My Creditor’s Keeper: Escalation of Commitment and Custodial Fiduciary Duties in the Vicinity of Insolvency

In several common law systems, creditors of corporate debtors enjoy legal protections beyond what their contracts with those companies afford them in the form of vicinity-of-insolvency fiduciary duties.  These duties form a notoriously murky area, where legal space warps.  The contours of this area are fuzzy.  Courts openly acknowledge that it is exceptionally difficult to identify clear guideposts for its threshold—as to when exactly these duties are enlivened.  The content of these duties is equally uncertain and is not conceptually consistent across jurisdictions.  At one end of the spectrum, Delaware law denies the legal existence of a zone of insolvency, thus relieving itself—and purportedly, also directors—of the need to consider creditors’ interests outside of bankruptcy.  At the other end, Canadian law locates shareholders’ and creditors’ interests at the same level, giving no priority to any one of them a priori.  Somewhere in a notional middle ground, the laws of several countries struggle to give concrete content to the duty to consider creditors’ interest in the vicinity of insolvency.  This is where we find the United Kingdom and Australia, for example. The UK Supreme Court is expected to hand down a much-anticipated decision in BTI 2014 LLC v. Sequana SA, in which a key question deals with the trigger for these creditor-consideration duties.

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.  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 behaviour by managers on behalf of shareholders.  I argue that this account may be sound but is nonetheless lacking.  In addition to such opportunism, law makers should also be mindful of managers’ tendency to unjustifiably continue failing projects, known as escalation of commitment.  Unlike opportunistic risk-shifting, for which empirical evidence is surprisingly sparse, escalation of commitment is an irrational factor that has been widely documented and studied but has been largely neglected by legal scholars. 

‘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.  Owner-managers, family firms, and venture capital firms exhibit escalation of commitment when the firm is on the verge of failure.  Considerations of personal and family pride exacerbate the tendency to escalate, and family owners in fact become more resolute in prolonging the life of their ailing firms in these settings.  Entrepreneurs in particular are prone to escalate.  Escalation of commitment is not only a personal irrational and emotional behaviour.  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. 

Since individuals and teams are prone to escalate, the practical challenge is to facilitate de-escalation—namely, shutting down the project or winding up the firm with a view to salvaging what could be saved.  Change in management is the primary mode of breaking out of the escalation trap.  Additional 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 therefore essential.

It is submitted that 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. 

Second, this article addresses the substantive content of the duty to protect creditors where such duties are recognized, 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. 

Amir Licht is Professor of Law at the Harry Radzyner School of Law, Interdisciplinary Center Herzliya.