Vanderbilt Law Review


Laura Lin

First Page



In the wake of the debt binge of the 1980s, the number of financially distressed corporations has increased dramatically.' Because a struggling company rarely ceases operations overnight, directors still need to make investment and operational decisions concerning the best use of the company's existing assets. This need remains whether the firm will regain profitability or will be liquidated. Financial distress also intensifies conflicts of interest between shareholders and creditors. Indeed, when these constituencies are unable to recover their investments in the corporation because of insufficient assets, both shareholders and creditors have incentives to maximize their individual returns regard- less of the possible adverse impact on other corporate participants and on the overall value of the firm.

From the perspective of corporate governance, therefore, determining for whose interest directors should act during this highly volatile period will lead to different outcomes. Directors' alliances with either shareholders or creditors influence decisions ranging from the day-to- day operation of the business to the future of the firm, such as whether to attempt an out-of-court debt restructuring or to seek protection under the Bankruptcy Reform Act of 1978.'

Most commentators thus far have focused on the relationship among the corporation's managers, shareholders, and creditors during bankruptcy proceedings.5 Although corporate governance is an important issue when a firm is in bankruptcy, we also need to address the problem of these corporate actors' opportunistic behavior as the company's financial condition deteriorates before bankruptcy. This Article thus shifts the focus to an earlier point on the time line of corporate existence. If we can devise a set of rules that gives parties incentives to maximize the firm's value even when the firm is in financial trouble, we can reduce the overall societal loss when the corporation eventually is pushed into either voluntary or involuntary bankruptcy.

Part II of this Article examines the self-interested behavior of shareholders and creditors during pre-bankruptcy insolvency and argues that maximizing either constituency's interest does not provide an accurate yardstick for value maximization. This point is illustrated by using several numerical examples to highlight the various sources of conflict between shareholders and creditors that emerge as the company's financial health declines. Part III argues that directors should maximize the company's value even when the company is in financial distress. Because maximizing the expected value of the firm can minimize losses associated with business failure and reduce the overall cost of capital, directors should take actions that maximize the company's value even if such actions diverge from what shareholders or creditors would have chosen if left unconstrained. After arriving at this ideal standard of the directors' duty, this Part examines plausible ways of implementing this standard. The analysis suggests that the optimal means of achieving the value maximization goal is to place the cost of contracting on creditors.

The final Part of this Article examines the current law to (1) develop a theory that would explain the cases dealing with directors' fiduciary duties as the company becomes insolvent, and (2) evaluate this common-law doctrine in light of the rule proposed in Part III. Under current law, several courts have held that although directors owe duties of care and loyalty to shareholders when a firm is solvent, these duties shift to creditors upon insolvency.