Fiduciary Duties and Equity-Debtholder Conflicts
Executive Summary — Managerial decisions influence the distribution of value between different parties. This can lead to conflicting interests among financial claimants, such as holders of equity and debt. The Credit Lyonnais v. Pathe Communications bankruptcy ruling of 1991 before the Delaware court—a case widely perceived to have created a new obligation for directors of Delaware‐incorporated firms—provides an interesting opportunity to assess whether and how equity-debt conflict affects firm behavior. HBS professor Bo Becker and Stockholm School of Economics professor Per Strömberg outline important changes in behavior after Credit Lyonnais. Key concepts include:
- The Credit Lyonnais duties are a prime example of how important the Delaware courts are, and how the differences between Delaware corporate law and other jurisdictions can be of significance.
- After the ruling, behavior changed for Delaware firms in the vicinity of bankruptcy, which enabled them to enter Chapter 11 in a healthier state, thus making bankruptcy resolution easier.
- Firms in distress sometimes have an incentive to undertake actions that hurt debt and benefit equity. Such behavior leads to indirect costs of financial distress, discouraging leverage and reducing overall firm value. A reduction in such behavior took place after the Credit Lyonnais ruling.
We use an important legal event as a natural experiment to examine the effect of management fiduciary duties on equity‐debt conflicts. A 1991 Delaware bankruptcy ruling changed the nature of corporate directors' fiduciary duties in firms incorporated in that state. This change limited managers' incentives to take actions favoring equity over debt for firms in the vicinity of financial distress. We show that this ruling increased the likelihood of equity issues, increased investment, and reduced firm risk, consistent with a decrease in debtequity conflicts of interest. The changes are isolated to firms relatively closer to default. The ruling was also followed by an increase in average leverage and a reduction in covenant use. Finally, we estimate the welfare implications of this change and find that firm values increased when the rules were introduced. We conclude that managerial fiduciary duties affect equity‐bond holder conflicts in a way that is economically important, has impact on ex ante capital structure choices, and affects welfare.