Equity-Debtholder Conflicts and Capital Structure

by R. Christopher Small, for The Harvard Law School Forum at Harvard Law School, March 26, 2010.

In the paper, Equity-Debtholder Conflicts and Capital Structure, which was recently made publicly available on SSRN, we present a novel approach to identifying debt‐equity conflicts and the associated agency costs, employing a 1991 legal event as a natural experiment. Our natural experiment revolves around the fiduciary duties of corporate officers. Broadly speaking, these duties require that officers take actions that are in the interest of owners. Historically, the position of U.S. courts has been that such duties are owed to the firm as a whole and to its owners, but not to other firm stakeholders, such as creditors. Creditors are assumed to be able to protect themselves by contractual and other means (e.g. covenants). This situation changes once a firm becomes insolvent. At this point, fiduciary duties are owed to creditors, since for insolvent firms creditors become the residual claimants. As long as the firm is solvent, however, the traditional view was that no such rights were held by creditors. This changed with the Delaware court’s ruling in the 1991 Credit Lyonnais v. Pathe Communications bankruptcy case. The case ruling argued that when a firm is not insolvent, but in the “zone of insolvency”, duties may already be owed to creditors.

Using a difference‐in‐difference methodology, we examine both behavioral changes (e.g. investment) and leverage outcomes following Credit Lyonnais. The difference‐in‐difference methodology contrasts public firms incorporated in Delaware and to those incorporated elsewhere, and before and after 1991. In our tests we control for time and firm fixed effects and eliminate changes affecting the whole firm population by differencing with non‐Delaware firms. We find important changes in behavior after Credit Lyonnais. Firms increase equity issues and investment, consistent with debt overhang. Delaware firms reduced operational and financial risk, consistent with risk shifting and asset substitution theories…(continue reading)

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