Fiduciary Duties and Equity-Debt-holder Conflicts

The Credit Lyonnais ruling was followed by slight increases in leverage and a modest increase in average firm values.

One of the cornerstones of U.S. corporate governance is that directors and officers have a duty to manage their firms to maximize shareholder value. However, decisions that increase shareholder value may impose costs on other stakeholders, such as creditors and employees. To ensure that firms are run in shareholders' interest, directors and officers may be assigned fiduciary duties, requiring that they take certain actions that are in the interest of owners. Historically, the position of U.S. courts has been that for solvent firms, such fiduciary duties were owed to the firm as a whole and to its owners, but not to other firm stakeholders, such as creditors. If a firm became insolvent, however, then fiduciary duties were owed to all interested parties (including creditors).

This changed with a Delaware court's ruling in the 1991 Credit Lyonnais v. Pathe Communications bankruptcy case. The ruling argued that when a firm is not insolvent but is in the "zone of insolvency", duties already are owed to creditors. The case was widely understood to have created a new obligation for directors of Delaware-incorporated firms. Because this ruling did not affect firms incorporated outside Delaware, it provides a "natural experiment" for examining whether and how equity-debt conflict affects firm behavior.

In Fiduciary Duties and Equity-Debt-holder Conflicts (NBER Working Paper No. 17661), authors Bo Becker and Per Strömberg compare Delaware-incorporated firms to non-Delaware firms before and after the 1991 change. They find that firms affected by the court ruling increased equity issues and investment and reduced operational and financial risk. They also find that in this same group of firms, leverage increased and the use of covenants -- contractual features that are often understood as control mechanisms for creditors -- declined after 1991.

There appears to have been little impact of this court ruling on firms with low leverage, or firms unlikely to default -- firms far from the "zone of insolvency." Instead, the effects of the new ruling were isolated to the subset of firms in which financial distress was more likely.

In the absence of rules like those associated with this court case, firms in distress may have an incentive to undertake actions that are unfavorable to creditors but valuable for equity holders. These behaviors lead to indirect costs of financial distress, discouraging leverage and reducing overall firm value. Indeed, the authors find that the Credit Lyonnais ruling was followed by slight increases in leverage and a modest increase in average firm values around the time of announcement. Thus, firms appear to have reaped immediate benefits of lower agency costs in the form of higher investment, lower operational risk, higher equity issues, and better access to debt. In addition, stock prices responded positively to the ruling, especially for firms with moderate levels of debt.

--Lester Picker

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