Debtholders and Equityholders

The University of ChicagoThe University of Chicago Law School

Debtholders and EquityholdersAuthor(s): Hideki KandaSource: The Journal of Legal Studies, Vol. 21, No. 2 (Jun., 1992), pp. 431-448Published by: The University of Chicago Press for The University of Chicago Law SchoolStable URL: http://www.jstor.org/stable/724489 .

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DEBTHOLDERS AND EQUITYHOLDERS

HIDEKI KANDA*

I. INTRODUCTION

WHILE the economic and the legal status of equityholders has been much studied in the past, that status of debtholders has been poorly understood in the literature. Recent ventures for restructuring corporate capital incident to corporate takeovers and leveraged buyouts, however, have focused attention on the importance of corporate borrowing and the claimed necessity of protecting debtholders who face a risk of unexpected decrease in the value of their investment as a result of such restructuring transactions. Thus, it is no surprise that arguments have emerged to the effect that corporate law should offer stronger predictions to bondholders.'

Simply put, these arguments run as follows. Bondholders suffer economic loss if their corporation incurs further risky-or high-yield-borrowing. Contractual provisions in bond contracts do not sufficiently protect them because predicting future events in advance is difficult and costly. Consequently, corporate law should provide bondholders with

* Associate Professor of Law, University of Tokyo. I thank Douglas Baird, Lloyd Cohen, Saul Levmore, and Jonathan Macey for their help and suggestions. I also received helpful comments and criticism on earlier drafts from Albert Alschler, Michael Dooley, David Haddock, John Hetherington, Thomas Jackson, Mark Ramseyer, Robert Scott, George Triantis, and the workshop and seminar participants at University of Chicago, Cornell University, and University of Virginia Law Schools.

See Morey W. McDaniel, Bondholders and Corporate Governance, 41 Bus. Law. 413 (1986); Morey W. McDaniel, Bondholders and Stockholders, 13 J. Corp. L. 205 (1988); Albert H. Barkey, The Financial Articulation of a Fiduciary Duty to Bondholders with Fiduciary Duties to Stockholders of the Corporation, 20 Creighton L. Rev. 47 (1986); Note, Fiduciary Duties of Directors: How Far Do They Go? 23 Wake Forest L. Rev. 163 (1988). See also Note, Creditors' Derivative Suits on Behalf of Solvent Corporations, 88 Yale L. J. 1299 (1979); Lawrence E. Mitchell, The Fairness Rights of Corporate Bondholders, 65 NYU L. Rev. 1165 (1990). But see Kenneth E. Scott, The Law and Economics of Event Risk (Working Paper No. 62, Stanford Law School, Olin Program in Law and Economics 1990).

[Journal of Legal Studies, vol. XXI (June 1992)] ? 1992 by The University of Chicago. All rights reserved. 0047-2530/92/2102-0005$01.50

431



432 THE JOURNAL OF LEGAL STUDIES

greater protection. Specifically, directors and officers should bear fiduciary duties to bondholders, and bondholders should be given standing to bring derivative suits. These arguments naturally stress the economic similarity between debtholders and equityholders rather than the difference in their legal status and assert that corporate law should treat similar economic actors alike.2

While this line of argument carries superficial appeal, careful analysis of both the economic nature of debtholding and equityholding and the legal apparatus governing the manager-investor relationship-such as the fiduciary principle-suggests different solutions to the problem. This article will contrast the economic nature of debtholding with that of equityholding and will offer an analytical framework for the desirable legal treatment of debtholders and equityholders in publicly held business corporations. Section II reviews and identifies the economic nature of debtholding and equityholding. Section III analyzes current law dealing with debtholders and equityholders. The discussion focuses on three rules that appear puzzling and shows that current law more or less correctly reflects ex ante hypothetical bargains among the participants. Section IV examines normative issues such as the desirability of imposing fiduciary duties to debtholders on corporate managers. While contractual protections are sometimes insufficient as means of protecting debtholders, I argue that directors and officers should owe fudiciary duties only to common equityholders. Creating a fiduciary relationship between managers and debtholders or even between managers and preferred equityholders would produce new problems rather than solve existing ones.

II. ECONOMIC NATURE OF DEBTHOLDING AND EQUITYHOLDING

Debtholders can suffer several types of economic loss if the debtor attempts further borrowing. The first type can be illustrated in a simple numerical hypothetical example.

Debtor borrows $100,000 from Creditor 1 with annual interest of 10 percent. Debtor then borrows another $100,000 from Creditor 2 with annual interest of 20 percent. Debtor runs a business with these borrowed funds, which produces annual return of 12 percent. If there only were borrowing from Creditor 1, Debtor would get $112,000 back at the end of the year. The additional borrowing from Creditor 2, however, changes the picture. Debtor now ends up with $224,000, which is insufficient to satisfy both Creditor 1 and Creditor 2. Because bankruptcy law directs both creditors to share equally, Creditor 1 ends up with $107,000.3

2 Notably McDaniel, Bondholders and Stockholders, supra note 1. 3 Here, I of course assume that 10 percent interest Creditor 1 charges does not include

insurance premium for covering the risk of loss illustrated in the example.



DEBTHOLDERS AND EQUITYHOLDERS 433

I call this "the sharing problem." Inasmuch as insolvency law treats unsecured creditors equally, creditors face the sharing problem unless they make an arrangement in advance and in a legally enforceable manner to get priority or otherwise protect themselves.

