Debt-Equity Conflict and the Incidence of Secured Credit

Barry E. Adler is the Bernard Petrie Professor of Law and Business at New York University School of Law and Vedran Capkun is Associate Professor at HEC Paris. This post is based on their recent paper, forthcoming in the Journal of Law and Economics.

Classic finance theory—from the framework created by Jensen and Meckling—observes that while debt can mitigate the conflict between equity and management, the issuance of credit creates a conflict between debt and equity. To explore the latter conflict, we take advantage of the insight that once a firm creates a debt-equity conflict through the issuance of debt, if the firm’s management, on behalf of equity, is to exploit the firm’s creditors, the optimal vehicle for such exploitation is additional debt, senior debt in particular. Despite recent conjecture that risk averse managers eschew the exploitation of credit, we predict, and find, that the debt-equity conflict, fueled by distressed firms’ issuance of secured credit, is a live problem for firms, one worthy of consideration.

Consistent with our hypothesis, critics of secured finance, argue that financially vulnerable firms use priority credit to externalize (at least in an ex post sense) the risk of failure. On this view, the winners are a coalition of a debtor’s shareholders and secured creditors, which share investment’s upside, at the expense of the debtor’s unsecured creditors, who bear the downside. And because the debtor may be more interested in enhanced risk that favors junior interests than expected return to the firm, the expected loss may well exceed the expected gain. The threat of such inefficient overinvestment has led some to call for a reduction in secured credit’s priority.

Other scholars describe a competing dynamic where, in part to avoid secured creditor control and conflict among creditors, managers of financially distressed firms shy away from secured credit at least where the use of such credit would be inefficient. Consistent with this hypothesis, the recent trend of secured creditor dominance in bankruptcy practice may give managers greater reason to have the firms forgo secured credit as bankruptcy approaches.

The former argument stems from the finance theory principle that secured credit is the cheapest, and thus most effective, way for shareholders to extend equity’s option on a debtor’s assets. The latter argument rests on a belief that the cost of secured credit, at least to a firm’s managers, eliminates or restrains a debtor’s tendency to use such credit.

Evidence is scarce and largely anecdotal or indirect, so we design our own tests to determine whether firms load up on secured credit as they approach bankruptcy. If they do, then further investigation is needed into whether such use is inefficient and whether critics’ call for limitations on priority may be warranted. If firms do not increase the use of secured finance as they sink toward bankruptcy, then even without further investigation one may reasonably conclude that the concern over secured credit is misplaced.

Our study comprises publicly traded firms that filed for bankruptcy between 1993 and 2012. We find a significant run-up of secured credit, as a proportion of assets and of liabilities, prior to bankruptcy filing. That is, more than at other times in their life cycles, and despite negative pledge clauses in bond covenants, firms increase the use of secured credit when bankruptcy becomes imminent. This observation is consistent with the claim that firms employ secured finance to transfer value from unsecured creditors to shareholders.

Our main finding is that secured debt increases as a firm gets closer to bankruptcy filing. We explain why reports to the contrary are misguided and provide additional evidence that firms not only increase the level of secured debt, but also accelerate its issuance during the pre-bankruptcy period.

Because there may be a difference between financially distressed firms that eventually enter bankruptcy and firms that avoid that fate, we replicate our tests for a large sample that includes firms regardless of whether they enter bankruptcy within our sample period. We confirm our main results, which would have been interesting even if firms that avoided bankruptcy did not issue as much secured credit as otherwise similar firms that did file for bankruptcy. But we did not expect, and do not find, differences in behavior between otherwise similar firms that do file for bankruptcy and those that do not. They all increase secured debt as financial distress intensifies.

Our results here do not directly address whether the use of secured finance by distressed debtors is on balance inefficient. Although secured credit can be used inefficiently, as discussed, there are also efficient uses of secured credit, such as the prevention of risk alteration by a debtor and a later creditor at the expense of an earlier creditor. Furthermore, secured credit may efficiently mitigate debt overhang even when used in the very manner that could exacerbate overinvestment, to finance risky projects that would not otherwise satisfy equity’s participation constraint. That is, theory provides reason to believe that the use of secured finance can either facilitate inefficient investment or promote efficient investment.

Though there is uncertainty over the efficiency consequences of any particular secured credit issue, the potential inefficiencies from secured credit make it importantly desirable that firms have the ability to bond themselves against the issuance of secured credit should they desire to do so. Inasmuch as we provide evidence here that the use of secured credit by financially distressed firms is both prevalent and not entirely deterred by negative pledges, we argue here that such covenants should be granted a property rights enforceable by unsecured creditors of an insolvent debtor.

We are reinforced in this opinion by the results of our own companion study, which offers evidence that that the increased use of secured credit by insolvent firms on net exacerbates inefficiencies in financially distressed firms. That study, combined with our results here, support the malign view of late secured credit and the call for legal reform.

The complete paper is available for download here.

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