the cause of the corporation's failure--the collapse of the spectrum market in the wake of the Worldcom scandal--suggests that at all relevant times the corporation was actually "insolvent", rather than in the "zone" or "vicinity" of insolvency.

2.  Direct v. Derivative Claims

Second, the decision rests heavily on the distinction between a "direct" and "derivative" cause of action. This distinction has always been a bit muddy and manipulable. In 2004, however, the Delaware Supreme Court gave some guidance, in the Tooley decision, explaining that the distinction "must be based solely on the following questions: Who suffered the alleged harm--the corporation or the suing stockholder individually--and who would receive the benefit of the recovery or other remedy." Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031, 1035 (Del. 2004).

While I am not entirely sure what this means, it is easy to imagine that creditors of an insolvent corporation could suffer individual harm, and benefit from an individual remedy, in many of the same ways as could a shareholder when the corporation is solvent. In concluding as a matter of law that creditors can never sue in a direct capacity, Gheewalla appears to ignore the Tooley rule (even though Gheewalla cites Tooley).

3.  Priority and Duty

Which brings me to a third, more basic, problem: The decision perpetuates the failed conceptual foundation of all these cases: priority-in-right-of-payment. As I first pointed out in a UCLA article a couple of years ago, all of the cases that say that directors of distressed corporations become fiduciaries for creditors make a strong, if flawed, link between duty and priority in right of payment because they say that creditors "step into the shoes of" shareholders.

This link between duty and priority has a long pedigree, but today makes very little sense in most cases. The link is rooted in the "trust fund" cases from the early part of the 19th century. Those cases, most famously Justice Story's opinion in Wood v. Dummer, 30 F. Cas. 435 (C.C.D. Me. 1824)(No. 17,994), held that directors of insolvent liquidating corporations were fiduciaries for creditors.

It seems to me, though, that there is a world of difference between a distressed firm that is liquidating and one that is reorganizing. Moreover, a total liquidation today is much more likely to be managed by a bankruptcy trustee or other fiduciary for creditors. If the real condition that creates duties to creditors is liquidation, then in most cases the directors will be long gone.

Unfortunately, this is not a distinction the courts have actually recognized. Rather, cases like Gheewalla continue to talk as if creditors are somehow subrogated to the rights of shareholders when a firm is in distress. The problem, of course, is that while they may say this, they don't actually do it. After all, why wouldn't creditors step into shareholders' right to sue directly, under Tooley? Gheewalla's treatment of creditors suggests Delaware doesn't actually take its priority-duty model very seriously.

4.  Duties for Whom?

Which for the most part is fine, albeit confusing. But, if I am correct that priority should not determine fiduciary duty, Gheewalla leaves a final question: What should?

My view is that fiduciary duty is an equitable matter. As such, in most--but not all--cases, creditors protected "at law" need no help from equity. Mostly, these protections will come from contract rights (e.g., covenants, security interests).

The corollary, however, should be that in the absence of contract, or credible protections at law, equity may have a greater role to play, at least if the firm is in distress. It is easy to imagine that directors would be tempted by "opportunism" to take strategic action that creates (or further harms) tort or other involuntary creditors. This may involve putting shoddy products into the stream of commerce; it may involve fraud; it may involve reneging on promises to employees. This is where I would probably part company with those who laud Gheewalla, which makes it virtually impossible as a matter of law for tort creditors to sue directors. 

This is not to suggest that tort creditors should routinely sue directors once a corporation is in distress, or that they should win. Rather, the point is that conceptually, the only appropriate group for whom we should keep open the remedial door of equity would be involuntary creditors. For reasons I'll further explain in my next post, Gheewalla effectively--and, i/m/h/o, mistakenly--closes that door.