By many accounts, we have entered an era of unprecedented contentiousness in debtor-creditor relations. For an example of the new status quo, consider the recent actions of PetSmart, a perfectly normal American corporation struggling with debt from a leveraged buy-out gone sour. The textbook account of corporate governance would suggest that PetSmart’s board of directors would respond to this financial distress by seeking to improve the underlying business or, perhaps, by filing for Chapter 11 bankruptcy to maximize the value of the firm for the benefit of creditors. Instead, PetSmart’s board authorized a transaction that seems shocking for a firm in its situation: It took $1.5 billion out of the reach of creditors, distributing about $900 million to its shareholders and placing $750 million in a subsidiary that was not an obligor on its $9 billion in debt.
In our new working paper, we describe this type of scorched earth bargaining as a form of ‘bankruptcy hardball.’ To be sure, distressed companies and their major financial creditors have always had their share of combative negotiations, conflict, and litigation. But the current level of chaos and rent-seeking is unprecedented. It is now routine for distressed firms to engage in tactics that harm some creditors for the benefit of other stakeholders, often in violation of contractual promises and basic principles of corporate finance.
We argue that the new environment is rooted, in part, in a series of Delaware court decisions in the late 2000s that added up to a radical change in law: Creditors would no longer have the kind of common law protections from opportunism that helped protect their bargain for the better part of two centuries. In these decisions—most importantly Gheewalla followed by Quadrant Structured Products—the Delaware courts dramatically reduced the ability of creditors of insolvent firms to prosecute claims for breach of fiduciary duty. To be sure, other factors contribute to the status quo, such as debt market conditions, a loosening of the basket of traditional covenants, and broader economic factors. But the common law’s retreat from protecting creditors has qualitatively changed the liability calculus for boards of directors of troubled firms.
To illustrate the change, consider the advice that law firms provide to the boards of troubled companies. In an article for clients written in 2001, prior to Gheewalla, a leading law firm wrote that ‘[w]hen a corporation becomes insolvent, … [r]ather than pursuing high-risk strategies for the benefit of shareholders, directors must seek to protect creditors’ claims to corporate assets and earnings. After Quadrant, a leading law firm wrote in a client alert that directors can now favor some creditors over others without having to worry about liability. Similarly, another leading law firm wrote that Quadrant will protect directors ‘adopting a high-risk business strategy that might benefit controlling shareholders when a corporation is insolvent… .’
We argue that this revolution in the common law was premised on the faulty assumption that creditors are fully capable of protecting their bargain during periods of distress with contracts and bankruptcy law. We show through a series of case studies how the creditor’s bargain is, contrary to that undergirding assumption, often an easy target for opportunistic repudiation and, in turn, dashed expectations once distress sets in. First, it is impossible for even the most sophisticated creditor to protect herself with contract law alone. Not only can she not foresee every contingency, but skilled debtor’s lawyers can often find ways to get around even carefully written contracts. For example, the bondholders of Forest Oil contracted ex ante for redemption in the event of a change in control—only to see the debtor claim it ‘contracted around’ that covenant even though the firm had, in fact, been sold to a new controller.
Second, while bankruptcy law does protect creditors, it also answers to other policy goals, such as reorganizing distressed firms and protecting jobs. And well-advised debtors and creditors can run strategic and smart bankruptcy processes that use procedural tools to pressure the judge into making decisions that further the policy goal of, say, promoting reorganization, even at the expense of vindicating creditor rights. For example, bankrupt LyondellBassell’s managers exploited an odd quirk of bankruptcy law to settle valuable fraudulent transfer claims worth potentially billions, without, initially, the input of the unsecured creditors who were the real plaintiffs. Bankruptcy law can protect the rights of creditors, but it can also be used to take rights from creditors that they would have had outside of bankruptcy.
We further argue that the Delaware courts paved the way for bankruptcy hardball to be become the de facto mode of distressed governance, but also that judges can help fix the problem by pushing back against overreach with existing doctrine. For example, judges can do more searching examinations of facts before determining that a transaction that harms creditors deserves the protection of the business judgment rule. Procedural loopholes in bankruptcy law can also be closed, and bankruptcy judges can refuse to grant relief that strips creditors of valuable rights simply because managers assert that the firm cannot survive a prolonged bankruptcy process.
 See J Douglas Bacon and Jennifer A Love, ‘When Good Things Happen to Bad People: Practical Aspects of Holding Directors and Managers of Insolvent Corporations Accountable’ (2001) 10 Journal of Bankruptcy Law & Practice 185, 186.
This post first appeared on the Columbia Law School Blue Sky blog here.
The authors’ working paper will be published in 108 California Law Review (forthcoming 2020).