The second problem creditors face is the risk-alteration problem, which is well known in the literature. Consider the following examples.

Case 1. Debtor undertakes business with $400,000. Debtor is given two business opportunities. One opportunity (project 1) would give Debtor $500,000 at the end of the year. The other opportunity (project 2) would result in $800,000 with 50 percent probability and $100,000 with 50 percent probability. Debtor will choose project 1 because project 2 has the expected value of $450,000 and thus is less attractive than project 1.

Case 2. Debtor now becomes incorporated and finances the business with the mixture of debt and equity. Debtor receives $300,000 equity from Equityholder and borrows $100,000 from Creditor 1. For simplicity, I assume that the borrowing is made with no interest. Debtor, who rep- resents Equityholder, will choose project 1 because project 2 has an expected value of $350,000 to Equityholder and is less attractive than project 1.

Case 3. Incorporated Debtor in case 2 now reduces its equity to $100,000 and borrows an additional $200,000 from Creditor 2. Debtor now will choose project 2. If project 2 is successful, Debtor would get $800,000. After paying $300,000 to the two creditors, Debtor would end up with $500,000, which would belong to Equityholder. If it fails, all $100,000 should go to the creditors, but neither Debtor nor Equityholder would be liable to the creditors beyond that amount because of the limited liability in corporate law. Thus, the expected value of project 2 to Equi- tyholder is $250,000, which is more attractive than project 1.

This risk-alteration problem simply means that the debtor and its equityholders "gamble" with borrowed money,4 but there are two aspects in this gambling game. First, in case 3, Debtor chooses project 2, and, if it fails, Creditor 1 cannot collect its debt unless it seeks some form of protection in advance. Second, in case 3, Debtor chooses project 2 rather than project 1. This result is socially inefficient.5

4 For a detailed description of debtholder-equityholder conflict, see, for example, Michael C. Jensen & Clifford W. Smith, Jr., Stockholder, Manager, and Creditors Interests: Applica- tions of Agency Theory, in Recent Advances in Corporate Finance 93 (Edward I. Altman & Marti G. Subrahmanyam eds. 1985); William A. Klein & John C. Coffee, Jr., Business Organization and Finance 306-38 (4th ed. 1990).

5 A believer in the Modigliani-Miller propositions (Franco Modigliani & Merton H. Miller, The Cost of Capital, Corporation Finance, and the Theory of Investment, 48 Am. Econ. Rev. 261 (1958)) might argue that even incorporated Debtor with $400,000 equity and no




The sharing problem and the risk-alteration problem are sometimes related but should be distinguished. The sharing problem arises simply because the debtor incurs further borrowing at a higher cost even if the risk of the debtor's business is not altered. The risk-alteration problem arises because the debtor has an incentive to alter the risk of her business, due normally-but not necessarily-to further borrowing. This risk alteration harms creditors unless it is fully negotiated for and incorporated in the initial debt contractual terms.

Equityholders are different. They do not face the sharing problem or the risk-alteration problem when the debtor obtains further equity funds. As for the former, corporate law generally treats all equityholders (of the same class) in equal ranking, but it also prohibits the corporation from inviting new equityholders with "higher interest." In other words, corporate law generally requires that new equity must be issued at a price equal to the fair market price of the outstanding equity. Equityholders face a different type of problem, which can be called "the insufficient risk taking problem." Consider the following example.

Case 4. Incorporated Debtor undertakes business with $400,000 equity obtained from Equityholder and with no debt. In addition to the two business opportunities shown in case I above, another alternative (project 3) is available. Project 3 will produce $800,000 with 50 percent probability but result in $300,000 with 50 percent probability.

In this case, if Debtor is an unincorporated proprietor and runs business with its own funds, Debtor would choose project 3. The expected value of project 3 is $550,000, which is more attractive than project 1 (or project 2). This result is socially efficient. If Debtor is incorporated, however, Equityholder faces a typical agency problem, inasmuch as the result of the manager's business efforts goes to Equityholder and not to the manager unless otherwise agreed. Thus, the manager has an incentive to shirk by not choosing project 3.6 The manager also might be tempted to misbehave by a variety of means, such as looking for side deals in

debt may choose project 2 because, for instance, Equityholder itself can gamble by borrowing $300,000 at the individual level. This homemade gambling, however, is unrealistic. See, for example, Victor Brudney, The Role of the Board of Directors: The ALI and Its Critics, 37 U. Miami L. Rev. 223, 240 (1984) (individuals and corporations have different cost-benefit calculations). Individual equityholders might try to set up a vehicle like pension funds to obtain home-made gambling. But this attempt would be penalized by tax law.

6 In addition, managers who invest firm-specific human capital may want less gambling. See John C. Coffee, Jr., Shareholders versus Managers: The Strain in the Corporate Web, 85 Mich. L. Rev. 1 (1986); but see also Jonathan R. Macey, Externalities, Firm-specific Capital Investments, and the Legal Treatment of Fundamental Corporate Changes, 1989 Duke L. J. 173, 185-88.




conducting business with outsiders.7 To the extent that the debtor corporation obtains more funds from a variety of sources and is given more business opportunities, the insufficient risk taking problem becomes exacerbated simply because monitoring the manager's conduct becomes more difficult and costly. Debtholders do not care about this problem so long as their fixed claims are safe.

