The technology of creditor protection.

• Author: Adler, Barry E.

Contract is the primary means through which creditors control a firm's debt-equity conflict. There is an irony here, however. Actions that may render a debtor insolvent are the events against which creditors contract. Yet when a breach of contract yields a debtor's insolvency, the debtor cannot fully satisfy its creditors. Thus, a general creditor's contractual remedy against a debtor cannot be fully effective, and anticipation of this shortcoming may increase a debtor's cost of capital. A solution to this conundrum, proposed here, would permit creditors and debtors to contract for creditor remedies against third parties--other creditors, shareholders, and corporate affiliates--who may have benefitted from a debtor's breach, provided that the creditor gave actual or constructive notice of its right to seek such remedies. This solution would offer creditors protection akin to that now afforded contractually through secured credit and now afforded by legal rule through the laws of voidable preference and fraudulent conveyance. Because the proposed protection would be contractually based, it could be tailored to the needs of individual firms and could thus improve, and to some extent obviate the need for, the protections now provided by law.

INTRODUCTION I. TYPOLOGY OF CREDITOR PROTECTION II. THE PROMISE AND LIMITS OF CONTRACTUAL CREDITOR PROTECTION III. REMEDIES AGAINST THIRD PARTIES A. Remedies Against Directors and Officers B. Remedies Against Shareholders and Corporate Affiliates C. Remedies Against Other Creditors IV. LEGAL RULES IN THE AID OF CONTRACTS: A PROPOSAL FOR LEGAL RULES THAT CREATE OPTIONAL THIRD-PARTY REMEDIES FOR CREDITORS A. Remedies Against Other Creditors B. Remedies Against Shareholders and Corporate Affiliates C. Short-Term and Nonfinancial Creditors V. OUR PROPOSED REMEDIES AND EXISTING LAW CONCLUSION INTRODUCTION

Almost four decades ago, Michael Jensen and William Meckling wrote Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, which sets out to combine "elements from the theory of agency, the theory of property rights and the theory of finance to develop a theory of the ownership structure of the firm." (1) They focused on dueling conflicts among a firm's constituents: on the one hand, conflict between a firm's investors and its managers; and on the other, conflict between a firm's debtholders and its shareholders. Debt itself serves as a tool to control the investor-manager conflict but also generates a new conflict, between shareholders and creditors. Whenever ownership and control are separated, agency costs cannot be wholly eliminated, but they can be minimized. Since the publication of Jensen and Meckling's seminal article, there has been an evolution in the theory of how to accomplish such minimization.

As one of us has argued in earlier work, (2) the agency costs between a firm's shareholders and its managers have recently declined. Reasons for the decline include the greater use of incentive compensation, the growth and increased activism of institutional shareholders, the rise of hedge funds, regulatory changes, and the increased independence of outside directors. (3) Where debt persists despite the reduction in equity agency costs, such reduction increases the relative importance of the relationship between a firm's creditors and its managers, a relationship that encompasses the conflict between a firm's creditors and its shareholders to the extent that managers represent shareholders. (4)

As we discuss below, financial creditors rely principally on contracts to protect their interests, though legally supplied rights offer some additional protections. We generally favor this reliance on contractual rights and, with one important exception, we are skeptical about the need and desirability of additional legal protections for financial creditors. The exception, and this Article's central theme, is this: where a creditor does achieve contractual protection against exploitation, the terms of such protection should, subject to some limits, be enforceable against third parties.

By endorsing contractual remedies that run against third parties--those who are not parties to the contract at issue--our proposal is conceptually related to the literature on property rights. (5) Like the remedies we are proposing, property rights do not require the assent of all those against whom such rights are asserted.

The legal reform recommended here expands and elaborates on a suggestion made by one of us that a firm's public pledge to abjure debt should be enforceable against subsequent creditors that obtain an interest in violation of such pledge. (6) In this Article, we apply the intuition behind this proposal to a wider set of contractual terms; we also root the proposal in a more general theory of contract and property rights and integrate it into a theory of agency cost and firm ownership.

