The following post comes to us from Shai Levi
of the Department of Accounting at Tel Aviv University, Benjamin Segal
of the Department of Accounting at Fordham University and The Hebrew University, and Dan Segal
of the Interdisciplinary Center (IDC) Herzliyah and Singapore Management University. This post is part of the Delaware law series
, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here
Financial reports should provide useful information to both shareholders and creditors, according to U.S. accounting principles. However, directors of corporations have fiduciary duties only toward equity holders, and those fiduciary duties normally do not extend to the interests of creditors. In our paper, Does Corporate Governance Make Financial Reports Better or Just Better for Equity Investors?, which was recently made publicly available on SSRN, we examine whether this slant in corporate governance biases financial reports in favor of equity investors. We show that the likelihood that firms will manipulate their reporting to circumvent debt covenants is higher when directors owe fiduciary duties only to equity holders, rather than when they owe fiduciary duties also to creditors. Covenants limit the amount of new debt that the firm issues, for example, and by that reduce bankruptcy risk, and allow creditors to avoid bankruptcy costs, and to recover more from the borrowing firm in case it approaches insolvency. When managers manipulate financial reports to circumvent these debt covenants, they transfer wealth from creditors to shareholders. Our results suggest that when corporate governance is designed to protect only equity holders, firms’ financial reports serve equity holders’ interests at the expense of other stakeholders. We find that when the legal regime requires directors to consider creditors’ interests, firms are less likely to use structured transactions designed to skirt debt covenant limits, particularly if the board of directors of the firm is independent.
…continue reading: Does Corporate Governance Make Financial Reports Better or Just Better for Equity Investors?