Fiduciary Duties and Equity‐Debtholder Conflicts

Working papers are in draft form. This working paper is distributed for purposes of comment and discussion only. It may not be reproduced without permission of the copyright holder. Copies of working papers are available from the author. Abstract. 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 debt‐ equity 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. comments and suggestions. 2 One of the cornerstones of U.S. corporate governance is that directors and officers should run the firm to maximize shareholder value. It is well understood, however, that shareholder maximization does not necessarily lead to welfare maximization. Decisions that increase shareholder value may impose costs on other stakeholders, e.g. creditors, employees, or the environment, which are not internalized by shareholders. One important instance is the conflict between equity‐ and debt holders in financial distress. 1 Shareholders of distressed firms may prefer low investment, may want to limit new equity finance, and may like high risks, since it benefits the value of equity at the expense of debt. 2 Despite these problems, the prevailing view among economists is that shareholder maximization is the second‐ best solution to the corporate governance problem. 3 One mechanism, which ensures that firms are run in shareholders' interest, is assigning directors and officers fiduciary duties to shareholders. These duties require that officers take actions that are in the interest of owners. If officers fail to do so, shareholders can sue them. This mechanism provides management with an incentive to act in shareholders' interest. Some observers have argued that the shareholders' ability to …