February 5, 2019 - Is the widely discussed debtor opportunism “problem” enabled merely by the supply/demand imbalance the loan market has been experiencing for years? Or could it be due to changes in how courts view debtors’ fiduciary duties?

In fact, a recently published law review article suggests that the opportunistic “hardball” tactics that have become familiar in many distressed loan restructurings are the result of a series of Delaware court decisions that added up to a radical change in corporate law:  Creditors would no longer have the protections from opportunism that helped protect the benefit of their bargain for the better part of two centuries.  Below, we briefly summarize this important and provocative article and examine how the authors believe these changes have impacted the leveraged loan market and what could be done to fix the problem.

In their article, “Bankruptcy Hardball”, authors Jared Ellias, a professor at Hastings College of Law, and Robert Stark, a partner at Brown Rudnick, cited numerous examples such as PetSmart, General Growth, Forest Oil, Cumulus, and Colt Holdings, to posit that, increasingly, companies concoct transactions that turn creditors’ expectations on their head, often for the benefit of shareholders or management.  In these transactions and others, debtors have, for example, moved collateral assets out of the reach of creditors, attempted to structurally subordinate creditors through the questionable issuance of additional debt or equity, and caused so-called bankruptcy remote companies to file for bankruptcy. While recognizing that credit agreement terms have gotten looser because of market imbalances, the companies were able to do this, the authors argue, through a moral hazard they call “control opportunism” that is abetted by courts that give undue deference to debtors and management.

The authors identify a particular line of Delaware cases, most notably a Delaware Supreme Court case called Gheewalla, that limited the fiduciary duties that managers previously owed to creditors.  These cases, they argue, were based on an ideological motivation, i.e., that creditors did not need protection from judges and that fiduciary duties were unnecessary to protect creditors from control opportunism because those creditors, generally banks and institutional investors, can protect themselves.  Moreover, some judges declared that creditors were protected by fraudulent conveyance laws and other provisions of the bankruptcy code.  The authors argue, however, that in reality it is very difficult for creditors to protect themselves in these situations, even when documentation is very tight.  They suggest that even the best-written contracts are susceptible to a “cat-and-mouse” game in times of distress where well-advised debtors routinely end up with outcomes inconsistent with their original business deals.

Just as the problem is largely judge-made, the authors believe that courts can do much better without resorting to shifting the fiduciary duties back to pre-Gheewalla days.  Rather than taking legislation or a radical shift back in the law, it would simply require courts to take a more skeptical view of managers of distressed firms, “recognizing that control opportunism might influence whatever management is trying to do.”

Is a major cause of debtor opportunism the change in the fiduciary rule and not just the imbalance in supply and demand that the market has been experiencing for years?  In an environment where investors are often frustrated by what they view as the unfair machinations of distressed debtors, the Bankruptcy Hardball article raises provocative issues along with a path that could potentially mitigate these overreaches.

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