Print
E-MailAdam Badawi is a Professor at UC Berkeley School of Law. This post is based on a recent paper by Professor Badawi. This post is part of the Delaware law series; links to other posts in the series are available here. Related research from the Program on Corporate Governance includes Breaking Bankruptcy Priority: How Rent-Seeking Upends the Creditors’ Bargain, by Mark J. Roe and Frederick Tung (discussed on the Forum here).
Debt contracts use covenants as a way to manage conflicts between debt holders and equity holders. Covenants accomplish this goal by limiting the ability of debtors to engage in excessive risk taking, dividend payouts, claim dilution, and other actions that can harm the interests of creditors. But different types of creditors go about limiting the agency costs of debt in quite different ways. A wave of recent research shows that banks manage much of this agency conflict through the use of financial maintenance covenants. These covenants allow banks to accelerate the entire amount of the loan if a financial metric—such as the firm’s net worth—falls below the level specified in the loan agreement. Loan contracts typically set these covenants tightly, meaning they are set at levels that are close to those present at the time of loan origination. This practice ensures that even moderate financial distress will trigger maintenance covenants. When the covenants get tripped, banks rarely actually accelerate the debt. Instead, they typically renegotiate with debtors and, through that process, are able to limit actions that favor equity.
This sort of monitoring and renegotiation is much more difficult for most bond creditors. Their diffuse and largely passive nature makes it difficult to engage in the monitoring and renegotiation that are necessary to use financial maintenance covenants as a mechanism to control risk. In addition, the Trust Indenture Act poses additional impediments to renegotiation. As a consequence of these limitations on renegotiation, covenants that place direct limitations on actions that favor equity play an especially important role in the context of bonds.
The difference in these contracting technologies is likely to have consequences for the evolution of contract terms that restrict debtors from taking actions that harm creditor interests. For banks, fine tuning these ex ante restrictions is relatively unimportant because of their ability to renegotiate contracts. Investments in the drafting and negotiation of ex ante restrictions are thus unlikely to provide much of a payoff. This calculus is different for bond indentures. If these agreements do not include express restrictions, bondholders will have little recourse if the bond issuer wants to take an action that favors equity at the expense of debt. This difference suggests that bond holders are likely to get a larger return from ex ante investments in these types of restrictions. It follows that bond contracts should react more strongly to changes in the background legal rules that affect their rights against debtors.
To test this theory, this paper treats two Delaware cases from 2006 as a shock to the ability of creditors to recover damages for decisions made by directors when corporations are, or are nearly, insolvent. These two cases–decided within weeks each other–both limited the ability of creditors to recover damages from directors for taking creditor-adverse actions. The first of these cases, Trenwick America Litigation Trust v. Ernst & Young, L.L.P, declined to recognize deepening insolvency as a cause of action. This claim would allow a creditor to recover when the directors of an insolvent corporation make decisions that further deteriorate the financial condition of the corporation.
The second, and likely more important, decision, North American Educational Programming Foundation, Inc. v. Gheewalla similarly limited the default rights of the creditors of Delaware corporations. That decision foreclosed the possibility that creditors could assert a direct claim against directors for breach of fiduciary duty and also eliminated the possibility that creditors could bring any fiduciary duty claim while in the “zone of insolvency.” After Gheewalla, the only viable fiduciary duty claim for creditors of a Delaware corporation was a derivative claim once the corporation had actually become insolvent. This decision reversed course from Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp., which suggested that creditors could assert direct claims while in the zone of insolvency.
The limitations that Trenwick and Gheewalla placed on the ability of creditors to sue debtors who were in or approaching insolvency are likely to have affected the way creditors governed their relationships with debtors. Prior to these cases, creditors may have been able to deter actions that would benefit equity at their expense because there was a somewhat viable threat of a lawsuit for violation of a fiduciary duty or for deepening insolvency. After these cases, creditors would need to increase the overall restrictiveness of the covenants in their debt agreements to makeup for this lost deterrence. This deterrence benefit must, however, be traded off against the cost of tailoring these terms to prospective debtors and then negotiating those terms. For banks, that benefit is likely to be minimal because they can use their ability to monitor and renegotiate with debtors to keep them from taking actions that conflict their interests. Given this small gain, there is little point in bearing the costs of developing a well-tailored package of ex ante restrictions. For bondholders, however, the diminished scope of ex post litigation rights may create real risks because they cannot use maintenance covenant-based governance to influence debtors. In that case, the cost of negotiating a restriction may be worth the gain in deterrence. This difference suggests that bond contracts for Delaware firms were likely to become more restrictive in the wake of Trenwick and Gheewalla, but that loan agreements were less likely to change.
The evidence is broadly consistent with this expectation. There is no statistically detectable increase in the restrictiveness of loan contracts for Delaware and non-Delaware firms in the periods before and after these cases. There is, however, evidence of increased restrictiveness in the bond contracts entered into by Delaware firms relative to non-Delaware firms during the post-Gheewalla period. As one would expect, the results are particularly strong for those debtors who are in poor financial health. This evidence suggests that the substantial differences in the way banks and bondholders govern their relationships with debtors is borne out in the content of their contracts.
The complete paper is available for download here.
