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New York Professional Responsibility Rules vs. Delaware Corporate Law?

posted by Adam Levitin

The Caesars examiner's report makes for interesting reading. Of particular interest for our readers might be its discussion of the role of the lawyers, namely those at Paul Weiss, who simultaneously represented the Caesars holding company, its operating subsidiary, and the holding company's private equity sponsor.  As the report notes, it is not unusual for a law firm to simultaneously represent at a parent and a sub or a sponsor and a portfolio company. But the examiner's report argues that things change in one of the entities is insolvent because then the real party interest in that firm are the creditors, not the shareholders, and that means there is a real conflict of interest between the insolvent (or potentially insolvent) sub and the holding company (and private equity sponsor). 

Although the examiner's report ultimately concludes that there's probably not much basis for finding liability against Paul Weiss (which might not have even know of the insolvency), something jumped out at me:  the lurking conflict between Delaware corporate law and NY Rules of Professional Conduct.  

Here's the problem.  While the examiner's report is correct in describing creditors as the real party in interest in an insolvent company, that's not how Delaware corporate law treats things. In North American Catholic Educational Programming Foundation, Inc. v. Gheewala, the Delaware Supreme Court made very clear that even if a firm is insolvent, the duties of the directors still run to the firm and its shareholders, not to the creditors. (Were it otherwise, we'd have a lot of interesting litigation every time a firm got anywhere near insolvent, and risk averse directors would be well-counseled to file for bankruptcy the second insolvency appeared on the horizon.)

But let's assume that the examiner's report is correct that for the purposes of New York Rules of Professional Conduct there would be a conflict of interest such that the attorneys could not simultaneously represent both the parent and the insolvent sub.  Presumably whatever attorneys would represent the sub would have to look to the interests of the creditors of the sub under NYRPC.  How on earth would that work, when the sub's directors are responsible to the shareholder (i.e., the parent) under Delaware law?  If the examiner's report's interpretation of NY RPC is correct, then I don't see how any NY barred lawyer can represent a Delaware corporation that might be insolvent. (Of course, the solution to all of this might be simply be that there is a violation of NY RPC, but it isn't really actionable by any body, and no bar committee is going to look at this too closely.) 

Comments

Your statement of the Delaware case law seems to be slightly overstated. The NACEPF decision states that the directors’ have a "duty to maximize the value of the insolvent corporation for the benefit of all those having an interest in it." and indicates that the reason creditors don't have a direct claim when the corp is insolvent is that could give individual creditors too much power when negotiating with the insolvent corp.

I don't think it's correct to say that the directors of an insolvent DE corp still owe their duties to the shareholders. (Obviously zone of insolvency is completely different).

Overreading? I think Gheewala's pretty clear: "In this opinion, we hold that the creditors of a Delaware corporation that is either insolvent or in the zone of insolvency have no right, as a matter of law, to assert direct claims for breach of fiduciary duty against the corporation’s directors."

Gheewala allows creditors of insolvent firms to bring derivative suits, but that just means that the duties run to the firm. They never run to the creditors. And Gheewala does not say that the duties cease running to shareholders if the firm is insolvent. (Indeed, recognizing option value would suggest that such duties should never be cut off.)

Isn't there a clear difference between creditors having the right to a direct claim and the fiduciary duties of the directors running to the shareholders (who except in very limited cases can't sue directly either!)?

Gheewala states that the duties of the directors run to the firm and that in the case of actual insolvency this refers to "all those with an interest in" the firm, not just the shareholders.

As I understand Gheewalla, the board of an corporation that the directors deem insolvent owes a duty to creditors. However, the board's determination of insolvency is subject to the business judgment rule. That means that it won't be reviewed by a court if the board is not conflicted, and the determination of (in)solvency was procedurally correct.

Agree that as a practical matter, the post is completely on target re: the effects of Gheewala.

One does wonder, however, how a court would deal with a board determination of solvency, where solvency is redefined to take into account only the market (not the face) value of the liabilities. Would lack of conflict in formal terms and procedural correctness really prevail in such a case?

Now granted, I'm not the sharpest tool in the shed, as anyone who knows me can attest to, but it seems Gheewala is saying that, under Delaware law, 1) a corp is either solvent or insolvent; there is no such thing as "a little bit insolvent", and 2) creditors replace shareholders as the residual beneficiaries of an insolvent corp, but that they do not do so as quasi-shareholders but rather pursuant to their contracts with the corp. Creditors' relationships therefore continue to run only to the firm and not directly against the directors.

I think the special master in Caesars is simply saying an insolvent sub, which now has its duties running to the creditors, has a conflict of interest with its parent that it can not waive to allow a firm to represent both entities. I don't think this necessarily crosses Gheewala because I don't see that Gheewala holds that directors continue to owe a duty to the shareholders (or certainly at least not the duty they held before) but rather to the corp and the creditors. Creditors can force the directors to behave derivatively and, if the parent gets too intrusive, through receivership or involuntary bankruptcy. Since the corp should be answering to the creditors not the shareholders, I think attorneys avoid a conflict by staying on one side or the other, either with the parent or the sub.

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