October 2013 Vol. 112 No. 1 THE REVIEW

A CAPITAL MARKET, CORPORATE LAW APPROACH TO CREDITOR CONDUCT

Mark J. Roe and Federico Cenzi Venezze

The problem of creditor conduct in a distressed firm-for which policymakers ought to have the distressed firm's economically sensible repositioning as a central goal-has vexed courts for decades. Because courts have not come to coherent, stable doctrine to regulate creditor behavior and because they do not focus on building doctrinal structures that would facilitate the sensible repositioning of the distressed firm, social costs arise and those costs may be substantial. One can easily see why developing a good rule here has been hard to achieve: A rule that facilitates creditor intervention in the debtor's operations beyond the creditor's ordinary collection on a defaulted loan can induce creditors to intervene perniciously, to shift value to themselves even at the price of 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 managerial alternative-the creditor-paralyzed by judicial doctrine.

The doctrinal difficulty and the potential for creditor paralysis arise from unclear and inconsistent judicial doctrine. Some courts hold that it is the creditor's inequitable control of the debtor that leads to creditor liability. Others rule that the creditor's contract rights go beyond simply suing and collecting, fully allowing the creditor to condition its own forbearance from suing on the debtor complying with the creditor's wishes-even if the conditions are costly to the firm's other creditors. Worse for encouraging positive creditor engagement, the doctrinal standard through which courts shift from protected contract rights to perniciously exercised control is obscure. Leading cases have the same basic facts-sometimes even the same court-but sharply differing results. Creditor control is the key doctrinal metric, but the better metric for judicial focus is the creditor's goal. 

Here we show, first, that there is often no on-the-ground, operational difference between these two standards-pernicious control and free wheeling contract enforcement-and that this lack of sharp difference helps explain why the judicial results are vexing, contradictory, and costly. We next show how similar problems are dealt with differently in corporate law settings: courts evaluate the questioned transaction but defer to the business judgment of an unconflicted board of directors. Then we show how putting a layer of basic corporate duties-entire fairness for conflicted transactions and business-judgment-rule deferential review for nonconflicted transactions-atop the creditor-intervention doctrines clarifies the creditor-in-control problem and shows us a conceptual way out from the problem. A safe harbor for creditors is plausible-if courts could reduce the extent of creditor conflict for critical decisions-and would both encourage constructive creditor intervention and discourage detrimental, value-shifting creditor intervention.

Finally, we show that modern financial markets yield a practical way out, using this 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 doctrinal overlay, can better inform courts and parties on how to evaluate and structure creditor entry into managerial decisionmaking. The capital market and corporate doctrine combination can create a doctrinal conduit to better incentivize capital market players to improve distressed firms than the current doctrines regulating creditor conduct.

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