By Amir Licht (Professor, Interdisciplinary Center Herzliya, Israel)
In several common law jurisdictions, creditors of corporate debtors enjoy legal protections through vicinity-of-insolvency fiduciary duties, beyond what their contracts with those companies afford them. These duties form a notoriously murky area, where legal space warps. The contours of this area are fuzzy. Courts openly acknowledge that it is difficult to identify clear guideposts for its threshold—as to when exactly these duties are enlivened. In a forthcoming article, I purport to make two main contributions. First, the article expands the theoretical basis for a special legal regime in virtually insolvent firms by pointing out escalation of commitment as a potent and relevant factor that has been largely overlooked by insolvency scholars. Second, this article addresses the substantive content of the duty to protect creditors where such duties are recognized.
The standard account that is usually invoked to explain and justify special fiduciary duties to consider creditors’ interest points to the danger of opportunistic high-risk behavior by managers on behalf of shareholders. I argue that this account may be sound but is nonetheless lacking. In addition to such risk-shifting opportunism, lawmakers should also be mindful of managers’ tendency to unjustifiably continue failing projects, known as escalation of commitment. Escalation of commitment refers to a phenomenon, in which people tend to remain married to their original choices and to commit resources to them even when it is no longer rational to do so. Escalation of commitment is ubiquitous. It has been observed in organizations large and small, in business corporations and in the public sector. Escalation of commitment is not only an irrational and emotional personal behavior. More often than not, it takes place in a broader social context of one’s ingroup—in particular, the board of directors, the organization, and one’s community and culture.
Escalation of commitment poses an equal, if not greater, challenge than risk shifting does to optimal regulation of companies in looming or virtual insolvency. Being largely detached from rational calculations, escalation of commitment presents a more compelling justification for legal regulation, and a more interventionist one at that. In this view, managers—especially owner-managers—of virtually insolvent firms may not enjoy the usual level of deference that the law affords to their business judgment in regular times, as their discretion at that point is prone to be clouded by a misplaced motivation to stay the course, weather the storm, and similarly-spirited no-quitting notions.
Factors that could facilitate de-escalation include better information on costs and benefits of the project, regular evaluation and monitoring of projects, clear criteria for success and minimum target performance levels, and clear feedback about underperforming projects. Such measures will have limited efficacy, however, if the information they generate is interpreted and acted on by decision-makers who have initiated the failing project and even by different persons who are nonetheless related to those decision-makers. Change in management is thus essential.
While Delaware law rejects the idea of a pre-insolvency creditor-focused fiduciary duty, several jurisdictions do recognize duties to protect creditors, either as a duty to consider creditors’ interests or as the rule against wrongful (or insolvent, or reckless) trading. I argue that these duties should be enlivened at the very edge of the zone of insolvency, close to the latter. At that point, the mission of directors should transform from entrepreneurial to custodial. That is, they should implement strategies that aim to preserve the firm—in working condition, to the extent possible, with a view to resuming regular business—but avoid seeking new projects with a view to maximizing profits. This could mean that the shield of the business judgment rule may not be available to the same extent as in regular circumstances. The Covid-19 pandemic that swept the globe in 2020 provides a fresh context for this approach and underscores the need to implement such a regime sensibly, with high deference to business decisions even if outside the scope of the business judgment rule. The article concludes with a comparative analysis of creditor-oriented duties in several common law jurisdictions and examines how they could implement a custodial approach.