INVESTOR PRIMACY

Abstract

This Article contends that managers have a fiduciary obligation to maximize free cash flow, and not shareholder wealth: managers owe a fiduciary duty to all investors, and not just shareholders.  Three rationales are provided for this more expansive view of the scope of corporate fiduciary duties: (1) lowers agency costs between management and the firm, (2) lowers agency costs between investors, and (3) reduces legal uncertainty.   In setting forth this claim, this Article pushes back against a contractarian approach to corporate law, asserting that loan contracts are almost always incomplete and that courts should be more willing to use fiduciary duties, which define, and lie at the very heart of corporate law, as untailored default rules to protect the best interests of corporate debtholders.   

In support of this claim, two types of firms are defined: (1) shareholder-controlled firms, and (2) debtholder-controlled firms.  This Article shows that a shareholder-controlled firm maximizes enterprise value except when the firm is in financial distress, in which case the two types of investment distortions that can arise are: (a) excessive risk-taking, and (b) under-investment.  Likewise, it is shown that a debtholder-controlled firm also maximizes enterprise value except when the firm is under financial distress, in which case the two types of investment distortions that can arise are: (a) insufficient risk-taking, and (b) over-investment.  This Article contends that the agency costs of debtholder control are likely to exceed the agency costs of shareholder control for low probabilities of default on corporate debt, whereas the agency costs of shareholder control are likely to exceed the agency costs of debtholder control for relatively high probabilities of default.  The “zone of insolvency,” which corresponds to a period before insolvency where some courts (outside of Delaware) have held that corporate managers owe a fiduciary duty to creditors, is defined as the range of default probabilities where the agency costs of shareholder control exceed the agency costs of debtholder control.  This definition is new to the existing literature on corporate insolvency and improves upon existing approaches that rely upon arbitrarily chosen default probabilities to demarcate the zone of insolvency, with no theoretical justification provided for how particular values are to be selected. 

Keywords: Corporate Law, Fiduciary Duty, Corporate Purpose, Corporate Governance, Zone of Insolvency, Agency Costs, Creditor Rights

JEL Classification: G33, G34, K22