Fiduciary duties

Question 1

What about is the article

Answer 1

This paper uses the novel approach (natural experiment) of 1991 Delaware bankruptcy verdict that ruled that “when a firm is not insolvent, but in the “zone of insolvency”, duties may already be owed to creditors”.

Question 2

 Fiduciary duties

Answer 2

Duties of managers that require them to take actions in shareholders’ interest.

Question 3

Debt-equity conflicts that authors examine

Answer 3

o Debt overhang problem
o Risk-shifting problem
o Contractual protection

Question 4

Debt overhang problem

Answer 4

When a firm is highly leveraged and debt is risky, equityholders have a disincentive to raise new capital to invest in projects that would make the debt safer, even if these projects have positive net present value. This is due to the fact that part of the value of investment would go to creditors

Question 5

Risk-shifting problem

Answer 5

Equity holders have an incentive to increase the riskiness of the firm’s existing assets, even in some cases when this would reduce the value of the firm. This is because the benefits of higher risks got to equityholders, thanks to their limited liability, whereas the costs are primarily borne by creditors.

Question 6

Contractual protection

Answer 6

Credit Lyonnais gave creditors more power, especially contractual protection through covenants.

Question 7

 Findings after the ruling took place in Delaware

Answer 7

o Delaware companies more likely to issue equity
o Financial and operational risk was reduced
o Debt covenants have become less popular
o Equity valuation increased- reducing conflicts creates value & increases welfare
o Equity issue ↑
o No change in dividends/repurchases- possibly due to existing debt contracts
o Investment increased =≻ debt-overhang matters

Question 8

Conclusion

Answer 8

They conclude that firms in distress sometimes have an incentive to undertake actions that hurt debt and favor equity, as predicted by some influential theories of corporate capital structure. There are financial distresses costs that decrease firm value and that are borne by shareholders. Also, equity-bond holders’ conflicts are economically important, determine capital structures and affect welfare.
If debtholders are more protected the firm will be less willing to take up a high level of leverage.