The discussion above shows that debtholders and equityholders are similar in the sense that they can suffer economic loss if their company attempts to obtain additional funds.8 The economic nature of the risk these two types of investors face, however, is different. The purpose of the manager-equityholder contract is simple: the best gambling. But the purpose of the manager-debtholder contract is complex. One might be tempted to say that debtholders want to be "safe" with their fixed claims. This, however, is not accurate. Debtholders want safety after the debt contract is signed under specific terms and conditions. More precisely, the extent to which they want safety depends on the terms and conditions written in the debt contract. Some debtholders might agree to future risk taking in the debtor's business in exchange for a high interest, while other debtholders might view such risk taking as nonbargained-for risk alteration. In short, debtholding allows debtholders to write tailor-made terms and conditions as a response to the sharing and risk-alteration problems. A single and uniform purpose does not exist in the manager- debtholder contract.9 This suggests that legal rules designed to "protect" debtholders, if necessary, must be differently structured than those for equityholders.

III. LEGAL RULES FOR DEBTHOLDERS AND EQUITYHOLDERS

This section examines three rules under current law that are relevant to the problems described in Section II.1' The analysis is limited to pub-

7 I assume that overt misbehavior such as fund stealing is effectively deterred by the legal system.

8 The discussion in the text focuses on additional borrowing. A similar analysis can be applied when the company attempts to restructure its capital.

9 Even where market conditions do not change, different creditors normally charge different interests to the debtor. One can make two observations regarding this fact. One is that creditors are all risk neutral or otherwise have the same risk taste and either lack of information or informational asymmetries cause them to charge different interests. The other is that creditors have different tastes and attitudes toward the debtor's venture. Both observations are plausible. As I will discuss below, the current legal rules are consistent with either or both observations.

0o This article does not discuss "general" legal rules-such as fraudulent-conveyance law and dividend restrictions in corporate law-protecting a corporation's creditors as applied to the sharing and risk-alteration problems. Excluding such a discussion is a some-




licly held business corporations. First, while preferred equity is permitted, preferred debt is not. Second, while new equity must be issued at a price that is "fair" to the existing equityholders, no equivalent rule exists for new borrowing. Third, managers owe fiduciary duties to equityholders but not to debtholders. Equityholders are normally given standing to bring derivative suits against managers, but debtholders are not. Debt- holders are given no protection unless they put provisions in the debt contract," whereas equityholders are given many protections by corporate law even if they are silent in their contracting and some of these protections are, as discussed below, mandatory and cannot be contracted out. Economists normally take these rules as given, and lawyers seldom ask why these rules exist. Yet they are puzzling even at first glance. Why has the law evolved these specific rules to govern the rights of debtholders and equityholders?

A. Absence of Preferred Debt

Preferred equity-or preferred stock in a business corporation-is well recognized in corporate law. But "preferred debt" cannot be created even when debtor and creditor agree. Such an agreement is enforceable between the debtor and the creditor but not against other creditors.12 Thus, such an agreement enables the creditor to accelerate her claim only if the debtor breaches the promise, and her claim would be treated as unsecured with no priority over other creditors. The creditor can place a negative pledge clause in the debt contract and prevent later creation of security interest by other-typically subsequent-creditors.13 But again, she cannot get a priority. Debtor and creditor can agree on subordi- nated debt, which makes the creditor rank lower than existing and subsequent creditors,14 but they cannot agree on preferred debt.15

The rationale for this rule may not be immediately evident. The law could offer a system that allows debtor and creditor to establish the credi-

what arbitrary decision. For such general rules, see Robert Charles Clark, The Duties of the Corporate Debtor to Its Creditors, 90 Harv. L. Rev. 505 (1977).

" But they enjoy general rules protecting a corporation's creditors. See note 10 supra. 12 Compare U.C.C. ? 9-312(5) (an unperfected security interest loses against a later per-

fected secured creditor who has actual knowledge). 13 The enforceability of such a negative pledge clause under current law, however, is

unclear. See Douglas G. Baird & Thomas H. Jackson, Cases, Problems, and Materials: Security Interests in Personal Property 882 (2d ed. 1987).

14 See Bankruptcy Code ? 510(a), 11 U.S.C. ? 510(a). 15 One might be able to create something approximating preferred debt by taking an

all-encompassing U.C.C. security interest. The question is, Why not allow it by a direct path?




tor's priority over other creditors.16 Alan Schwartz recently addressed this point and argued that priority should be given the initial creditor, whether or not such a creditor is unsecured.17

One might expect that such a system would give the debtor an incentive to supply potential preferred creditors with as much information as possible about her business in order to get the best deal. Creditors as a whole would then benefit. One might also argue that subsequent creditors do not care about preferred creditors as long as they are notified because they can easily adjust to the existing preferred debt by contractual terms such as interest.1" Existing creditors can also adjust, in theory, if they expect subsequent creation of preferred debt.

These arguments are impressive but not entirely persuasive. First, a creditor who wants preferred status is not necessarily the most efficient creditor in the sense that the contractual terms she offers, typically high- lighted by lower interest, optimally reflect the financing opportunities or value of the debtor's business, actually or potentially."9 If preferred status is given to one creditor, and another-more efficient--creditor shows up later, it would be difficult and costly to renegotiate the existing contract to change the priority. Moreover, the manager representing equityholders has an incentive to offer such a "super priority" to any creditor in order to get as many risk-alteration opportunities as possible.

