As a result, experts fear that the cases in question have established an opportunity for unsecured creditors to sue individual directors and officers for fiduciary liability if they take actions to boost shareholder value once their companies encounter financial difficulty. Some experts dismiss such fears by pointing out that the Delaware cases do not necessarily provide unsecured creditors with the standing to sue for fiduciary liability, and that the judicial views outlining fiduciary duties to such creditors are merely footnotes, or "dicta" in legal terms. Yet Georgetown's Bratton notes that bankruptcy judges, while bound by Delaware law on Delaware claims, are not required to follow it elsewhere. "They're federal actors," says Bratton, "and they might take dicta and apply them as if they're real."
Even some experts who doubt the courts will act in this fashion concede that market participants take the prospect seriously. David Skeel, a law professor at the University of Pennsylvania, notes that the possibility that courts would find a fiduciary liability owed to unsecured creditors has made banks wary of becoming too deeply involved in restructuring efforts. The banks fear that if they go so far as to select individuals to direct such efforts, they will become fiduciaries and see their own claims to the assets subordinated to those of such creditors. Even in cases in the 1980s and 1990s, says Skeel, "banks acted as if it was a serious risk."
For its part, Standard & Poor's takes claims from unsecured creditors into account when estimating potential recovery values on senior secured debt. "We can see some accommodation" given to such creditors by bankruptcy courts going forward, says William Chew, managing director of Standard & Poor's.
There is a risk of fraudulent conveyance, if not fiduciary liability, in virtually any transaction that benefits shareholders at bondholders' expense, so those who arrange such a deal have to hope that a significant amount of time passes before the company involved goes belly up. But there's no rule of thumb as to how much time is enough to prevent a claim from advancing in court. "As much as possible" is how one lawyer put it at a recent conference.
Based on the 1991 Delaware court decision, however, a company need only be found to be approaching insolvency to trigger a claim of fiduciary liability. Once in the vicinity of insolvency, warns Bratton, "all side deals made by issuers of bonds with equity holders or other insiders become legally questionable."
The CFO's Biggest Challenge
To head off potential legal problems, experts caution that CFOs should take bondholders' complaints more seriously than they may have in the past. At a minimum, notes David DeBerry, vice president of Hartford Financial Products, which sells insurance coverage for directors and officers, CFOs should see to it that decisions favoring shareholders during periods of financial stress are approved by independent board members after obtaining the guidance of financial experts. As DeBerry puts it: "These are changing times for directors." (For specific actions to avoid, see "On the Hook" at the end of this article.)
That view was seconded at a recent Standard & Poor's conference by Ronald Nelson, president and CFO of Cendant Corp., itself rumored to be an LBO candidate. Nelson insisted that demands for dividends and share buybacks from such shareholders must be met with "management fortitude." Legal issues aside, he warned that managers otherwise run a risk of being "left holding the bag without enough capital to grow the business."
That risk may seem distant when credit conditions have been as easy as in recent years. Even now, defaults by U.S. companies remain few and far between, and their bonds are trading at narrow spreads over Treasuries. But a growing number of observers worry that current trends are unsustainable in light of rising interest rates. S&P's Chew, for one, contends that current market conditions fail to reflect the amount of financial risk facing companies, but points out that those conditions can change dramatically. "Credit means nothing one moment," notes Chew, "and then it's the only thing."
Of course, the problems associated with a reversal in credit conditions aren't limited to companies in private-equity portfolios. Even CFOs of publicly owned investment-grade companies are growing more wary of rewarding shareholders at the expense of bondholders. At a panel discussion with Nelson, Carol Tome of Home Depot, which is rated AA by S&P, called the "balancing act" of managing the conflicts of interest between these two sets of investors "the biggest challenge we face going forward." (Still, Tome noted that Home Depot's board no longer thinks a AAA rating is worth shooting for, and the company recently announced a $3.5 billion acquisition that will be financed in part with debt.) On the same panel, Devon Energy CFO Brian Jennings warned that bond investors would be even quicker to react to negative developments than they were in the 1990s because they take creditworthiness much more seriously following the failures of Enron and WorldCom. Jennings attributed that to "the lack of [such] focus earlier that led to disastrous results for all constituencies involved."
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