The last post labored on about flaws in Gheewalla, the Delaware Supreme Court’s recent opinion on directors’ duties to creditors. This post discusses some gaps created by the case.

Recall that  Gheewalla tells us that directors of the distressed (insolvent) firm are, for unarticulated reasons, still fiduciaries for corporate creditors in a derivative sense. This presumably means that any suit by the creditor will be in the name of the corporation, and any recoveries will go to the corporation, to be shared by all corporate constituents. But this leaves at least four gaps in the law.

Gap 1–How Does this Work?

The first gap involves the procedural rules that apply to derivative suits in Delaware. Rule 23.1 of the Delaware rules of procedure requires that shareholders first make "demand" on directors before they will have standing to sue in the corporation’s stead.

Fine, but what does this mean for creditors? The statue says nothing about creditors–only shareholders. Does this mean it simply does not apply? If not, then what sort of procedural predicates must occur for a creditor (or class of creditors) to pursue the derivative claim?

Vice Chancellor Strine chided counsel in Production Resources because they "ha[d] not burdened [him] with input" on this question. Prod. Res. Group, L.L.C. v. NCT Group, Inc., 863 A.2d 772, 795-96 (2004). I can see why. It would be nice to know.

Gap 2–Pesky Bankruptcy Law

Assuming for the moment we can overcome this procedural gap, we then face another practical problem: How is this supposed to work when the corporate debtor goes into bankruptcy? Recall that bankruptcy law makes a fairly strong distinction between claims that belong to the estate and claims that belong to creditors.Caplin v. Marine Midland, for example, holds that a bankruptcy trustee has no standing to assert claims on behalf of an estate’s creditors. See 406 U.S. 416, 434 (1972).

Caplin did not distinguish "direct" from "derivative" creditor claims, but that distinction would now appear to matter. If Gheewalla means that creditors can only assert derivative claims, then in bankruptcy terms, it is saying that creditors can only assert claims that are property of the estate. But, if those claims are nevertheless creditors’ duty claims, we have a remedial gap. Even if breach of duty claims exist, Caplin may require creditors to pursue them, but Gheewalla nevertheless means they can only be brought by the estate.

Consider an example: Directors of a distressed firm decide that the only way to save the company is through a risky strategy that involves putting shoddy products into the stream of commerce. They know this will cause a certain amount of harm to tort creditors, but decide the strategy is worthwhile, because they know they are not likely to be held liable, and this may in the short term generate cash sufficient to save the company. If they bet wrong, the tort creditors bear the risk of this loss.

As things stand, if the directors are sued by the estate for the tort creditors’ losses, they will defend by arguing that these are creditors’ claims, which under Caplin the trustee cannot bring. If, instead, the creditors try to bring direct claims, the directors will cite Gheewalla for the proposition that creditors can only assert derivative claims (there would also other procedural problems not having to do specifically with the fiduciary nature of the claim). Either way, tort creditors lose.

This is obviously (at least, it’s obvious to me) an absurd result. Courts may be able to avoid it by clarifying that these derivative claims–no matter the basis–may always be pursued by the estate. But that still leaves a practical problem. If we are in chapter 11, and management of the debtor is aligned with the directors, they may be understandably reluctant to cause the estate to sue. Cases like Cybergenics permit a court to give a creditors’ committee derivative standing to sue on the estate’s behalf. See Official Comm. of Unsecured Creditors of Cybergenics Corp. ex rel. Cybergenics Corp. v. Chinery, 330 F.3d 548, 580 (3d Cir.2003) (en banc). But that was a decision governed largely by "equity" and Bankruptcy Code section 105, the meaning and continuing force of which are not clear.

Gap No. 3–If It’s the Estate’s Claim, Who Really Gets It?

A third gap left by Gheewalla derives (sorry, bad pun) from the way that capital structure is likely to work in the real world. In the real world, corporations often grant blanket liens on their assets, with "after acquired property" clauses (meaning any property the debtor acquires automatically becomes collateral). What does this mean for the derivative claims that would, technically, "belong" to the corporation but which really result from harm to other creditors?

UCC-junkies would note that the security interest in the derivative claim would likely be characterized under 9-102(a)(13) as a "commercial tort claim." If so, the security interest would not automatically attach under a blanket lien after-acquired property clause. Rather, under 9-204(b)(2), the debtor would have to specifically grant a security interest in the claim after it arose.

But, it is easy to imagine directors of the corporate debtor buddying up with secured creditors, and granting them a security interest in the litigation, in order to strip it away from unsecured creditors. (Is that a fraudulent conveyance or preference?  Not clear.) In any event, once a judgment is rendered or the debtor is paid in satisfaction of the duty claim, the UCC label would change, and thus be outside the special attachment rule of 9-204(b). Whatever the corporation gets, in other words, may well become subject to the blanket lien.

If, as the Gheewalla court says, we distinguish direct from derivative claims in part because of their incentive effects on directors and potential plaintiffs, we have a gap. Unsecured creditors would have little incentive to pursue derivative claims if the debtor has granted a blanket lien. Why should they sue to enrich the debtor’s bank?

Gap 4: Who’s A Creditor?

A final gap involves creditor status. As noted in my prior post, one of the oddities of Gheewalla is that, under Delaware law, the plaintiffs would appear not to have been "creditors" because they did not have a "proven entitlement to payment." This is a much narrower definition of creditor than used in bankruptcy, where holders of contingent and unliquidated claims–those who do not yet have a "proven entitlement" to payment–are nevertheless treated as creditors.

As and to the extent creditors have contract claims, this is not terribly exciting. I suspect a defaulted promissory note would be sufficient "proof" to pass muster under Delaware law. But this exposes the one group who might actually matter in this–involuntary creditors, like the tort creditors mentioned in the example above.

If the corporate debtor goes into bankruptcy before the entry of judgment on the tort plaintiff’s claim, there would be no "proven entitlement" to payment when the debtor commences its case. Perhaps the bankruptcy would result in liquidation or estimation of the claim. But this would probably happen long after the violations of duty allegedly occurred. How would that work under Gheewalla’s duty analysis?

The Net Effect

The basic effect of Gheewalla–and this may have been its real point–was to make it very difficult, if not impossible, for tort and other involuntary creditors to sue corporate directors. Being limited to derivative claims, they would have to jump procedural hurdles of uncertain scope and, in any event, share recoveries with others who may have very different incentives than they do. As I will discuss in the next post, tort creditors are a mixed bag. But effectively immunizing directors entirely may not be such a good idea, either.