Second, other creditors are generally made worse off by the introduction of new creditors if their claims rank higher. Inviting such new creditors does not alleviate the risk-alteration problem and aggravates the

16 Under current law, a creditor can get a priority over other existing creditors if they agree on subordination.

"7 Alan Schwartz, A Theory of Loan Priorities, 18 J. Legal Stud. 209 (1989). He argues that the bargain over priority between the initial financier and the debtor is always optimal, that the optimal priority contract between the debtor and the initial financier would rank the initial financier first, and that other creditors, if informed, would not be worse off. He then proposes that current law be changed accordingly.

It would not be difficult to design a mechanism to notify potential subsequent creditors about the existence of such a "preferred creditor" in a way similar to that for security interests under Article 9 of the Uniform Commercial Code. Compare Schwartz, id. at 218-24 (arguing that filing should be unnecessary among creditors). Such a system would probably limit future advances that enjoy a preferred status. See Schwartz, id. at 252. See also Peter F. Coogan, Homer Kripke, & Fredric Weiss, The Outer Fringes of Article 9: Subordination Agreements, Security Interests in Money and Deposits, Negative Pledge Clauses, and Participation Agreements, 79 Harv. L. Rev. 229, 263 (1965) (recommending that the Uniform Commercial Code be amended to accommodate money as original collateral for security interest and to provide a rule for the perfection of such security interest as proceeds).

18 Schwartz, supra note 17, at 254-55, 260-61. 19 This condition might be satisfied in situations where a small company attempts its first

borrowing from a bank.




sharing problem. Preferred debt does not respond in any meaningful way to the risk-alteration problem other creditors face. They are thus worse off to the extent that the sharing problem becomes exacerbated.20

Allowing security interests for creditors is somewhat different from allowing preferred creditors. Security interests may reduce the debtor's opportunities for gambling because the collateral may be worth more to the debtor than to the secured creditor.21 They also may alleviate the monitoring problem that creditors as a whole face.22 Preferred creditors can hardly be good monitors.

In sum, the current law rejecting the creation of preferred debt might be defensible as a correct reflection of the creditors' bargain. Creditors as a whole would hardly agree on the creation of preferred debt. By contrast, contracting out the equal-ranking rule by agreeing on subordination does not create the concerns described above and therefore should be enforceable.

The current corporate law also correctly mirrors the equityholders' bargain. Existing common equityholders do not care about and, indeed, welcome the injection into their venture of further funds, even when the new claimants rank higher, as long as the new equity is sold at a fair market rate. Those funds enable existing equityholders-and the managers representing them-to undertake more gambling activities that are beneficial to equityholders.

B. Absence of "Fair Price" Restrictions on Debt Issuance

While corporate law generally requires that new equity be issued at a price equivalent to the fair market value of the existing equity,23 no such restrictions are imposed for debt. Thus, a debtor corporation is allowed

20 This statement presupposes that, among creditors at least, a creditor would agree to rank lower only when the benefits from it exceed costs.

21 See Robert E. Scott, A Relational Theory of Secured Financing, 86 Colum. L. Rev. 901, 927-29 (1986). See also Robert E. Scott, Rethinking the Regulation of Coercive Credi- tor Remedies, 89 Colum. L. Rev. 730, 748-49 (1989).

22 The academic efforts explaining why secured financing exists have been illuminative. The importance of monitoring concerns has been recognized, but opinions are split in understanding how security interests alleviate the monitoring concerns creditors face. See Thomas H. Jackson & Anthony T. Kronman, Secured Financing and Priorities among Creditors, 88 Yale L. J. 1143 (1979); Saul Levmore, Monitors and Freeriders in Commercial and Corporate Settings, 92 Yale L. J. 49 (1982); Scott, Relational Theory, supra note 21. See also Alan Schwartz, The Continuing Puzzle of Secured Debt, 37 Vand. L. Rev. 1051 (1984); Schwartz, supra note 17, at 243-47.

23 See, generally, Note, Judicial Control over the Fairness of the Issue Price of New Stock, 71 Harv. L. Rev. 1133 (1958). Of course, this rule does not exist for "rights" issues, in which new equity is offered to the existing equityholders.




to issue new debt at any price, unless otherwise agreed in the contract for existing debt.24 Given that equal ranking of unsecured creditors is the baseline rule, why does the law not offer, as it does for equity, another baseline rule that restricts the issuance of new debt at a lower price than the fair market value of the existing debt? Such a rule would eliminate the sharing problem.

Again, the economic nature of debtholding offers an answer. Inasmuch as debtholders face the risk-alteration problem, they attempt to deal with this risk in a variety of ways.25 They may want to charge higher interests to compensate themselves for the risk. They may want to create security interests by taking the debtor's certain assets as collateral. In other words, debtholders make different commitments toward the risk-alteration problem. They are not like equityholders who, as residual claimants, do not face the risk-alteration problem and rely on the efficient stock market with concerns about the nature of the best gambling in the venture. 26

It follows, therefore, that the market price of existing debt, if there is such, is not the reflection of the market for the entire debt, as is the case for equity, but rather the reflection of the particular debtholder's risk taking, or, more accurately, the bargain between the debtor and the particular debtholder. The fact that rating agencies rate only debt-and preferred equity-and not common equity simply reflects this economics. Prospective debtholders, particularly prospective purchasers of new debt, do not care about the current market price of the debt as much as prospective equityholders do about the current market price of the existing equity. Their concern is the riskiness of the debtor's present and future gambling. They decide the terms of their commitment according to their own taste. The sharing problem may be viewed as a price that debtholders might be willing to pay in order to get the range of their choice with respect to the debtor's future risk taking.

