A corporation’s financial distress exacerbates many corporate governance conflicts. For example, directors and officers of solvent corporations must direct and manage on behalf of the common shareholders, and are under no obligation to consider the interests of the firm’s creditors. Therefore, as a company weakens, directors have an incentive to risk further deterioration by attempting to generate future return for shareholders. Such shareholder loyalty is, however, directly adverse to the interests of creditors who generally prefer to preserve corporate assets for liquidation and distribution.
The Delaware Court of Chancery has used various methods to determine the point at which a company becomes not merely distressed, but insolvent, warranting a shift in the directors’ loyalty from the stockholders to the contractual creditors. Furthermore, the method to effectuate the shift itself is unclear. As such, director duties in distressed companies and the various analyses used to determine the extent of such distress are in need of clarification.
Historically, Delaware courts have used a company’s ability to pay its debts and whether its liabilities exceed the market value of its assets to assess the company’s solvency. A single formula, however, cannot accurately measure the solvency of all companies because each company has a unique combination of assets (some more readily resalable than others), liabilities, operating leverage (ratio of fixed to variable costs), investors (debt-to-equity ratios), etc. For example, while a manufacturing company with steady earnings and fixed assets may better weather an economic downturn, a tech company with volatile earnings and an appetite for risky projects is more likely to invest in a high-return venture generating value for the residual claimant shareholders.
Therefore, to accurately assess a company’s solvency, courts must look to the market’s evaluation of a given company’s future prospects. Such an approach uses the market’s assessment of the company’s specific characteristics, including its risk relative to the market as measured by the company’s levered equity beta.
Furthermore, director fiduciary duties in an insolvent corporation may shift to the creditors as the new residual claimants. Delaware law, however, is unsettled concerning whether the directors’ duties (1) are merely not breached by action taken for the primary benefit of creditors (permitting director action on behalf of the creditors) or (2) actively shift from the shareholders to the creditors (requiring director action on behalf of the creditors). Delaware must devise a reliable standard to increase certainty in director decision making. One potential solution is to implement option number one—directors’ duties are merely not breached by action taken for the primary benefit of creditors—in distressed yet solvent companies and implement option number two—actively shift directors’ duties from the shareholders to the creditors—once the corporation is insolvent.
This Comment attempts to clarify to whom directors of distressed and insolvent corporations owe their duties. It begins with a brief overview of corporate capital structure, follows with an explanation of the current law concerning fiduciary duties in a distressed corporation, and concludes by suggesting minor adjustments that can clarify directors’ duties as a company approaches insolvency.
