Does Fiduciary Duty to Creditors Reduce Debt-Covenant-Violation Avoidance Behavior?

42 Pages Posted: 23 May 2014 Last revised: 23 Nov 2017

See all articles by Shai Levi

Shai Levi

Tel Aviv University

Benjamin Segal

Fordham University; Hebrew University of Jerusalem

Dan Segal

Interdisciplinary Center (IDC) Herzliyah

Multiple version iconThere are 2 versions of this paper

Date Written: November 22, 2017

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 violation, 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’ violation 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? (November 22, 2017). Available at SSRN: https://ssrn.com/abstract=2439728 or http://dx.doi.org/10.2139/ssrn.2439728

Shai Levi (Contact Author)

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

Interdisciplinary Center (IDC) Herzliyah ( email )

P.O. Box 167
Herzliya, 46150
Israel

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