Does Fiduciary Duty To Creditors Reduce Debt-Covenant-Avoidance Behavior?

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Does Fiduciary Duty To Creditors Reduce Debt-Covenant-Avoidance Behavior?

Shai Levi
Tel Aviv University

Benjamin Segal
Fordham University; Hebrew University of Jerusalem

Dan Segal
Interdisciplinary Center (IDC) Herzliyah

March 26, 2016


Financial reports should provide useful information to shareholders and creditors. Directors, however, normally owe fiduciary duties to equity holders, not creditors. We examine whether this slant in fiduciary duties affects the likelihood that firms will use financial engineering to circumvent debt covenants. By avoiding debt covenants, firms prevent creditors from taking actions to reduce bankruptcy risk and recover their investment, and allow the firm to continue operating for the benefit of equity holders. We find that a Delaware court ruling that imposed fiduciary duties toward creditors led to a decrease in financial engineering and debt-covenant avoidance in Delaware firms. We also show that board quality lowers the probability that firms will avoid covenants only when directors owe a legal fiduciary duty to creditors. Collectively, our results suggest that unless directors are required to protect creditors’ interest, they are likely to take actions to circumvent debt covenants.

Does Fiduciary Duty To Creditors Reduce Debt-Covenant-Avoidance Behavior? – Introduction

Financial reports should provide useful information to creditors, and accounting regulators often revise financial standards to improve the faithful representation of debt. Accounting standards, however, cannot completely curtail financial engineering by firms that wish, for example, to reduce reported debt. Firms can interpret standards or structure transactions to circumvent criteria that classify transactions into debt or equity, in a cat-and-mouse game in which accounting regulators cannot win (Dye et al. 2014). In this paper, we examine the role of corporate governance in restraining reporting opportunism that hurts creditors’ interests. Although the literature shows that high-quality governance decreases the occurrence of fraud and misstatements in financial reports (Dechow et al. 1996; Abbott et al. 2004; Beasley et al. 2000; Agrawal and Chadha 2005), governance may not prevent financial engineering that hurts creditors—at least as long as governance requires managers to maximize shareholders’ value only, a requirement that stems from the asymmetry in fiduciary duties, whereby managers and directors owe fiduciary duties to shareholders and not to debtholders. Further, this asymmetry in fiduciary duties leads managers to maximize equity value even at the expense of debt value, thereby hurting debtholders. These debt-equity value conflicts are mitigated when the law extends the protection of fiduciary duties to include debtholders (Becker and Stromberg 2012). We examine the effect of fiduciary duties on debtequity reporting conflicts, or specifically on firms’ propensity to use financial engineering for debt-covenant avoidance.

Accounting-based covenants in debt contracts create a debt-equity reporting conflict. Debt covenants set limits on leverage and performance, and act as a trip wire allowing creditors to take timely actions to reduce bankruptcy risk and costs. Evidence, however, suggests that managers bias financial reports to avoid violation of debt covenants (e.g., Dichev and Skinner 2002).2 Managers that circumvent covenant violation may undermine creditors’ interests but allow the firm to continue operating and potentially gain positive equity value, and therefore act in line with their fiduciary duty to shareholders.3 We examine whether extending the protection of fiduciary duties to include creditors lowers firms’ propensity to circumvent accounting-based debt covenants.

We use two test approaches to investigate the effect of directors’ fiduciary duties on firms’ propensity to avoid covenant violation. First, we examine the relation between a legal change in fiduciary duties and the likelihood and extent of financial engineering through structured transactions that lower reported debt. Second, we use the covenant slack distribution around zero to test the extent to which firms manipulate financial reports to avoid debt-covenant violation.

Our main research setting is a 1991 Delaware court ruling that changed directors’ fiduciary duties. On December 30, 1991, in the Credit Lyonnais v. Pathe Communications case, the Court of Chancery of Delaware issued a ruling that effectively increased directors’ fiduciary duties to creditors. Historically, the position of US courts was that fiduciary duties are owed strictly to equity holders and not to creditors in solvent firms. The Delaware court, however, ruled in 1991 that when a firm is close to insolvency, directors are not merely the agent of the shareholders, but should consider the interests of creditors as well. The ruling was widely viewed as having created a new obligation for directors of Delaware firms, and evidence suggests that following this ruling, debt-equity conflicts decreased in Delaware firms (Becker and Stromberg 2012) and accounting conservatism increased (Aier et al. 2014; Tan and Wongsunwai 2014; Bens and Huang 2014), especially for firms that were close to

In our first test, we examine the impact of the change in fiduciary duties on the extent and likelihood of issuances of mandatory redeemable preferred shares—preferred shares with a debt-like maturity feature that requires issuers to redeem the invested amount by a specific future date. Prior to SFAS 150 (issued in 2003), these structured debt securities were not reported as a liability, and firms used them to lower their reported leverage and circumvent debt covenants put in place by creditors (e.g., Engel et al. 1999; Moser et al. 2011; Levi and Segal 2014).

Using a difference-in-differences analysis around the 1991 ruling, we find that Delaware firms that were close to insolvency reduced structured debt issuances after 1991. Delaware firms that were not close to insolvency, as well as firms not domiciled in Delaware, did not experience a similar change in structured debt issuance around 1991. The results suggest that when managers and directors owe legal fiduciary duty to creditors, they are less likely to use structured debt transactions that lower reported leverage and circumvent debt covenants.5 These results are consistent with our conjecture that unless required by law to protect creditors’ interests, directors may take actions that harm creditors’ interests.

Debt-Covenant-Avoidance Behavior, Fiduciary Duty, Creditors

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