‘Latchkey Corporations’: Fiduciary Duties in Wholly Owned, Financially Troubled Subsidiaries
47 Pages Posted: 9 Oct 2011 Last revised: 22 Nov 2011
Date Written: October 7, 2011
The current state of the law fails to provide clear guidance to directors of wholly owned, financially troubled ("WOFT") subsidiaries regarding to whom their fiduciary duties run. Directors of solvent wholly owned subsidiaries can act in the best interests of their parent corporation with little fear of liability because the parent corporation is the only party that can sue derivatively on behalf of the subsidiary corporation and is also the subsidiary's only shareholder. However, when a subsidiary corporation becomes insolvent, or in some jurisdictions merely becomes financially troubled, most courts grant the creditors of the subsidiary corporation standing to sue derivatively on behalf of the subsidiary for breaches of fiduciary duty. This grant of standing to creditors traps directors of WOFT subsidiaries between the proverbial Scylla and Charybdis. If directors of a subsidiary favor their parent corporation, the directors will risk facing a fiduciary duty lawsuit from the creditors. On the other hand, favoring creditor interests could open directors of a subsidiary to fiduciary duty-based lawsuits from the parent corporation or lead to prompt removal of the directors by the parent corporation.
Outside of the wholly owned subsidiary context, this conflict between corporate stakeholders is of little practical importance, as directorial decisions are largely protected by the business judgment rule and exculpatory charter provisions. In the wholly owned subsidiary context, however, current law will often classify directors of WOFT subsidiaries as "interested directors" when dealing with their parent corporations. This classification strips directors of WOFT subsidiaries of their legal protections and leaves them vulnerable to creditor claims based on breaches of the fiduciary duty of loyalty. Accordingly, the current law encourages directors of WOFT subsidiaries to favor creditors. If directors of WOFT subsidiaries do begin to favor creditors and begin to challenge the instructions of their parent corporations, administrative costs will increase and wealth creation will decrease. Ultimately, owners of parent corporations may choose more flexible entity forms, such as limited liability companies, where the bounds of fiduciary duties can be better controlled.
This Article argues that fiduciary duty law should not punish directors when they choose one of the subsidiary's legitimate constituencies, such as its parent corporation, over another constituency, such as its creditors. As a solution to theoretical and practical problems stemming from potential fiduciary duty lawsuits by creditors against directors of WOFT subsidiaries, this Article proposes extending business judgment rule or statutory protections to cover directors of WOFT subsidiaries who, in good faith, favor their parent corporations.
Keywords: Corporate, Business, Corporate Governance, Bankruptcy, Bankrupt, Insolvency, Insolvent, Vicinity of Insolvency, Zone of Insolvency, Fiduciary Duties, Fiduciary Duty, Duty of Loyalty, Duty of Care, Board of Directors, Directors, Parent Corporations, Wholly Owned, Subsidiaries
JEL Classification: L21, G34, K20, L10, M10
Suggested Citation: Suggested Citation