Larry Ribstein over at Ideoblog has written (together with coauthor Kelli Alces) an important new paper concerning the fiduciary duties of directors of failing firms. Conventional wisdom (as often stated in law review articles and judicial dicta) is that director fiduciary duties, though generally owed to shareholders, shift from shareholders to creditors when the firm nears or enters insolvency. Ribstein and Alces, however, argue persuasively against this view. They contend that the directors’ duties run to the firm itself rather than to any particular class of stakeholders such as shareholders or creditors. Thus, no special set of fiduciary duties to creditors arises on account of insolvency; the ordinary business judgment rule remains in effect.
Conceiving of fiduciary duties as extending to the firm rather than to individual stakeholders is a major breakthrough of both practical and theoretical importance. If Ribstein and Alces are correct, the capacity of creditors to sue derivatively on behalf of insolvent firms is weaker than many people think, and creditors will have to look elsewhere for remedies in cases where it is alleged that the directors improvidently gambled with the firm’s assets for the shareholders’ benefit but at the creditors’ expense.
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A basic problem corporate law has to face is the faithless fiduciary. As a board is permitted to increase the scope of the constituencies to be promoted, the board is given greater ability to rationalize faithless acts. Saying that the duties are owed to the corporation increases that flexibility, by giving the board greater leeway in finding a constituency whose interests are putatively being promoted, and is therefore problematic.
Additionally, stating that the duties are owed to the corporation seems somewhat dissonant with the obligations under Brincat to communicate truthfully. Brincat selects communication with a particular constituency to be the subject of enhanced duties. Saying that the fiduciary duty runs simply to the corporation provides no guidance concerning the scope of the communications to which these duties appertain during distress.
Moreover, corporation law forms only part of the regulatory scheme governing distress, and it needs to be understood in the context of those other principles. Finding that there is a direct fiduciary duty owed to creditors of distressed firms allows courts to reverse some bad outcomes that would otherwise obtain under the in pari delicto doctrine and the Wagoner rule.
As background: Following Wagoner, courts have applied the in pari delicto principle to prevent a trustee’s assertion of claims against a third party professional who participated with the debtor’s former management in fraudulent conduct. The outcome these cases reach materially undercuts the ability of firms to engage third party professionals to monitor corporate misconduct under contractual arrangements that provide remedies for breach that are effective.
A more detailed explanation of these and other pertinent principles is available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=846964, a paper which is forthcoming with the Ribstein work and other conference papers in the Journal of Business & Technology Law.