Policing Companies in the Vicinity of Insolvency
Martin P. Desmery & Richard C. Demerle
In Greek mythology, Odysseus had to sail his ship down a narrow channel between two monsters... the Scylla and the Charybdis. If Odysseus' ship sailed too close to either one, the monster would destroy his ship and kill his crew. In today's economy, many corporate directors of struggling businesses have the same problem: keeping the corporate ship on course, while balancing their duties to both shareholders and creditors.
In fact, corporate directors actually have a harder job than Odysseus did; at least Odysseus could see the monsters. The Charybdis sucked the water out of the channel and pulled ships towards it. How hard can shareholders pull? The Scylla had long tentacles to reach out and grab sailors off passing ships. How far can creditors reach?
The creditors' ability to reach out and grab directors arises when the corporation begins to operate "in the vicinity of insolvency." The creditors' grip gets stronger as the corporation sails closer and closer to insolvency, until the line is crossed and the duty to creditors becomes paramount. At that point, directors no longer have a fiduciary duty to maximize value for stockholders, but instead are obligated to preserve and protect corporate assets for the benefit of creditors. In a sense, the creditors have the directors wrapped around their fingers.
The practical problem is that the precise line between solvency and insolvency can be impossible to discern. Moreover, as commentator Thomas A. Smith wrote in The Efficient Norm for Corporate Law, many companies "are always in the vicinity of insolvency because all it takes ... to become insolvent is to lose a sufficiently risky bet. " So the question becomes, "How should directors weigh the interests of creditors and shareholders when managing a faltering business?" The answer lies in Greek mythology: act like Odysseus and sail right between the two monsters. In other words, directors must carefully weigh the interests of both creditors and stockholders before charting their course.
Like the Scylla and Charybdis, the shareholders and creditors are focused on grabbing the corporate ship for their own purposes. As a company's fiscal health crumbles, stockholders have little or nothing to lose and are likely to favor extremely risky ventures in an effort to generate a return on their investment. In contrast, most creditors will favor a conservative policy of preserving and perhaps liquidating assets in order to satisfy their claims. Several courts and commentators suggest that directors should act in a manner that "serves the entire corporate enterprise" rather than any single constituency. A corporate director, like a modern-day Odysseus, has a duty to his or her ship. The director who considers the interests of both creditors and stockholders when charting a course will have the best chance of remaining unscathed.
What does this mean in practical terms? What should a corporate director do when his or her ship starts drifting towards insolvency? Decide what is best for the corporation - rather than one constituency - and then get that decision on the record. When the board of directors discusses a particular transaction, the minutes of the meeting should include some key elements: the directors considered the potential costs and benefits of the transaction; the directors considered the effect on both creditors and shareholders; and, finally, the directors concluded that the ultimate decision struck a proper balance on behalf of the entire corporate enterprise.
Even in the fog-blanketed waters of insolvency, the law allows well-informed and well-intentioned directors to draw upon their knowledge, experience and business judgment to make difficult choices. Like Odysseus, corporate directors will encounter rough seas. Like Odysseus, corporate directors will have to rely on their own instincts about how far creditors and shareholders can reach, about where duty to one group ends and the other begins. And, like Odysseus, corporate directors who make decisions based on what is best for the entire ship and crew will have the best chance of staying out of avoiding the monsters, staying on course and steering the ship into calmer waters.
Martin Desmery is a shareholder, and Richard Demerle is an associate, of Craig and Macauley Professional Corporation in Boston, Massachusetts.