Directors' Duty to Creditors and the Debt Contract

Journal of Business & Technology Law, Vol. 1, No. 2, p. 553, 2007

54 Pages Posted: 22 Jan 2008

See all articles by Simone M. Sepe

Simone M. Sepe

University of Arizona - James E. Rogers College of Law; University of Toulouse 1 - Université Toulouse 1 Capitole; Toulouse School of Economics; European Corporate Governance Institute (ECGI)

Abstract

Under the current model of corporate fiduciary law, informational asymmetry between managers and creditors makes the debt contract inadequate to efficiently govern the debtor-creditor relationship. More specifically, as currently devised, the debt contract fails to prevent managerial opportunism, that is, the managers' tendency to increase the investment's risk ex post. Anticipating this contract's failure,creditors ask for higher interest rates. Moreover, because of the scarcity of credible information, they tend to pool firms in general risk categories and price debt on the basis of the average risk increase pursued within each category. As a result, social costs arise and credit capital is inefficiently allocated.

A governance model providing for a permissive regime of directors' duty to creditors and a rule of textualist interpretation of the debt contract are the legal tools I propose to attempt to redress the existing contractual inefficiency. By sanctioning directors with personal liability for increasing the level of risk contractually accepted by creditors, the proposed duty would serve: (i) as a bonding mechanism to induce directors to fulfill the contract and refrain from managerial opportunism; and (ii) to make the debt contract a credible signal on corporate risk. Paired to the duty's existence, the adoption of a textualist interpretative rule, which mandates to consider accepted by creditors any risk they have not contractually excluded or limited, would (i) give both parties the right incentives to write more state-contingent contracts; and (ii) reduce uncertainty in legal relationships by ruling out the possibility of ex post completion of the contract (and of the duty itself) by the third adjudicator. Ultimately, the model I propose aims at achieving a two-fold purpose. On the one hand, it attempts to make the credit market better able to price debt on the basis of firms' specific risks, i.e., to move the market from the existing pooling equilibrium to separating equilibria. On the other, it aims at enabling parties to contract so as to maximize the ex ante value of their exchanges.

Keywords: corporate governance, fiduciary duties, incomplete contracts, contract theory, covenants

JEL Classification: K0, K12, K22

Suggested Citation

Sepe, Simone M., Directors' Duty to Creditors and the Debt Contract. Journal of Business & Technology Law, Vol. 1, No. 2, p. 553, 2007. Available at SSRN: https://ssrn.com/abstract=1086139

Simone M. Sepe (Contact Author)

University of Arizona - James E. Rogers College of Law ( email )

P.O. Box 210176
Tucson, AZ 85721-0176
United States

University of Toulouse 1 - Université Toulouse 1 Capitole ( email )

2 Rue du Doyen-Gabriel-Marty
Toulouse, 31042
France

Toulouse School of Economics ( email )

21 allée de Brienne
31015 Toulouse Cedex 6
Toulouse Cedex, F-31042
France

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

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