Financially Stressed Companies Prone to Favoring Equity Investors over Debtholders
Companies in financial distress are prone to take actions that hurt creditors and favor equity investors, a new paper published by Harvard Business School finds.
The paper examines the effects of a 1991 Delaware bankruptcy ruling that changed the nature of corporate directors’ fiduciary duties in that state. The change limited incentives to take actions favoring equity over debt.
“The Credit Lyonnais v. Pathe Communications legal episode provides an interesting opportunity to assess the extent of creditor‐equity holder conflict and the impact of such conflict on equilibrium capital structure. For a period of time, starting in January 1992, directors of Delaware corporations, but not of firms incorporated elsewhere, had stronger duties to creditors. This presumably limited the extent to which directors and managers were willing to take actions favoring equity at the expense of debt, as duties shifted.”
Conclusions:
The Credit Lyonnais case created fiduciary duties toward creditors in Delaware‐incorporated firms in “zone of insolvency”. Because this did not affect firms incorporated outside Delaware, Credit Lyonnais provides a natural experiment for examining whether and how equity‐debt conflict affects firm behavior. 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. Firms reduced operational and financial risk, consistent with risk shifting and asset substitution theories.
We conclude that firms in distress sometimes have an incentive to undertake actions that hurts debt and favors equity. Such behavior leads to indirect costs of financial distress, discouraging leverage and reducing overall firm value.
Indeed, we find that Credit Lyonnais was followed by slight increases in leverage, and a modest increase in average firm values around the time of announcement. Firms thus appear to have reaped immediate benefits of lower agency costs in the form of better access to debt at lower costs. In addition, stock prices responded positively to the ruling, especially for firms with high but not ultra‐high debt, confirming the welfare impact of agency costs.
For details, see Equity-Debtholder Conflicts and Capital Structure by Bo Becker and Per Strömberg.
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