Does Fiduciary Duty to Creditors Reduce Debt-Covenant-Violation Avoidance Behavior?
42 Pages Posted: 23 May 2014 Last revised: 3 Nov 2021
Date Written: November 22, 2017
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: Suggested Citation