Much Ado about Little? Directors' Fiduciary Duties in the Vicinity of Insolvency

Journal of Business and Technology Law, Forthcoming

UCLA School of Law, Law-Econ Research Paper No. 05-26

44 Pages Posted: 25 Oct 2005  

Stephen M. Bainbridge

University of California, Los Angeles (UCLA) - School of Law

Abstract

Where the contract between a corporation and one of its creditors is silent on some question, should the law invoke fiduciary duties as a gap filler? In general, the law has declined to do so. There is some precedent, however, for the proposition that directors of a corporation owe fiduciary duties to bondholders and other creditors once the firm is in the vicinity of insolvency.

Courts embracing the zone of insolvency doctrine have characterized the duties of directors as running to the corporate entity rather than any individual constituency. This approach is incoherent in practice and insupportable in theory. Courts should focus on whether the board has an obligation to give sole concern to the interests of a specific constituency of the corporation.

Concern that shareholders will gamble with the creditors' money is the principal argument for imposing a duty on the board running to creditors when the corporation is in the vicinity of insolvency. On close examination, however, this argument proves unpersuasive. It is director and manager opportunism, rather than strategic behavior by shareholders that is the real concern. Because bondholders and other creditors are better able to protect themselves against that risk than are shareholders, there is no justification for imposing such a duty.

This article also argues that the zone debate is much ado about very little. The only cases in which the zone of insolvency debate matters are those to which the business judgment rule does not apply, shareholder and creditor interests conflict, and a recovery could go to directly to those who have standing to sue. In those cases, as this Article explains, there is a strong policy argument that creditors should be limited to whatever rights the contract provides or might be inferred from the implied covenant of good faith.

Keywords: corporation, corporate governance, board of directors, fiduciary duties, insolvency, creditors, shareholders

JEL Classification: K22

Suggested Citation

Bainbridge, Stephen M., Much Ado about Little? Directors' Fiduciary Duties in the Vicinity of Insolvency. Journal of Business and Technology Law, Forthcoming; UCLA School of Law, Law-Econ Research Paper No. 05-26. Available at SSRN: https://ssrn.com/abstract=832504

Stephen Mark Bainbridge (Contact Author)

University of California, Los Angeles (UCLA) - School of Law ( email )

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HOME PAGE: http://www.professorbainbridge.com

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