Does fiduciary duty to creditors reduce debt-covenant-violation avoidance behavior?

Forthcoming in Journal of Business Finance & Accounting

47 Pages Posted: 28 Jun 2016 Last revised: 1 Oct 2021

See all articles by Shai Levi

Shai Levi

Tel Aviv University

Benjamin Segal

Fordham University; Hebrew University of Jerusalem

Dan Segal

Reichman University

Date Written: September 26, 2020

Abstract

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.

Keywords: Debt Structuring, Director Fiduciary Duties, Board Independence

JEL Classification: G32, G34, M41, K22

Suggested Citation

Levi, Shai and Segal, Benjamin and Segal, Dan, Does fiduciary duty to creditors reduce debt-covenant-violation avoidance behavior? (September 26, 2020). Forthcoming in Journal of Business Finance & Accounting, Available at SSRN: https://ssrn.com/abstract=2800724 or http://dx.doi.org/10.2139/ssrn.2800724

Shai Levi

Tel Aviv University ( email )

Tel Aviv, 69978
Israel

Benjamin Segal

Fordham University ( email )

113 West 60th Street
New York, NY 10023
United States

Hebrew University of Jerusalem

Dan Segal (Contact Author)

Reichman University ( email )

P.O. Box 167
Herzliya, 4610101
Israel

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