Exploring the limits of contract design in debt financing.

• Author: Triantis, George G.
• Position: Response to articles in this issue, p. 1773 and 1907

In response to Barry E. Adler & Marcel Kahan, The Technology of Creditor Protection, 161 U. PA. L. REV. 1773 (2013) and Edward B. Rock, Adapting to the New Shareholder-Centric Reality, 161 U. PA. L. REV. 1907 (2013).

INTRODUCTION I. INCOMPLETE CONTRACTS AND MANDATORY LEGAL STANDARDS II. CONTRACT REMEDIES, THIRD PARTIES, AND PROPERTY RIGHTS III. COVENANT-LITE DEBT CONCLUSION INTRODUCTION

Two Articles in this issue, one by Professor Rock (1) and the other by Professors Adler and Kahan, (2) draw renewed attention to the contracting challenges raised by debt financing. The occasion for revisiting the agency costs of debt, according to Professor Rock, is the successful alignment of the interests of shareholders and corporate managers over the past thirty years. (3) This alignment has been achieved by a combination of contract, market, and legal measures (such as changes in compensation structure, shareholder concentration and activism, and board ideology). (4) As a result of these developments, Professor Rock observes that "managers and directors today largely 'think like shareholders.'" (5)

All investors, including creditors, benefit from the correction of inefficient incentives that lead managers to entrench themselves, build conglomerate empires, and shirk or consume perquisites. Other stakeholders such as employees, suppliers, and customers also benefit from such correction. However, the convergence of managerial and equity interests threatens to increase the agency costs of debt because debtholder and shareholder interests diverge in other respects. Most notably, as faithful agents of their shareholders, managers are more likely to (a) forego lower-risk, profitable projects ("underinvestment"); (b) invest in higher-risk, unprofitable alternatives ("overinvestment" or "risk alteration"); (c) incur additional debt to further leverage the equity in the firm; and (d) distribute firm value to shareholders in the form of dividends or share repurchases.

Professor Rock suggests that the negative externality of shareholder-centrism has been aggravated by the significant and contemporaneous increase in corporate leveraging. (6) The proposition that leveraging increased while the agency problems of debt became more severe is puzzling. To act in their shareholders' best interests, however, managers should borrow up to the point at which the marginal cost of further debt financing equals that of equity financing. The benefits of debt financing include the discipline imposed on managers by regular mandatory payments of free cash flow and the tax deduction from interest payments, while the costs stem from the resulting increase in the likelihood of bankruptcy and the agency costs of debt. The debt investors bear these costs and, to the extent they are informed, will compel the shareholders to internalize those costs. If the agency costs of debt truly have risen during the past three decades, what then explains the contemporaneous increase in corporate leveraging over that period?

While it is possible that the bankruptcy costs of debt have decreased or that the tax benefits have increased over this period, another possibility more germane to this Response is that the quality of debtholder contracts has improved as borrowing has increased. To the extent that debt investors price agency costs, a firm can lower its cost of capital by reducing the inefficiencies of debtor-creditor conflict. Empirical studies show that contractual covenants are indeed priced by debt investors, giving borrowers incentives to agree to them. (7)

The mechanisms of debtholder governance have been subject to substantial examination in both law and finance scholarship. The literature reveals that covenants play important roles in mitigating the agency costs of debt and adverse selection. (8) Professor Rock's and Professors Adler and Kahan's Articles in this issue contribute to this body of literature by focusing on the limitations of the existing technology of contractual protections and proposing reforms of the governing legal rules to address these limitations. (9)

