What Duty Is Owed in Vicinity of Insolvency?

IT HAS BECOME an increasingly common struggle. Public companies issue high-yield debt that starts to trade at a substantial discount when earning expectations are not met. The purchasers of the discounted debt see value in the company but fear management might engage in practices that jeopardize the noteholders’ investment in an effort to resurrect shareholder value. The company has not breached any covenants under its indenture, but the creditors have a concern that money is running out and default is impending. Must the creditors wait until disaster actually arrives before they can act to protect their interests?

Justice Helen E. Freedman of the Supreme Court of New York, County of New York, recently had occasion to consider this question in Fir Tree Partners, L.P. v. MCG Communications, Inc., et al., No. 114674 (Nov. 7, 2001). In Fir Tree, noteholders asked the court to declare that a corporation’s board of directors owed a fiduciary duty to creditors where the company’s financial statements strongly suggested that it would soon be insolvent. In a two-page decision, the court dismissed the complaint, finding that the “no action” clause contained in the applicable indenture precluded the holders of the public debt from taking action with respect to the indenture or the underlying notes. Despite this technical basis for the court’s ruling, the litigation raises legal arguments that provide a glimpse at important issues that may arise between troubled companies and their creditors.