Flashcards in Fiduciary duties Deck (8)
What about is the article
This paper uses the novel approach (natural experiment) of 1991 Delaware bankruptcy verdict that ruled that “when a firm is not insolvent, but in the “zone of insolvency”, duties may already be owed to creditors”.
Duties of managers that require them to take actions in shareholders’ interest.
Debt-equity conflicts that authors examine
o Debt overhang problem
o Risk-shifting problem
o Contractual protection
Debt overhang problem
When a firm is highly leveraged and debt is risky, equityholders have a disincentive to raise new capital to invest in projects that would make the debt safer, even if these projects have positive net present value. This is due to the fact that part of the value of investment would go to creditors
Equity holders have an incentive to increase the riskiness of the firm’s existing assets, even in some cases when this would reduce the value of the firm. This is because the benefits of higher risks got to equityholders, thanks to their limited liability, whereas the costs are primarily borne by creditors.
Credit Lyonnais gave creditors more power, especially contractual protection through covenants.
Findings after the ruling took place in Delaware
o Delaware companies more likely to issue equity
o Financial and operational risk was reduced
o Debt covenants have become less popular
o Equity valuation increased- reducing conflicts creates value & increases welfare
o Equity issue ↑
o No change in dividends/repurchases- possibly due to existing debt contracts
o Investment increased =≻ debt-overhang matters