A Capital Market, Corporate Law Approach to Creditor Conduct

Mark Roe is the David Berg Professor of Law at Harvard Law School, where he teaches bankruptcy and corporate law.

Earlier in October, Federico Cenzi Venezze and I posted “A Capital Market, Corporate Law Approach to Creditor Conduct” up on SSRN. Michigan Law Review is scheduled to publish the article in their next volume.

In this article, we focus on the problem of creditor conduct in distressed firms — for which policymakers ought to have the economically-sensible repositioning of the distressed firm as a central goal. This problem has vexed courts for decades, without coming to a stable doctrinal resolution. It’s easy to see why developing an appropriate rule here has been difficult to achieve: A rule that facilitates creditor operational intervention going beyond ordinary collection on a defaulted loan can induce creditors to intervene perniciously, to shift value to themselves. But a rule that confines creditors to no more than collecting their debt can allow failed managers to continue mismanaging the distressed firm, with the only real alternative to the failed incumbent management — the creditor — being paralyzed by unclear and inconsistent judicial doctrine.

The article proceeds in four steps. For the first step, we show that existing doctrines do not address themselves to facilitating efficacious management of the failing firms. Yet with corporate and economic volatility as important as ever, courts should seek to make doctrine here more functionally-oriented than it now is.

The second step is recognizing that the existing doctrines are deeply contradictory in practice. Judicial doctrine shifts from protecting creditors’ contract rights to refusing to hold creditors liable if they perniciously exercise control. But most creditor control rights arise from the contract itself, making the shift from control to contract obscure. The obscurity of the dividing line can be seen by examining multiple cases that have the same basic facts, sometimes even the same court, but sharply differing results. Control can be exercised through scrupulous use of contract terms; and creditors can induce value-diminishing actions in the debtor without exercising full control.

The third step is to see that corporate law has long dealt with similar conflict situations when articulating board-based fiduciary duties. The stripped-down version of the corporate law’s fiduciary duty rule is that the court will defer to the board’s business judgment if the board is not substantially conflicted in its decision-making. If the board has serious conflicts of interest and cannot extricate itself from those conflicts by delegating decision-making to a subcommittee, then the court will take over the decision from the board and evaluate the board’s actions for their entire fairness. Until now, there has been little reason to assess the severity of conflicts in the creditor setting for a deferential judicial review, because the creditors’ conflicts were obvious, pernicious, wide, and irremediable. Hence, courts rightly jumped to the creditor-in-control equivalent of entire fairness review.

The last step is to examine whether there is any practical way to apply the corporate law conceptual alternative. We show how one could use the corporate doctrinal alternative as a map via which modern financial market instruments and structures could yield a practical way out. Modern capital markets’ capacity to build options, credit default swaps, and contracts for equity calls provides new mechanisms that, when combined with the classic corporate doctrine overlay, can better inform courts and parties on how to evaluate and structure creditor entry into managerial decision-making. The capital markets and corporate doctrine combination can create a safe harbor for better incentivizing capital market players to improve distressed firms than the current doctrines covering creditor conduct.

Overall, we re-analyze a longstanding, difficult, and still unresolved problem of the proper standard for governing creditor action inside distressed firms, when the creditor moves beyond collection of its loan under its contract. We have shown why the transactional problem persists, is severe, and is still doctrinally unresolved. The doctrines fail to address the critical problem of encouraging the best management of distressed firms in volatile markets. We show how corporate law conceptualizations deal with a similar problem, deal with it differently, and can be used to best analyze the problems of creditor intervention in debtor affairs. And we also show how such conceptualizations today have the potential to be made real by using modern capital market instruments to channel the incentives of new players in financial markets via the safe harbors that we suggest. We can reduce the persistent doctrinal and fairness problems of controlling creditor action in distressed firms, while simultaneously increasing the chance that distressed firms will be better run, by using core corporate law doctrine to bring forth the correct usage of modern capital markets to reduce creditor conflict and enhance creditor incentives in managing distressed firms.

The full paper is available for download here.

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