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Financial Times, April 2, 2008 column


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Finance & governance


Zone of insolvency

Published: April 2 2008 08:59 | Last updated: April 2 2008 08:59


When things are going swimmingly, a corporate board’s primary duty is to shareholders. In bankruptcy, a company’s creditors are first in line. But what about that twilight period when things are going pear-shaped but the company is not completely bust? Dubbed “the zone of insolvency,” this period can be particularly thorny for US boards because America’s bankruptcy laws allow companies to keep operating while they reorganise. Elsewhere, companies must wind up immediately and return as much as possible to their creditors.

The confusion dates to a 1991 court decision in Delaware, where many top US companies are incorporated, that said the board of a failing company may consider creditors’ needs in addition to their traditional duty to protect shareholders. Though the ruling was far from definitive, vulture funds seized on it, snapped up distressed debt and began demanding that boards put their needs first rather than balance the interests of shareholders and creditors alike. Some creditors also began to sue boards for trying to keep troubled companies afloat, saying they were liable for “deepening insolvency”.

Now these issues have becoming pressing. Until JP Morgan raised its offer for Bear Stearns from $2 to $10 a share, some Bear shareholders were openly asking if the board had sold them out. The Delaware Supreme Court recently took steps to clarify board responsibilities during the crucial period, holding last year that creditors do not have any direct rights to sue directors for actions they take, even when the company has entered the zone of insolvency. The same court also smacked down a deepening insolvency claim, ruling that a board can continue to use its business judgment even if its decisions ultimately fail to pay off.

The federal courts need to back Delaware up and soon. More and more US companies are nearing insolvency. If they are to preserve shareholder value, their boards need the freedom to make tough cuts and sell off divisions without constantly being second-guessed by company creditors.



Copyright The Financial Times Limited 2008





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