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, 2020, Forthcoming
47 Pages Posted: 11 Aug 2017 Last revised: 7 May 2020
Date Written: October 12, 2017
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: Suggested Citation