In the paper, Equity-Debtholder Conflicts and Capital Structure, which was recently made publicly available on SSRN, we present a novel approach to identifying debt‐equity conflicts and the associated agency costs, employing a 1991 legal event as a natural experiment. Our natural experiment revolves around the fiduciary duties of corporate officers. Broadly speaking, these duties require that officers take actions that are in the interest of owners. Historically, the position of U.S. courts has been that such duties are owed to the firm as a whole and to its owners, but not to other firm stakeholders, such as creditors. Creditors are assumed to be able to protect themselves by contractual and other means (e.g. covenants). This situation changes once a firm becomes insolvent. At this point, fiduciary duties are owed to creditors, since for insolvent firms creditors become the residual claimants. As long as the firm is solvent, however, the traditional view was that no such rights were held by creditors. This changed with the Delaware court’s ruling in the 1991 Credit Lyonnais v. Pathe Communications bankruptcy case. The case ruling argued that when a firm is not insolvent, but in the “zone of insolvency”, duties may already be owed to creditors.
Using a difference‐in‐difference methodology, we examine both behavioral changes (e.g. investment) and leverage outcomes following Credit Lyonnais. The difference‐in‐difference methodology contrasts public firms incorporated in Delaware and to those incorporated elsewhere, and before and after 1991. 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. Delaware firms reduced operational and financial risk, consistent with risk shifting and asset substitution theories.
Credit Lyonnais appears to have had no impact on firms with low leverage, as predicted, since these firms were not in the zone of insolvency, almost certainly were not financially distressed, and likely were far from bankruptcy. Instead, the effects are isolated to the subset of firms where leverage is above the median. This is consistent with Credit Lyonnais being the true driver of our results, and is inconsistent with explanations involving contemporaneous changes specific to Delaware firms.
We conclude that firm 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. Our results are consistent with theories of capital structure based on agency costs. Such costs are an important part of how the trade‐off theory of capital structure is usually understood (see Myers 2003).
The full paper is available for download here.