24 Note, however, that managers would be liable to equityholders, subject to the protection by the business-judgment rule, if issuing debt with high interest does not produce gambling opportunities, the benefits from which outweigh the costs of such borrowing.

25 See, generally, James C. Van Horne, Optimal Initiation of Bankruptcy Proceedings by Debtholders, 31 J. Fin. 897 (1976).

26 Both debtholders and equityholders have among themselves different tastes about the risk that they want to take in making investments in the debtor's business. Equityholders can satisfy their taste by building an appropriate investment portfolio. Debtholders can do the same, but, in addition, they can also choose their commmitment to the risk alteration in the debtor's business. Inasmuch as eliminating the possibilities of future risk alteration in an enforceable manner is difficult and thus costly, there is reason to expect that they make concrete arrangements with the debtor in accordance with their tastes about future risk alteration rather than doing nothing. The availability and efficiency of the secondary market affect their decisions but do not eliminate their concern about risk alteration.




C. Off-the-Rack Legal Rules

The discussion above suggests that debtholding is best created and governed by contract. Inasmuch as debtholders' attitudes toward the sharing and risk-alteration problems vary from debtholder to debtholder, these problems are best solved by permitting them to design their own contractual terms.

The question of why current law does not give debtholders any protection unless they protect themselves in the contract remains. Why is this the default rule? In contrast, equityholders are given a variety of protections by corporate law: voting rights, fiduciary protections, and standing to bring derivative suits. Assuming away, for a moment, the fact that some of these protections for equityholders are mandatory and cannot be contracted out, why are the baseline rules different between two types of investors?

The no-protection rule for debtholders27 can be viewed as a reflection of the simple facts that debtholders decide the degree of their risk taking themselves and that their individual commitments vary. Under current law, aside from seeking credit enhancement from third parties-such as a third-party guarantee-at least three contractual means are available for debtholders: charging a higher interest, creating a security interest, and placing various "covenants" in the debt contract.28 Thus, each debt contract is the tailor made product of the debtor-creditor bargain.

In contrast, corporate law generally requires that equity issued at different times be in the same terms, particularly common equity. Common equityholders have many protective contractual terms that are supplied automatically by corporate law, even if they fail to protect themselves through explict contracting. They normally enjoy voting rights, they are protected by the fiduciary principle,29 and so on. Why does the law not begin with the no-protection rule here?

27 It should be noted, however, that, as discussed below, current law offers the full- protection rule to debtholders with respect to subsequent changes of the debt contract terms: all debtholders must give consent for such a change unless otherwise agreed in advance.

28 In addition, debtholders can choose the length of their commitment. They also can diversify the risk they face. See note 26 supra.

When a corporation issues debt securities, the trust indenture contains the terms of the debt for multiple debtholders. The Trust Indenture Act of 1939, 15 U.S.C. ?? 77aaa et seq., requires that public issuance of debt securities be generally contracted through trust indenture and have an indenture trustee.

29 For the distinctive attributes of the fiduciary principle in corporate law, see Robert C. Clark, Agency Costs versus Fiduciary Duties, in Principals and Agents: The Structure of Business 55, 71-76 (John W. Pratt & Richard J. Zeckhauser eds. 1985). "Fiduciary law is stricter on fiduciaries than contract law is on ordinary contracting parties in at least four




Again, the economic nature of equityholding offers an answer. Since equityholders are residual claimaints and do not face the risk-alteration problem, their individual attitudes toward the risk taking in the venture are identical: they want gambling that will maximize the net present value of the venture. As the number of equityholders increases, the liquidity of equity is enhanced. They also share the insufficient risk taking problem and, therefore, want the most effective arrangement for monitoring managers' behavior. Voting rights and fiduciary rules thus can be viewed as a reflection of the fact that most equityholders want these protections.30

D. Limits on Contractual Freedom

A related question is whether equityholders should be permitted freedom to contract out the rules supplied by corporate law. Indeed, corporate law normally permits the creation of different classes of equity if the terms are clearly identified in the charter or elsewhere.31 And, not surprisingly, some argue that corporate law should permit stockholders to change completely the fiduciary principle governing the manager- stockholder relationship,32 while others argue against allowing this contractual freedom.33 Debtholders are protected by the default rule, which requires unanimous consent of the debtholders to changes of the contrac-

fundamental respects. There are stricter rules about disclosure, more open-ended duties to act, tighter delineations of rights to compensation and to benefits that could flow from one's position, and more intrusive normative rhetoric. These elements of strictness do not arise from actual contracts but have been created by judges in the common law tradition." Id. at 76.

