VOLUME 161, ISSUE 7 June 2013

Contract is the primary means through which creditors control a firm’s debt– equity conflict. There is an irony here, however. Actions that may render a debtor insolvent are the events against which creditors contract. Yet when a breach of contract yields a debtor’s insolvency, the debtor cannot fully satisfy its creditors. Thus, a general creditor’s contractual remedy against a debtor cannot be fully effective, and anticipation of this shortcoming may increase a debtor’s cost of capital. A solution to this conundrum, proposed here, would permit creditors and debtors to contract for creditor remedies against third parties—other creditors, shareholders, and corporate affiliates—who may have benefitted from a debtor’s breach, provided that the creditor gave actual or constructive notice of its right to seek such remedies. This solution would offer creditors protection akin to that now afforded contractually through secured credit and now afforded by legal rule through the laws of voidable preference and fraudulent conveyance. Because the proposed protection would be contractually based, it could be tailored to the needs of individual firms and could thus improve, and to some extent obviate the need for, the protections now provided by law.

Note: Marcel Kahan would like to thank the Milton and Miriam Handler Foundation for financial support.

Should preferred stock be treated under corporate law as an equity interest in the issuing corporation or under contract law as a senior security? Should a preferred certificate of designation be subsumed in the corporate charter and treated as an incomplete contract filled out by fiduciary duty, or should it be treated as a complete contract with the drafting burden on the party asserting the right, as would occur with a bond contract? Is preferred stock equity or debt? This Article shows that preferred stock is both corporate and contractual—neither all one nor all the other. It sits on a fault line between two great private law paradigms, corporate and contract law, and draws on both. The overlap brings two competing grundnorms to bear when interests of preferred and common stockholders come into conflict: on the one hand, managing to the common stock as residual interest holder maximizes value; on the other hand, holding parties to contractual risk allocations maximizes value. When questions arise concerning the relative rights of preferred and common stock, the norms hold out conflicting answers. Delaware courts have taken the lead in confronting these questions by seeking to synchronize the law of preferred stock with the rest of corporate law—a project that has led to both innovation and stress.

This Article examines recent cases about preferred stock to show two facets of Delaware law coming to bear as the synchronization process proceeds: first, reliance on independent directors for dispute resolution, and second, the common stock– value maximization norm. These trends cause the law to tilt toward corporate norms, thereby disrupting allocated risks in heavily negotiated transactions, particularly in the venture capital sector. The Article makes three recommendations that would promote the goal of restoring balance between the corporate and contract paradigms. First, the meaning and scope of preferred contract rights should be determined by courts, rather than by issuer boards of directors. Second, conflicts between preferred and common should not be decided by reference to a norm of common stock–value maximization. Instead, the goal should be the maximization of the value of the equity as a whole. Third, independent-director determinations of conflicts between preferred and common should not be accorded ordinary business judgment review. Instead, a door should be left open for good faith review tailored to the context. This review would require a showing of bad faith treatment of the preferred where the integrity of a deal has been undermined, with the burden of proof on the board.

After more than eighty years of sustained attention, the master problem of U.S. corporate law—the separation of ownership and control—has mostly been brought under control. This resolution has occurred more through changes in market and corporate practices than through changes in the law. This Article explores how corporate law and practice are adapting to the new shareholder-centric reality that has emerged.

Because solving the shareholder–manager agency cost problem aggravates shareholder–creditor agency costs, I focus on implications for creditors. After considering how debt contracts, compensation arrangements, and governance structures can work together to limit shareholder–creditor agency costs, I turn to available legal doctrines that can respond to opportunistic behavior that slips through the cracks: fraudulent conveyance law, restrictions on distributions to shareholders, and fiduciary duties. To sharpen the analysis, I analyze two controversies that pit shareholders against creditors: a hypothetical failed LBO, and the attempts by shareholders of Dynegy Inc. to divert value from creditors through the manipulation of a complex group structure. I then consider some legal implications of a share- holder-centric system, including the importance of comparative corporate law, the challenges to the development of fiduciary duties posed by the awkward divided architecture of U.S. corporate law, the challenges for Delaware in adjudicating shareholder–creditor disputes, and the potential value of reinvigorating the tradi- tional “entity” conception of the corporation in orienting managers and directors.