| Published: | March 24, 2010 |
| Paper Released: | February 2010 |
| Authors: | Bo Becker and Per Strömberg |
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.
Abstract
We use an important legal event as a natural experiment to examine equity-debt conflicts in the vicinity of financial distress. A 1991 Delaware bankruptcy ruling changed the nature of corporate directors’ fiduciary duties in that state. This change limited incentives to take actions favoring equity over debt. We show that, as predicted, this increased the likelihood of equity issues, increased investment, and reduced risk taking. The changes are isolated to indebted firms (where the legal change applied). These reductions in agency costs were followed by an increase in average leverage and a reduction in interest costs. Finally, we can estimate the welfare implications of agency costs, because firm values increased when the rules were introduced. We conclude that equity-bond holder conflicts are economically important, determine capital structure choices, and affect welfare.
30 pages.
Paper Information
- Full Working Paper Text
- Working Paper Publication Date: February 2010
- HBS Working Paper Number: 10-070
- Faculty Unit: Finance