1. TYPOLOGY OF CREDITOR PROTECTION

   In examining the regime of creditor protection, one can distinguish types of creditor protection along two dimensions. The first dimension relates to the person in whom incentives are imbued or against whom remedies are imposed. The second dimension relates to the source and scope of these incentives and remedies.

   Regarding the person, most basically, it is the debtor that can be motivated or obligated to perform. When a debtor incurs an obligation, it has reputational and other incentives to fulfill that obligation. And if these incentives are insufficient, the debtor's legal obligation means that a creditor may enforce compliance to the extent the debtor is able to comply. These incentives do not always ensure that a debtor will perform on all of its promises. For example, the Argentine Republic has refused to pay some of its sovereign debt obligations while it continues to pay others. Its incentive to repay proved insufficient and, against sovereign debtors, a party's means of enforcement are limited. (7) Nevertheless, a creditor's reliance on performance by or recovery from a debtor is central to creditor protection.

   In addition to the debtor itself, incentives can be instilled in--or remedies imposed on--a number of other persons: subsidiaries of the debtor, shareholders of the debtor as well as entities owned by these shareholders, directors and officers of the debtor, and certain other creditors of the debtor. (8) These other persons can be influenced in their individual capacities, and not just as persons that have an interest in or control over the debtor. Examples of devices bearing on these other persons are parent and subsidiary guarantees, which make the guarantor liable for the debt of the principal obligor; the doctrine of veil piercing, which can make a shareholder liable for the debts of a company she controls; and the bankruptcy provisions governing preferences and equitable subordination, which provide for the return of certain payments made to creditors and the subordination of certain debts, respectively, in each case for the benefit of other creditors. These devices can serve a creditor's interest by helping deter a breach of contract in the first place (such as where a guarantor in control of a debtor induces the debtor to repay rather than default on a loan) or by compensating a creditor after a breach (such as where the guarantor pays after a debtor's default).

   The second dimension of creditor protection, regarding the source and scope of incentives and remedies, can be provided through two mechanisms: legal rules and contracts with creditors. Legal rules that provide incentives and remedies include, in addition to those mentioned above, rules on fraudulent conveyance law and lender liability as well as legal capital rules and fiduciary duties to creditors. Contractually supplied incentives and remedies include, among other provisions typically found in debt agreements, provisions on maturity and default interest, financial ratio covenants, restrictions on the issuance of additional or secured debt, restrictions on the payment of dividends, change of control provisions, and agreements to subordinate some debts to other debts. (9)

   It is worth noting that these creditor-protection incentives and remedies operate against a background of other fundamental structures. Of these, first and foremost is the shareholders' economic interest in the firm. Such interest engenders in the shareholders an incentive to create firm value and to provide corresponding incentives for officers and directors to create such value. Although the interests of shareholders and those of creditors sometimes conflict, and while such conflict is the subject of our discussion below, it is important not to forget that shareholder and creditor interests are broadly aligned with respect to a wide set of decisions: both shareholders and creditors want the company to be well run and profitable.

   In the United States, contractual provisions are the most significant component of the creditor-protection regime. These are supplemented by the legal rules identified above and, in some cases, described more fully below.

2. THE PROMISE AND LIMITS OF CONTRACTUAL CREDITOR PROTECTION

   In our view, it is sensible that creditors in the United States rely on contracts instead of legal rules for protection. Contractual protections have some general advantages over legal rules. Contracts afford the parties the ability to determine for themselves the terms that will govern their relationship and enable different debtors and different creditors to agree on different terms. Moreover, contracts can be changed more easily than laws as circumstances change. This is especially true for contracts with finite duration, such as contracts with creditors. Even if these contracts cannot be easily amended, they expire at some point, and debtors and creditors enter into new contracts to govern their relationship. (10)

   These arguments are especially forceful in the context of the...