Fiduciary Duties of Officers and Directors of Corporations Operating in the Vicinity of Insolvency
Royce de Rohan Barondes
University of Missouri-Columbia School of Law
In a recent case, the Delaware Court of Chancery held that directors of corporations operating in the vicinity of insolvency owe a fiduciary duty "to the community of interest that sustain[s] the corporation, to . . . maximize the corporation's long-term wealth creating capacity." Most recently, another court has held that this duty can be affirmatively enforced by creditors.The quoted rule of law was the product of the application of the familiar conclusion that corporations that incur debt have incentives to overinvest, and that those incentives are exacerbated by financial distress. This paper examines the benefits that this developing rule of corporation law may provide, as well as economic harms that may result from its adoption. This paper first reviews recent empirical evidence, which suggests that the overinvestment by nearly insolvent firms, predicted by theory, occurs to only a modest extent.This paper then examines two undesirable aspects of the rule: that the time-horizon selected is one that can be modified by contract only with significant difficulty, whereas other time-horizons could be more easily modified by contract, and that the rule creates substantial, unwarranted risks of personal liability for directors of nearly insolvent firms. This paper concludes that the costs associated with these aspects of corporation law exceed the contemplated benefits.
JEL Classification: G33, G34, G38, K22
Date posted: September 5, 1997
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