Bondholder Backlash

LBO debtholders are getting tougher about protecting their interests.

The Zone of Insolvency

It isn’t yet clear just how much the legal climate surrounding such insolvencies has changed since the last LBO boom. But the Delaware court’s decision in 1991 in a case involving the Dutch subsidiary of French bank Credit Lyonnais is widely considered a legal landmark.

In that case, a Delaware chancery court judge stated for the first time that creditors were owed fiduciary duties within the “zone” or “vicinity” of insolvency (see “Debating Creditors’ Rights” at the end of this article). Legal experts vigorously debate the merits of this view of fiduciary liability and its meaning for cases going forward. But many fear that empowering creditors could ultimately hamper the ability of directors and officers to run companies — and even, perhaps, subject LBO managers to claims for damages if their companies go bankrupt.

Complicating the issue, insolvency is ill-defined for legal purposes. Courts have accepted two traditional definitions: a balance-sheet definition, in which liabilities exceed assets; and an equity or cash-flow standard, where a company is unable to meet its obligations as they come due. But a company may be insolvent under one definition but not another, and there is no standard as to which test courts apply. They can even apply both, says Bratton.

Worse, two accountants employing the same definition may come to different conclusions. As a 2003 white paper by law firm Dorsey & Whitney LLP put it, “It is difficult for a corporation to know whether a court would find it to be insolvent, or ‘in the zone’ of insolvency.” While third-party advisers often supply courts with solvency opinions, these don’t always carry much weight.

As a result, experts fear that the cases in question have established an opportunity for unsecured creditors to sue individual directors and officers for fiduciary liability if they take actions to boost shareholder value once their companies encounter financial difficulty. Some experts dismiss such fears by pointing out that the Delaware cases do not necessarily provide unsecured creditors with the standing to sue for fiduciary liability, and that the judicial views outlining fiduciary duties to such creditors are merely footnotes, or “dicta” in legal terms. Yet Georgetown’s Bratton notes that bankruptcy judges, while bound by Delaware law on Delaware claims, are not required to follow it elsewhere. “They’re federal actors,” says Bratton, “and they might take dicta and apply them as if they’re real.”

Even some experts who doubt the courts will act in this fashion concede that market participants take the prospect seriously. David Skeel, a law professor at the University of Pennsylvania, notes that the possibility that courts would find a fiduciary liability owed to unsecured creditors has made banks wary of becoming too deeply involved in restructuring efforts. The banks fear that if they go so far as to select individuals to direct such efforts, they will become fiduciaries and see their own claims to the assets subordinated to those of such creditors. Even in cases in the 1980s and 1990s, says Skeel, “banks acted as if it was a serious risk.”

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