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I.
INTRODUCTION
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greater protection. Specifically, directors and officers should bear fiduciary duties to bondholders, and bondholdersshould be given standing
to bring derivative suits. These argumentsnaturallystress the economic
similaritybetween debtholdersand equityholdersratherthan the difference in theirlegal status and assert that corporatelaw shouldtreat similar
economic actors alike.2
While this line of argumentcarries superficialappeal, careful analysis
of both the economic nature of debtholdingand equityholdingand the
legal apparatusgoverningthe manager-investorrelationship-such as the
fiduciaryprinciple-suggests differentsolutionsto the problem.This article will contrast the economic nature of debtholdingwith that of equityholding and will offer an analytical frameworkfor the desirable legal
treatmentof debtholdersand equityholdersin publiclyheld business corporations. Section II reviews and identifiesthe economic natureof debtholdingand equityholding.Section III analyzes currentlaw dealingwith
debtholdersand equityholders.The discussionfocuses on three rules that
appearpuzzlingand shows that currentlaw more or less correctlyreflects
ex ante hypotheticalbargainsamong the participants.Section IV examines normativeissues such as the desirabilityof imposingfiduciaryduties
to debtholderson corporatemanagers.While contractualprotectionsare
sometimes insufficientas means of protectingdebtholders,I argue that
directorsand officers should owe fudiciaryduties only to common equityholders. Creatinga fiduciaryrelationshipbetween managersand debtholders or even between managers and preferredequityholderswould
producenew problemsratherthan solve existing ones.
II.
insurance premium for covering the risk of loss illustrated in the example.
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conductingbusiness with outsiders.7To the extent that the debtorcorporation obtains more funds from a variety of sources and is given more
business opportunities,the insufficientrisk taking problembecomes exacerbated simply because monitoringthe manager's conduct becomes
more difficultand costly. Debtholdersdo not care about this problemso
long as their fixed claims are safe.
The discussion above shows that debtholders and equityholdersare
similarin the sense that they can suffer economic loss if their company
attempts to obtain additionalfunds.8 The economic nature of the risk
these two types of investors face, however, is different.The purpose of
the manager-equityholdercontract is simple: the best gambling.But the
purpose of the manager-debtholdercontract is complex. One might be
temptedto say that debtholderswant to be "safe" with theirfixed claims.
This, however, is not accurate. Debtholders want safety after the debt
contract is signed under specific terms and conditions. More precisely,
the extent to which they want safety dependson the terms and conditions
written in the debt contract. Some debtholdersmightagree to futurerisk
taking in the debtor's business in exchange for a high interest, while
other debtholders might view such risk taking as nonbargained-forrisk
alteration.In short, debtholdingallows debtholdersto write tailor-made
terms and conditions as a response to the sharing and risk-alteration
problems. A single and uniformpurpose does not exist in the managerdebtholdercontract.9This suggests that legal rules designedto "protect"
debtholders, if necessary, must be differentlystructuredthan those for
equityholders.
III.
This section examines three rules under currentlaw that are relevant
to the problemsdescribed in Section II.1' The analysis is limited to pub7 I assume that overt misbehavior such as fund stealing is effectively deterred by the
legal system.
8 The discussion in the text focuses on additional borrowing. A similar analysis can be
applied when the company attempts to restructure its capital.
9 Even where market conditions do not change, different creditors normally charge different interests to the debtor. One can make two observations regarding this fact. One is that
creditors are all risk neutral or otherwise have the same risk taste and either lack of information or informational asymmetries cause them to charge different interests. The other is
that creditors have different tastes and attitudes toward the debtor's venture. Both observations are plausible. As I will discuss below, the current legal rules are consistent with either
or both observations.
0oThis article does not discuss "general" legal rules-such as fraudulent-conveyance
law and dividend restrictions in corporate law-protecting a corporation's creditors as
applied to the sharing and risk-alteration problems. Excluding such a discussion is a some-
436
licly held business corporations.First, while preferredequity is permitted, preferreddebt is not. Second, while new equity must be issued at a
price that is "fair" to the existing equityholders,no equivalentrule exists
for new borrowing.Third,managersowe fiduciaryduties to equityholders
but not to debtholders. Equityholders are normally given standing to
bring derivative suits against managers,but debtholdersare not. Debtholders are given no protection unless they put provisions in the debt
contract," whereas equityholdersare given many protectionsby corporate law even if they are silent in their contractingand some of these
protectionsare, as discussed below, mandatoryand cannotbe contracted
out. Economists normallytake these rules as given, and lawyers seldom
ask why these rules exist. Yet they are puzzlingeven at firstglance. Why
has the law evolved these specific rules to govern the rights of debtholders and equityholders?
