Distress-Triggered Liabilities and the Agency Costs of Debt

Draft chapter accepted for publication by Edward Elgar Publishing in Research Handbook on Corporate Bankruptcy Law, edited by Barry Adler, 2018, Forthcoming

Fordham Law Legal Studies Research Paper No. 3015977

47 Pages Posted: 11 Aug 2017 Last revised: 14 Oct 2017

See all articles by Richard Squire

Richard Squire

Fordham University School of Law

Date Written: October 12, 2017

Abstract

This chapter discusses distress-triggered liabilities: contingent obligations of a corporate debtor that are likely to be triggered by the debtor’s own financial distress. Three common examples of such liabilities are loan default penalties, loan prepayment fees such as make-whole premiums, and intragroup guarantees. Because the risk that a distress-triggered liability will become payable correlates positively with the debtor’s insolvency risk, the incurring of the liability shifts expected losses onto the debtor’s general creditors. The result is an incentive-distorting value transfer from creditors to shareholders that generates the agency costs of debt. Bankruptcy courts could prevent these costs by subordinating distress-triggered claims to general creditor claims. Subordination would preserve the positive economic functions of distress-triggered claims, which in most instances require only that the claims be enforceable to the extent the debtor is solvent. A subordination rule would be consistent with both the purpose and the text of the Bankruptcy Code.

Keywords: Bankruptcy, corporations, make-whole premiums, agency costs of debt, default penalties

JEL Classification: K22, G33

Suggested Citation

Squire, Richard C., Distress-Triggered Liabilities and the Agency Costs of Debt (October 12, 2017). Draft chapter accepted for publication by Edward Elgar Publishing in Research Handbook on Corporate Bankruptcy Law, edited by Barry Adler, 2018, Forthcoming; Fordham Law Legal Studies Research Paper No. 3015977. Available at SSRN: https://ssrn.com/abstract=3015977 or http://dx.doi.org/10.2139/ssrn.3015977

Richard C. Squire (Contact Author)

Fordham University School of Law ( email )

150 West 62nd Street
New York, NY 10023
United States
212-964-1584 (Phone)

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