Lender Control Liability Functional Examination: The Firm and Heuristics
39 Pages Posted: 29 May 2008
Date Written: May 28, 2008
Control is one of the most important and commonly used concepts in corporate governance and difficult to define. Some legal scholars in the United States have recently argued that control does shift to creditors in distressed firms and that such shift is indeed beneficial from an efficiency standpoint, which contrasts the recent United Kingdom.
I consider some implications of allocating control to a lender. Drawing inferences from the literature on the theory of the firm, I uncover the existence of lender control costs beyond conflict of interests due to claimholders with priority differences. The priority differencesý cosmology stems from a view of the firm as composed by explicit contracts. Breaking away from that paradigm allows us to identify other sources of lender control costs not tied to priority differences between classes of claimholders.
In addition, I argue that broadening the definition of the firm sheds light on the role of lender control and functionally related theories (i.e. equitable subordination) of liability. These theories had been criticized by academics and practitioners alike due to the dire consequences they pose on lending, while their role has been dwarfing. In particular, widening the definition of the theory of the firm allows us to visualize that lender control liability should serve to penalize self-serving behavior which runs counter to the optimal use of the assets.
Finally, I discuss the strict nature of lender control liability and its relation to cognitive errors. The ordinary understanding is that lender control triggers harmful strict lender liability. Therefore, lender control liability should be heavily limited or even suppressed so that the efficient lending is not precluded. I argue that the strict nature of lender control liability may avoid inefficiencies deriving from hindsight bias, but that hindsight is not the only cognitive error distorting adjudicators. A closer look at anchoringýs role in damage assessments, permits to refocus policy recommendations and help explain the shortcomings of strict liability in this context.
Keywords: Control, reorganization, bankruptcy, heuristics, lender liability, theory of the firm
JEL Classification: K29
Suggested Citation: Suggested Citation