A.
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438
439
to issue new debt at any price, unless otherwise agreed in the contract
for existing debt.24Given that equal rankingof unsecuredcreditorsis the
baseline rule, why does the law not offer, as it does for equity, another
baseline rule that restricts the issuance of new debt at a lower price than
the fair market value of the existing debt? Such a rule would eliminate
the sharingproblem.
Again, the economic natureof debtholdingoffers an answer. Inasmuch
as debtholdersface the risk-alterationproblem,they attemptto deal with
this risk in a variety of ways.25They may want to charge higherinterests
to compensatethemselves for the risk. They may want to create security
interests by taking the debtor's certain assets as collateral. In other
words, debtholders make different commitmentstoward the risk-alteration problem. They are not like equityholderswho, as residual claimants, do not face the risk-alterationproblemand rely on the efficientstock
market with concerns about the nature of the best gambling in the
venture. 26
440
C.
protection rule to debtholders with respect to subsequent changes of the debt contract
terms: all debtholders must give consent for such a change unless otherwise agreed in
advance.
28 In addition, debtholders can choose the length of their commitment. They also can
diversify the risk they face. See note 26 supra.
When a corporation issues debt securities, the trust indenture contains the terms of the
debt for multiple debtholders. The Trust Indenture Act of 1939, 15 U.S.C. ?? 77aaa et
seq., requires that public issuance of debt securities be generally contracted through trust
indenture and have an indenture trustee.
29 For the distinctive attributes of the
fiduciary principle in corporate law, see Robert C.
Clark, Agency Costs versus Fiduciary Duties, in Principals and Agents: The Structure of
Business 55, 71-76 (John W. Pratt & Richard J. Zeckhauser eds. 1985). "Fiduciary law is
stricter on fiduciaries than contract law is on ordinary contracting parties in at least four
441
A related question is whether equityholdersshould be permittedfreedom to contract out the rules suppliedby corporatelaw. Indeed, corporate law normally permits the creation of different classes of equity if
the terms are clearly identifiedin the charter or elsewhere.31And, not
surprisingly,some argue that corporatelaw should permit stockholders
to change completely the fiduciary principle governing the managerstockholderrelationship,32while others argue against allowing this contractualfreedom.33Debtholdersare protected by the default rule, which
requiresunanimousconsent of the debtholdersto changesof the contracfundamental respects. There are stricter rules about disclosure, more open-ended duties to
act, tighter delineations of rights to compensation and to benefits that could flow from one's
position, and more intrusive normative rhetoric. These elements of strictness do not arise
from actual contracts but have been created by judges in the common law tradition." Id.
at 76.
30 Fiduciary rules in corporate law can be viewed as a legal apparatus to deter abuse of
managerial discretion. See Clark, id. at 77. See also Tamar Frankel, Fiduciary Law, 71 Cal.
L. Rev. 795 (1983) (discussion in wider contexts involving fiduciaries); and Alison Grey
Anderson, Conflicts of Interest: Efficiency, Fairness, and Corporate Structure, 25 UCLA L.
Rev. 738, 793 (1976) ("some compromise must be reached between [managerial] unlimited
discretion and overly rigid rules [to restrict such discretion]"). Equityholders surely do not
want abuse of managerial discretion, but they do want the best gambling. The fiduciary
principle enables them, though not perfectly, to monitor and enforce this best-gambling
promise. Compare Charles J. Goetz & Robert E. Scott, Principles of Relational Contracts,
67 Va. L. Rev. 1089 (1981) (discussion on "best-efforts" clauses in relational contracts).
31 See, for example, Revised Model Corporation Act
?? 6.01, 6.02.
32 Richard A. Posner, Economic
Analysis of Law 390 (3d ed. 1986); Frank H. Easterbrook
& Daniel R. Fischel, Corporate Control Transactions, 91 Yale L. J. 698 (1982); Frank H.
Easterbrook & Daniel R. Fischel, Voting in Corporate Law, 26 J. Law & Econ. 395 (1983);
Frank H. Easterbrook & Daniel R. Fischel, The Corporate Contract, 89 Colum. L. Rev.
1416 (1989).
33 See, for example, Lucian Arye Bebchuk, Limiting Contractual Freedom in Corporate
Law: The Desirable Constraints on Charter Amendments, 102 Harv. L. Rev. 1820 (1989).
For a survey of the debate, see Lucian Arye Bebchuk, Foreward: The Debate on Contractual Freedom in Corporate Law, 89 Colum. L. Rev. 1395 (1989).
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444
41
445
446
D.
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CONCLUSION
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