Equity-Debtholder Conflicts and Capital Structure
30 Pages Posted: 17 Mar 2010
Date Written: February 17, 2010
We use an important legal event as a natural experiment to examine equity-debt conflicts in the vicinity of financial distress. A 1991 Delaware bankruptcy ruling changed the nature of corporate directors’ fiduciary duties in that state. This change limited incentives to take actions favoring equity over debt. We show that, as predicted, this increased the likelihood of equity issues, increased investment, and reduced risk taking. The changes are isolated to indebted firms (where the legal change applied). These reductions in agency costs were followed by an increase in average leverage and a reduction in interest costs. Finally, we can estimate the welfare implications of agency costs, because firm values increased when the rules were introduced. We conclude that equity-bond holder conflicts are economically important, determine capital structure choices, and affect welfare.
Keywords: Bankruptcy, Costs of Financial Distress, Capital Structure
JEL Classification: G32, G33, L2
Suggested Citation: Suggested Citation