Zone of Insolvency, Directors’ Duties and Creditors’ Protection in U.S.

Abstract

When a company is navigating in the “zone of insolvency” – usually defined as the extent of the risk that creditors will not be paid – its directors face the dilemma related to their managerial decisions in the light of the foreseeable effects and risks for shareholders and for creditors. It is a generally accepted principle in U.S. that when a company is approaching such “zone of insolvency” or is in the “vicinity of insolvency” no fiduciary duties are owned to the creditors as expression of the shareholder primacy rule. The aim of this article is to demonstrate the existence of provisions of law together with important policy reasons that impose the duties shifting to creditors in the zone of insolvency and that allow to create a presumption of directors’ knowledge of when their duties shift, which means when the company is getting closer to insolvency. Accordingly, this article seeks to demonstrate that directors’ duties toward creditors should shift on the ground of two reasons: Firstly, the directors’ and shareholders’ opportunistic behavior – together with the opportunistic behavior of well-informed creditors–. Secondly, the need to preserve value for creditors. By comparing U.S. principles with UK insolvency system the conclusion is in the sense that in the zone of insolvency directors should have a clear duty to take every reasonable step in order to minimize the risk of potential losses for creditors. Moreover, this article shows that in U.S. from the interconnection of the MD&A provisions with the law of avoidable preferences, a general principle accordingly can be inferred. It brings that directors have the duty to know when the company is in trouble and therefore that insolvency is looming at the horizon, with a presumption that covers the period of time starting from the last financial statements release until the day of the bankruptcy filing. Specifically, the law of preferences as section 547 of the Bankruptcy Code – by striking down last-minute grabs – conceptually admits the principle that directors together with control shareholders and strong creditors know longer time in advance that the company will face a liquidation proceeding than other creditors and outsiders. As a consequence, the Delaware approach of allowing full discretion to the board of directors even at the “end game” stage with its actual risk of opportunistic behavior (asset dilution, asset substitution, debt dilution, conflicts among creditors) is incongruent with the retrospective approach of both state creditors’ remedies and federal bankruptcy law that after insolvency challenges distributions to shareholders and favors creditors and seeks recoupment. Therefore, this article argues for a pre-insolvency, “end stage” rule of constraint by demonstrating that the UK wrongful trading liability of directors is more coherent and congruent with majority legal systems’ post-bankruptcy recapture approaches than the U.S. one found in the Delaware jurisprudence.