30 Fiduciary rules in corporate law can be viewed as a legal apparatus to deter abuse of managerial discretion. See Clark, id. at 77. See also Tamar Frankel, Fiduciary Law, 71 Cal. L. Rev. 795 (1983) (discussion in wider contexts involving fiduciaries); and Alison Grey Anderson, Conflicts of Interest: Efficiency, Fairness, and Corporate Structure, 25 UCLA L. Rev. 738, 793 (1976) ("some compromise must be reached between [managerial] unlimited discretion and overly rigid rules [to restrict such discretion]"). Equityholders surely do not want abuse of managerial discretion, but they do want the best gambling. The fiduciary principle enables them, though not perfectly, to monitor and enforce this best-gambling promise. Compare Charles J. Goetz & Robert E. Scott, Principles of Relational Contracts, 67 Va. L. Rev. 1089 (1981) (discussion on "best-efforts" clauses in relational contracts).

31 See, for example, Revised Model Corporation Act ?? 6.01, 6.02. 32 Richard A. Posner, Economic Analysis of Law 390 (3d ed. 1986); Frank H. Easterbrook

& Daniel R. Fischel, Corporate Control Transactions, 91 Yale L. J. 698 (1982); Frank H. Easterbrook & Daniel R. Fischel, Voting in Corporate Law, 26 J. Law & Econ. 395 (1983); Frank H. Easterbrook & Daniel R. Fischel, The Corporate Contract, 89 Colum. L. Rev. 1416 (1989).

33 See, for example, Lucian Arye Bebchuk, Limiting Contractual Freedom in Corporate Law: The Desirable Constraints on Charter Amendments, 102 Harv. L. Rev. 1820 (1989). For a survey of the debate, see Lucian Arye Bebchuk, Foreward: The Debate on Contrac- tual Freedom in Corporate Law, 89 Colum. L. Rev. 1395 (1989).




tual terms unless otherwise agreed in advance.34 No one has explained why.

The economic nature of debtholding and equityholding offers an answer. Because equityholders face the insufficient risk-taking problem, they want day-to-day renegotiation in order to monitor and enforce their bargain with managers. Gambling opportunities tend to vary from time to time. In particular, these opportunities change whenever the venture incurs further borrowing. Requiring equityholders' unanimous consent to managers' conduct in every instance would lessen the chances of produc- ing the best gambling. But allowing changes of the manager-equityholder contract without the unanimous consent of equityholders would risk misbehavior by the majority equityholders. Also, whether or not unanimity is required, ex post renegotiation always faces opportunism and thus is costly. Consequently, opinions might well be split as to whether depar- ture from the standard fiduciary rule by majority consent should be permitted.

Debtholders are different. They face the risk of the debtor's future excessive risk taking from the outset and fix their attitudes toward their commitment at the outset in a clear and easily enforceable manner. Changes of the initially negotiated terms then simply mean changes in their commitment, or new debtholding. The current law, which begins with the default rule requiring all debtholders' consent for changes of the contractual terms, is thus understandable.

IV. NORMATIVE IMPLICATIONS FOR THE LEGAL TREATMENT OF

DEBTHOLDERS AND EQUITYHOLDERS

This section examines the recent arguments that corporate law should offer greater protections to bondholders. I will show that these arguments are only partially correct and then offer better solutions to the problem. Again, the analysis is limited to publicly held corporations.

A. The Need for Greater Debtholder Protections

Corporate takeovers and leveraged buyouts frequently produced restructuring transactions of corporate capital. These restructuring transactions have sometimes brought losses to bondholders in the form of an unexpected decrease in the value of their investment.35 Thus, not surpris-

34 For debts issued to the general public, the federal law limits the freedom to change the unanimity rule. See the Trust Indenture Act of 1939, ? 316, 15 U.S.C. ? 77ppp (1991).

35 See McDaniel, Bondholders and Stockholders, supra note 1; Schwartz, supra note 17.




ingly, arguments have emerged to the effect that corporate law should offer greater protections to bondholders.

These arguments can be summarized as follows.36 Bondholders suffer economic loss if their corporation incurs further risky-or high yield- borrowing. Contractual provisions in bond trust indentures do not sufficiently protect them because predicting future events is difficult and costly. Their attempt to renegotiate the contractual terms after they no- tice the restructuring toward a more risky venture is neither easy nor practical. Consequently, corporate law should provide bondholders with greater protections. Specifically, directors and officers should bear fiduciary duties to bondholders, and bondholders should be given standing to bring derivative suits. These ex post rules would complement unsatis- factory ex ante price adjustments and other contracting processes between bondholders and the debtor corporation.37

These arguments stress the economic similarity between bondholders and stockholders rather than the difference in their legal status and assert that corporate law should treat similar economic actors alike. The arguments also assert that the value of the firm is not the value of the equity but, rather, the value of the equity plus debt and that managers should be obliged to maximize the value of the firm, not the value of the equity.38

These assertions are correct only in that debtholders can suffer unexpected loss as a result of insufficient contracting. Although empirical studies show that bond covenants serve to control conflict between debtholders and equityholders,39 dispersed debtholders face three familiar contracting and enforcement problems, which make contractual protections only partially effective. First, they face lack of information when they negotiate for desirable contractual terms. The debtor's managers cannot be expected to supply debtholders with optimal information, inasmuch as they are tainted by their self-interest, and thus cannot be ex-

36 Notably, in McDaniel, Bondholders and Stockholders, supra note 1.

37 Id. Thus far, fiduciary duties to bondholders have not been recognized in courts. See, for example, Simons v. Cogan, 549 A.2d 300, 302-4 (Del. Supr. 1988).