Although debt contracts offer significant protection to debtholders, the extent to which debt contracts mitigate agency problems might be limited by three features raised by Professors Rock and Professors Adler and Kahan. First, specifying and enforcing optimal protective covenants is costly, and the costs of some conceivable protections exceed the benefits. Second, contract law limits the parties' ability to provide for effective remedies for breaches of those covenants, particularly against third parties who either have control of, or benefit from, those breaches. Third, the parties may sometimes omit even covenants whose benefits outweigh their costs because of imbalances in market conditions or bargaining power; one example might be the period of covenant-lite bonds preceding the financial crisis of 2007. Professor Rock and Professors Adler and Kahan propose legal reforms to address these limitations, including (a) extending mandatory, legally imposed standards such as fiduciary duties and the duty of good faith; and (b) expanding contract remedies to allow enforcement of contract covenants against third parties. As discussed below, the available technology for debt contracting is more potent than it may appear and the incremental gains from the authors' proposals are probably not worth the costs. Part I explains that the typical remedy contracted for by lenders is the right to terminate and assume greater control of the debtor's decisionmaking. This is a distinctive and effective remedy that contrasts with the usual contract remedy of expectation damages; indeed, debt contracts do not provide for such damages. Part II suggests that the existing combination of debt covenants and security interests can achieve much of what Professors Adler and Kahan are seeking without the social cost of imposing greater information burdens on creditors. For example, the ability of managers of a firm to engage in either massive borrowing or a leveraged buyout will be constrained if the firm has given most of its assets as collateral for a prior loan. Part III begins to tackle the more puzzling phenomenon raised by the authors' examples: debt contracts sometimes do not incorporate the available technology and are both unsecured and light on covenants. Although the omissions might be the result of market failure, they may alternatively be efficient responses to changing market conditions.

1. INCOMPLETE CONTRACTS AND MANDATORY LEGAL STANDARDS

   The academic discipline of contract theory is founded on the observation that many contracts are incomplete because transaction costs prevent parties from providing for the efficient set of obligations in each possible future state of the world. Consequently, parties are relegated to choosing second-best tools of contract design. To illustrate in the context of a debt contract, suppose that Project A is the value-maximizing alternative in state i, while Project B is the value-maximizing alternative in state j. The optimal complete contingent contract would oblige the firm to invest in the efficient project in each respective state of the world. However, providing in this respect for each possible future state of the world is costly--both at the front end of contract design and at the back end of enforcement. At the front end, parties must contemplate and define each relevant state of the world, and they must agree to and specify the contingently optimal investment for each state. At the back end, they must monitor and observe the debtor's actions and, if necessary, verify performance or breach during the enforcement proceedings in court. The front- and back-end cost of providing for different obligations in states i and j may outweigh the incremental gains. Therefore, it may be more efficient to lump the two states together, by requiring, for example, Project A (or prohibiting project B) in both states. In a debt contract, the parties might prohibit sales of assets in bulk, mergers, or future borrowing, rather than incur the contracting costs of specifying the conditions under which such sales, mergers, or borrowing are permitted. In practice, then, most covenants are either under- or overinclusive in proscribing undesirable behavior, and this incompleteness leaves behind residual agency costs.

   Contract design is fundamentally an exercise in minimizing these residual costs. The technology of contract design is quite rich, allowing parties significant flexibility to tailor their contracts to their circumstances. (10) Two important mechanisms in the toolkit for reducing agency costs are (1) the use of standards (as opposed to rules) and (2) contingent control rights and renegotiation.

   The first mechanism, the use of standards, invites the court to determine ex post whether the firm's decisions met the expectations of the parties--for example, whether the decision was reasonable given the realized state of the world. Performance standards, such as obligations of good faith, best efforts, and due diligence, convey this discretion to the court. These standards can be effective tools if the reason for contract incompleteness is the cost of specifying the optimal project in each state of the world. While performance standards save front-end negotiating and drafting costs, they also raise back-end enforcement costs, especially the costs of litigation and judicial error in applying the standard. In some cases, this trade is advantageous, especially if the probability of going to court is low. However, if the obstacle to contract completeness is the high cost of litigation and judicial error in verifying the existing state or the efficient project in that state, then the case for a standard is more controversial and complicated, (11) Indeed, a key reason that many commentators oppose the broadening of fiduciary duties or weakening of the business judgment or good...