DIRECTORS’ DUTY TO CREDITORS AND OPTIMAL DEBT CONTRACT

1. DIRECTORS’ DUTY TO CREDITORS AND OPTIMAL DEBT CONTRACT Simone M. Sepe Yale Law School

2. The Status Quo of Directors’ Fiduciary Duties • The traditional view: Directors’ duties run to shareholders while the company is solvent (i.e., shareholder primacy rule) and shift to creditors when the company becomes insolvent (i.e., insolvency exception) • The 1991 Credit Lyonnais Revolution: Directors’ duties shift to creditors “in the vicinity of insolvency” • Now?

3. The Positions of the Doctrine • The communitarian multi-fiduciary model: directors’ duties must run to all corporate constituents • The contractual solution of contractarians: directors’ duties run exclusively to shareholders, b/c creditors’ rights can be adequately protect by contract

4. Contract Efficiency and Directors’ Duties to Creditors • It is true that the debt contract is per se sufficient to protect creditors rights, however • under the current fiduciary law paradigm, managerial opportunism and informational asymmetrymake the contract inefficient from a social viewpoint to govern the debtor-creditor relationship → as currently devised, the debt contract fails to maximize the ex-ante value of the parties’ relationship and produces social costs

5. Managerial Opportunism and Informational Asymmetry • The Managerial Opportunism (MO) Problem → Managerial opportunism is the tendency of managers, acting as shareholders’ fiduciaries, to design the firm’s operating characteristics and financial structures, once the firm has incurs indebtedness, in ways that maximize shareholder value to the detriment of creditor value → in particular, managerial opportunism indicates the managers’ tendency to increase the investment’s risk once the firm has incurred indebtedness (i.e., asset substitution)

6. The Informational Asymmetry (IA) Problem → in the manager-creditor relationship, managers have information on the investment’s underlying risk that is not observable to creditors → under the current corporate fiduciary law paradigm, managers have no (or very weak) incentives to disclose this information to creditors b/c by concealing information they can borrow at a lower cost and reserve costless options to invest in riskier projects (i.e, disclosure problem) → even though managers disclosed information to creditors, such information would be difficultly credible b/c creditors expect managers to act in the exclusive interest of shareholders (i.e., signalling problem)

7. The Social Costs Implied by the Debt Contract • The costs arising from sub-optimal covenants: → general covenants, which are poorly state contingent on the external state (e.g., no-new-lines-of-business covenant): more easily verifiable, but high opportunity costs → analytical covenants, which are more state contingent: lower opportunity costs, but higher monitoring costs because they are not as easily verifiable as general covenants ➙ in both cases, the debt contract fails to govern efficiently the MO problem

8. The costs arising from the credit market pooling equilibrium → anticipating the debt contract’s inadequacy to govern the MO problem, creditors ask higher interest rates; → b/c of the IA problem, creditors tend to pool firms together and price debt ( i.e., increase the cost of debt) on the basis of the average risk increase ➙the result is that credit capital is inefficiently allocated: → good firms end upsubsidizing bad firms → adverse selection problems may arise

9. The Proposed Solution: A Permissive Regime Combining a Default Duty of Directors to Creditors with a Textualist Interpretative Regime of the Debt Contract • The default duty to creditors imposes on directors an obligation not to increase unilaterally the risk contractually accepted by creditors (CAR) → as a default rule, parties themselves set the boundaries of the duty depending on the (specific) * risk they agree upon in the debt contract → from this viewpoint, parties can also decide to exclude the duty altogether * parties always accept the systematic risk

10. ➙ unlike the current fiduciary law paradigm, the proposed regime is contractual in nature • The textualist interpretative regime mandates to consider as accepted by creditors any risk that they have not expressly excluded or limited by contract

11. The Default Duty to Creditors Three basic functions: • Deter managerial opportunism • Remedy the lack of managerial incentives to disclose credible information (iii) The bonding mechanism function

12. (i) Deter managerial opportunism By making directors’ personally liable to creditors for the unilateral increase of the investment’s risk ex-post, the duty deter managers from exercising investment options for which creditors have not been ex-ante compensated (ii)Remedy the lack of managerial incentives to disclose credible information → B/c under the proposed regime managers must abide by the risk level agreed upon in the debt contract, they would have incentives to disclose information on the actual investment’s risk they intend to pursue → Creditors would deem disclosed information credible b/c of the liability threat

13. (iii) The bonding mechanism function → The violation of the contractual provisions on the CAR, which also results in a default on payment, constitutes an automatic breach of the duty to creditors → The duty serves as a mechanism giving directors incentives to stay in the contract→monitoring costs to verify directors’ performance are reduced

14. The duty’s overall effect The duty would enable creditors to screen firms on the basis of their specific risk → parties could negotiate better investment policy restrictions (i.e., more state contingent) and the debt contract would become more effective in controlling the MO problem → the credit market would tend to move from the existing pooling equilibrium to separating equilibria, in which debt pricing is determined on the basis of the firm’s specific risk

15. The textualist interpretative regime Why do we need a literal interpretative regime? For two reasons: (i) the duty to creditors might not be enough to move the credit market to separating equilibria → as a matter of financial theory, creditors’ payoffs in pooling and separating equilibria are the same (ii)reduce uncertainty in legal relationship

16. (i) The Nash bargaining induced by the contract’s textualist interpretation → b/c creditors are supposed to accept any risk they do not expressly limit or exclude by contract, they would have incentives to specify the risk they accept → to avoid the draft of general covenants, which would not only impose opportunity costs but also broaden their liability, directors would be induced to disclose information

17. ➙ Parties could draft more state contingent contracts ➙ Both parties’ utilities would be maximized: → creditors would be ex-ante compensated for the risk they bear →debtors would benefit from a reduction of both the interest rate applied to debt and opportunity costs

18. (ii) The contract should be interpreted on a narrow evidentiary base → parties have more and better information on the substantive terms of their exchange → they know how to allocate contractual rights so to maximize the value of their exchange (A. Schwartz) → if the CAR was determined on the basis of the court’s subjective interpretation, rather than the letter of the contract, the result would be a managerial policy of underinvestment