735. Mark J. Roe & Federico Cenzi Venezze, A Capital Market, Corporate Law Approach to Creditor Conduct, 10/2012.
Abstract: The problem of creditor conduct in distressed firms ought to have the economically-sensible repositioning of the distressed firm as a central goal. The doctrines dealing with such creditor conduct have, however, vexed courts for decades, without coming to a stable doctrinal resolution. It's easy to see why: 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 even at the price of somewhat mismanaging the debtor. 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 -- intervention from the creditor -- being paralyzed by unclear and inconsistent judicial doctrine.
The doctrinal difficulty and the potential for creditor paralysis arise from judicial doctrine that shifts from protecting creditors' contract rights to not protecting creditors if they perniciously-exercise control. But most creditor control rights arise from the lending contract itself, making the line separating pernicious control from protected 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 holdings. Control can be exercised through scrupulous use, waiver, and renegotiation of contract terms; and creditors can induce value-diminishing actions in the debtor without exercising full control.
We show how corporate law doctrine confronts similar problems differently.
Putting a layer of basic corporate duties -- entire fairness for conflicted transactions and
business judgment rule deferential review for non-conflicted transactions -- atop the
creditor intervention doctrines clarifies the creditor conduct problem and shows a
conceptual way out. If courts could reduce the range of creditor conflict for critical
decisions, then doctrine akin to a business judgment safe harbor could be considered -- and thereby both encourage constructive intervention and discourage detrimental valueshifting.
We then show that modern financial markets could also yield a practical way out,
using corporate doctrine as the map: 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 decisionmaking.
The capital markets and corporate doctrine combination can create a conduit for better
incentivizing capital market players to improve distressed firms than the current doctrines
covering creditor conduct.