For the presentation and criticism of an argument that managers' fiduciary duties should be extended more broadly to cover all "nonstockholder constituencies," see Macey, supra note 6; and Jonathan R. Macey, An Economic Analysis of the Various Rationales for Making Shareholders the Exclusive Beneficiaries of Corporate Fiduciary Duties, 21 Stetson L. Rev. 23 (1991).

38 McDaniel, Bondholders and Stockholders, supra note 1. 39 See Fischer Black & John C. Cox, Valuing Corporate Securities: Some Effects of

Bond Indenture Provisions, 31 J. Fin. 351 (1976); Clifford W. Smith, Jr., & Jerold B. Warner, On Financial Contracting: An Analysis of Bond Covenants, 7 J. Fin. Econ. 117 (1979); Avner Kalay, Stockholder-Bondholder Conflict and Dividend Constraints, 10 J. Fin. Econ. 211 (1982).




pected to represent equityholders even though rational equityholders want to agree on some covenants to restrict excessive risk taking. Sec- ond, dispersed debtholders may not be able to evaluate the risk involved in the debtor's venture even if information on the venture's riskiness is perfectly supplied to them. Third, even if these two problems do not exist or are resolved, debtholders face a typical coordination-or collective action-problem. Because each individual debtholder's stake is small and she has many other "colleagues," each debtholder tends to free ride on the others' activities, which is likely to both result in less desirable cove- nant provisions in the first place and lead to undermonitoring and underenforcement of debt contracts.40 As a result, debtholders suffer loss. The different economic natures of debtholding and equityholding, however, suggest different solutions between these two investors.

B. The Fiduciary Principle with Multiple Beneficiaries

Situations in which an agent is obliged to act for the best interest of more than one principal are not uncommon. A classical trustee can serve more than one set of beneficiaries. A lawyer can have more than one client. Thus, managers can serve two masters: debtholders and equityholders. Indeed, if one investor owned the entire equity and debt of the venture, she would naturally ask the manager to act to maximize the combined value of the debt and equity. In publicly held corporations, however, there is reason to think that the fiduciary principle should be structured for the benefit of one set of beneficiaries: residual claimants.

Interactions between one agent and multiple principals are highly complex.41 In publicly held corporations, the costs of monitoring and enforcing the fiduciary duties owed to multiple beneficiaries are high. Whether the manager's day-to-day conduct meets such fiduciary criteria is hardly observable. For dispersed investors, this would surely lead to undermonitoring and underenforcement. It is much easier for the principals-and the court-to look at the manager's behavior from the standpoint of one criterion rather than many. True, this does not necessarily mean that the beneficiaries enjoying the fiduciary protections should only be equityholders. There are, however, two reasons to think that equityholders are normally the best candidates to be the beneficiaries.

40 Levmore, supra note 22, at 53-54. Dispersed equityholders face the same problems. 41 See Kenneth J. Arrow, Economics of Agency, in Pratt & Zeckhauser eds., supra note

29, at 37, 42-46. See also Sanford J. Grossman & Oliver D. Hart, The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration, 94 J. Pol. Econ. 691 (1986).




First, as noted above, debtholders have different commitments to the venture, and, thus, the value of the debtor's business to debtholders varies among debtholders who hold debt instruments issued at different times. If the fiduciary duties were created for the benefit of debtholders, the criteria for such duties would vary among debtholders. As a result, there would be confusion when monitoring and enforcing such a fiduciary principle. Debtholders are better off with more concrete contractual terms, which enable them to monitor and enforce their tailor-made commitments.

Second, equityholders all have the same goal: the best gambling. They also share the insufficient risk taking problem. It is difficult to determine whether managers are engaging in the best gambling for equityholders at all times, simply because gambling opportunities tend to change over time. Potential conflicts of interest are also difficult to detect. Thus, equityholders expect the market for corporate control and other mechanisms to monitor and enforce the manager-equityholder bargain. If the fiduciary principle requires managers to maximize the value of equityholders' investment, it also enables equityholders to enforce the manager-equityholder bargain.

The discussion above suggests that the beneficiary of the fiduciary principle in corporate law should be residual claimants. Thus, not surprisingly, the current law provides that the manager ordinarily owes fiduciary duties to shareholders only but that in corporate insolvency, managers owe fiduciary duties to creditors rather than equityholders, inasmuch as creditors are normally residual claimants in the debtor's insolvency.42

C. Contractual Solutions

The problems faced by dispersal debtholders can be minimized best through improving market environments for contracting, monitoring, and enforcement. Rating agencies-notably Standard and Poor's and Moody's-act as information processors, and they have incentives to produce the information necessary for debt contracting. Investment bankers who seek underwriting revenues have incentives to offer the optimal contractual terms to attract new issuers and debtholders. Both groups have made enormous investments in their reputational capital, which gives them the incentive to make efforts to acquire the necessary

42 See Douglas G. Baird & Thomas H. Jackson, Cases, Problems, and Materials on Bankruptcy, 208-10 (Supp. 1989). See also In re Central Ice Cream Co., 836 F.2d 1068, 1072 (7th Cir. 1987).




information for investors. The "shelf registration" system under the Securities Act of 1933 produced highly competitive environments for investment bankers. As for monitoring and enforcement, the indenture trustee might serve as a representative for dispersed debtholders.43 Fur- ther improvement of these market environments would encourage private contracting, monitoring, and enforcement.

