The New Death of Contract: Creeping Corporate Fiduciary Duties for Creditors

Abstract:     
The article identifies a worrisome trend in corporate law and scholarship. Across seemingly unrelated issue areas, courts and scholars have lost faith in private corporate bargains. They invite judicial intervention into private contract, proposing to expand fiduciary duties beyond their traditional shareholder centered focus to protect non-shareholder claimants from managerial opportunism. When conflict between claimant classes becomes acute, managers pursuing shareholder value may make inefficient investments that benefit shareholders but harm other claimants and the firm generally. I argue that claimants' private contracts with the firm are superior to expanded duty for constraining this opportunism.

I focus on one specific conflict - the conflict between shareholders and creditors. Existing doctrine already works a shift in fiduciary duties to creditors when this conflict becomes acute - when a firm becomes insolvent. Scholars propose to expand on current doctrine to include more creditors more of the time. I argue that both existing doctrine and its proposed expansions suffer fatal theoretical infirmities. The chief failing is that the accepted hypothetical bargain analysis from which corporate fiduciary duty derives cannot justify current doctrine or expansion proposals. Expanded duty to creditors is also costly compared to private contract.

I propose an approach I call contract primacy. Shareholder primacy should remain the default rule. Private contracting should be effective to curb manager opportunism. Additional legal constraints are costly and unnecessary. Sophisticated creditors typically negotiate elaborate covenant protections by the time a firm is in distress, often to the benefit of other creditors, who implicitly delegate monitoring responsibilities to the low cost monitor. A creditor may even negotiate for control of the firm, displacing shareholder primacy. Against the current doctrine and conventional wisdom, courts should vindicate these contracts for creditor primacy without insisting on the firm's insolvency. The doctrine should be abandoned, and proposals for further expansion of fiduciary duty for creditors should be rejected.

Keywords: corporate governance, fiduciary duties, insolvency, creditors, debt-equity conflict, incomplete contract, delegated monitoring

JEL Classifications: K22, G30

Working Paper Series