The insufficient risk taking problem faced by equityholders, however, cannot be easily solved through intermediaries such as rating agencies and investment bankers. Rather, the voting-right and fiduciary principles require managers to maximize the value of the equityholders' investments.44 This is the legal apparatus that enables equityholders to enforce the manager-equityholder bargain.

The debt contract can "contract in" fiduciary rules if the parties want. Then, for instance, the debtor would be required not to engage in excessive risk taking. As noted above, however, debtholders presumably do not want such fiduciary rules simply because it is difficult to enforce them. The criteria for determining whether the debtor's particular risk taking is excessive are difficult to formulate. Debtholders, therefore, want more concrete contractual terms.45

In this light, current law, which does not recognize fiduciary rules for preferred equityholders, also makes sense.46 Common equityholders and preferred equityholders are different masters. The more preferred equityholders' investment returns have fixed elements, the more they want specific contractual terms to fix their commitment. Thus, for preferred equityholders, the default rule should probably begin with no fiduciary duties and full protection for changes in their contract. Protections for such equityholders and for equityholders of a class different from common stock both should be assigned to private contracting.

43 Compare Stewart M. Robertson, Debenture Holders and the Indenture Trustee: Con- trolling Managerial Discretion in the Solvent Enterprise, 11 Harv. J. L. & Pub. Pol. 461 (1988).

4 Easterbrook & Fischel, Corporate Control Transactions, supra note 32; Easterbrook & Fischel, Voting in Corporate Law, supra note 32.

45 Compare William W. Bratton, Jr., The Economics and Jurisprudence of Convertible Bonds, 1984 Wis. L. Rev. 667; William W. Bratton, Jr., The Interpretation of Contracts Governing Corporate Debt Relationships, 5 Cardozo L. Rev. 371 (1984); William W. Brat- ton, Jr., Corporate Debt Relationships: Legal Theory in a Time of Restructuring, 1989 Duke L. J. 92; Dale B. Tauke, Should Bonds Have More Fun? A Reexamination of the Debate over Corporate Bondholder Rights, 1989 Colum. Bus. L. Rev. 1; Macey, supra note 37 (suggesting solutions through contract interpretations).

46 See, for example, Robinson v. T.I.M.E.-DC, Inc., 566 F. Supp. 1077, 1081 (N.D. Tex. 1983). See also Jedwab v. MGM Grand Hotels, 509 A.2d 584, 593-94 (Del. Ch. 1986).




D. Optimality of Incorporated Business

As noted above, there are reasons that managers should be fiduciaries for one set of beneficiaries: equityholders. This does not mean, however, that maximizing the value of the equityholders' investments is socially optimal. The examples in Section II clearly demonstrate this. In case 3, equityholders want the managers to choose project 2, but this choice is not socially efficient. In such cases, should the law require-or at least encourage-managers to choose the most socially efficient business? The recent arguments in favor of fiduciary rules for bondholders assert that it should.

I submit three responses to this line of thinking. First, restructuring the fiduciary principle for bondholders would produce large monitoring and enforcement costs. True, the rule imposing the primary obligation of managers to equityholders does have costs: it imposes drafting and other costs on the debtholders. While such a rule has lower costs than the rule requiring the managers to make the most socially efficient decisions, the issue awaits empirical study. By the same token, an effort to liberalize standing to bring derivative suits may produce difficult policing problems.47 Second, current law may already embrace a number of rules that can be understood as encouraging managers to choose the most socially efficient business. Certain limitations on equityholders' limited liability and dividend restrictions in corporate law may serve this goal. Fraudu- lent-conveyance law48 and acceleration clauses in the debt contract may do as well. Third, maximizing the residual value may be, in most instances, the best proxy for choosing the most socially efficient project.49

V. CONCLUSION

Debtholding and equityholding are different. The current law offers different default rules for debtholders and equityholders and reflects the

47 Compare Note, Creditors' Derivative Suits, supra note 1, with Levmore, supra note 22.

48 See, generally, Clark, supra note 10; Douglas G. Baird & Thomas H. Jackson, Fraudu- lent Conveyance Law and Its Proper Domain, 38 Vand. L. Rev. 829 (1985); Douglas G. Baird, Fraudulent Conveyances, Agency Costs, and Leveraged Buyouts, 20 J. Legal Stud. 1 (1991).

49 Tying managers to shareholders in solvent corporations is a close proxy for the rule requiring managers to make decisions a sole owner would make. In insolvent corporations, the creditors, as the residual claimants, benefit from good decisions but pay the costs of bad ones. Those cases in which the residual claimaints are the shareholders when one choice is made but the creditors when a different choice is made present difficulties. See In re Central Ice Cream Co., supra note 42.




difference between the two. Debtholding is best governed by private contracting with the no-protection default rule for the sharing and risk- alteration problems and the full-protection rule for future changes in contracts.

Existing bond contracts may be insufficient for the bargain that debtholders want. This problem, however, should be solved through improving market environments within which private contracting, monitoring, and enforcement are undertaken. Creating by law a fiduciary relationship between managers and debtholders would produce new problems rather than solve existing ones.



Documents

Debtholders and Equityholders