The University of Chicago

The University of Chicago Law School

Debtholders and Equityholders

Author(s): Hideki Kanda
Source: The Journal of Legal Studies, Vol. 21, No. 2 (Jun., 1992), pp. 431-448
Published by: The University of Chicago Press for The University of Chicago Law School
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DEBTHOLDERS AND EQUITYHOLDERS

HIDEKI KANDA*

I.

INTRODUCTION

the economic and the legal status of equityholdershas been

WHILE
much studied in the past, that status of debtholders has been poorly
understoodin the literature.Recent ventures for restructuringcorporate
capital incident to corporatetakeovers and leveragedbuyouts, however,
have focused attentionon the importanceof corporateborrowingand the
claimednecessity of protectingdebtholderswho face a risk of unexpected
decrease in the value of their investment as a result of such restructuring transactions.Thus, it is no surprisethat argumentshave emerged to
the effect that corporate law should offer strongerpredictions to bondholders.'
Simply put, these argumentsrun as follows. Bondholderssuffer economic loss if their corporationincurs furtherrisky-or high-yield-borrowing. Contractualprovisions in bond contracts do not sufficientlyprotect them because predicting future events in advance is difficult and
costly. Consequently, corporate law should provide bondholders with
* Associate Professor of Law,
University of Tokyo. I thank Douglas Baird, Lloyd Cohen,
Saul Levmore, and Jonathan Macey for their help and suggestions. I also received helpful
comments and criticism on earlier drafts from Albert Alschler, Michael Dooley, David
Haddock, John Hetherington, Thomas Jackson, Mark Ramseyer, Robert Scott, George
Triantis, and the workshop and seminar participants at University of Chicago, Cornell
University, and University of Virginia Law Schools.
See Morey W. McDaniel, Bondholders and Corporate Governance, 41 Bus. Law. 413
(1986); Morey W. McDaniel, Bondholders and Stockholders, 13 J. Corp. L. 205 (1988);
Albert H. Barkey, The Financial Articulation of a Fiduciary Duty to Bondholders with
Fiduciary Duties to Stockholders of the Corporation, 20 Creighton L. Rev. 47 (1986); Note,
Fiduciary Duties of Directors: How Far Do They Go? 23 Wake Forest L. Rev. 163 (1988).
See also Note, Creditors' Derivative Suits on Behalf of Solvent Corporations, 88 Yale
L. J. 1299 (1979); Lawrence E. Mitchell, The Fairness Rights of Corporate Bondholders,
65 NYU L. Rev. 1165 (1990). But see Kenneth E. Scott, The Law and Economics of Event
Risk (Working Paper No. 62, Stanford Law School, Olin Program in Law and Economics
1990).
[Journal of Legal Studies, vol. XXI (June 1992)]
? 1992 by The University of Chicago. All rights reserved. 0047-2530/92/2102-0005$01.50
431

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THE JOURNAL OF LEGAL STUDIES

432

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.

ECONOMIC NATURE OF DEBTHOLDING AND EQUITYHOLDING

Debtholders can suffer several types of economic loss if the debtor

attemptsfurtherborrowing.The first type can be illustratedin a simple
numericalhypotheticalexample.
Debtor borrows $100,000 from Creditor 1 with annual interest of 10
percent. Debtor then borrows another$100,000from Creditor2 with annual interest of 20 percent. Debtor runs a business with these borrowed
funds, which produces annual return of 12 percent. If there only were
borrowingfrom Creditor 1, Debtor would get $112,000back at the end
of the year. The additionalborrowingfrom Creditor2, however, changes
the picture. Debtor now ends up with $224,000, which is insufficientto
satisfy both Creditor 1 and Creditor2. Because bankruptcylaw directs
both creditorsto share equally, Creditor1 ends up with $107,000.3
2 Notably
McDaniel, Bondholders and Stockholders, supra note 1.
3 Here, I of course assume that 10 percent interest Creditor 1 charges does not include

insurance premium for covering the risk of loss illustrated in the example.

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DEBTHOLDERS AND EQUITYHOLDERS

433

I call this "the sharingproblem." Inasmuchas insolvency law treats

unsecured creditors equally, creditors face the sharingproblem unless
they make an arrangementin advanceand in a legally enforceablemanner
to get priorityor otherwise protect themselves.
The second problemcreditorsface is the risk-alterationproblem,which
is well known in the literature.Considerthe following examples.
Case 1. Debtor undertakesbusiness with $400,000. Debtor is given
two business opportunities. One opportunity (project 1) would give
Debtor $500,000 at the end of the year. The other opportunity (project 2) would result in $800,000with 50 percent probabilityand $100,000
with 50 percentprobability.Debtorwill choose project 1because project2
has the expected value of $450,000 and thus is less attractive than
project 1.
Case 2. Debtor now becomes incorporatedand financesthe business
with the mixture of debt and equity. Debtor receives $300,000 equity
from Equityholderand borrows$100,000fromCreditor1. For simplicity,
I assume that the borrowingis made with no interest. Debtor, who represents Equityholder,will choose project 1 because project 2 has an expected value of $350,000to Equityholderand is less attractivethan project 1.
Case 3. IncorporatedDebtor in case 2 now reduces its equity to
$100,000 and borrows an additional $200,000 from Creditor 2. Debtor
now will choose project 2. If project 2 is successful, Debtor would get
$800,000. After paying $300,000to the two creditors, Debtor would end
up with $500,000, which would belong to Equityholder. If it fails, all
$100,000should go to the creditors, but neitherDebtor nor Equityholder
would be liable to the creditorsbeyond thatamountbecause of the limited
liabilityin corporatelaw. Thus, the expected value of project 2 to Equityholder is $250,000, which is more attractivethan project 1.
This risk-alterationproblemsimply means that the debtorand its equityholders "gamble" with borrowedmoney,4but there are two aspects in
this gamblinggame. First, in case 3, Debtor chooses project 2, and, if it
fails, Creditor 1 cannot collect its debt unless it seeks some form of
protectionin advance. Second, in case 3, Debtor chooses project2 rather
than project 1. This result is socially inefficient.5
4 For a detailed description of debtholder-equityholder conflict, see, for example, Michael
C. Jensen & Clifford W. Smith, Jr., Stockholder, Manager, and Creditors Interests: Applications of Agency Theory, in Recent Advances in Corporate Finance 93 (Edward I. Altman
& Marti G. Subrahmanyam eds. 1985); William A. Klein & John C. Coffee, Jr., Business
Organization and Finance 306-38 (4th ed. 1990).
5 A believer in the Modigliani-Miller propositions (Franco Modigliani & Merton H. Miller,
The Cost of Capital, Corporation Finance, and the Theory of Investment, 48 Am. Econ.
Rev. 261 (1958)) might argue that even incorporated Debtor with $400,000 equity and no

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434

THE JOURNAL OF LEGAL STUDIES

The sharing problem and the risk-alterationproblem are sometimes

related but should be distinguished.The sharingproblem arises simply
because the debtor incurs furtherborrowingat a highercost even if the
risk of the debtor's business is not altered. The risk-alterationproblem
arises because the debtorhas an incentiveto alterthe risk of herbusiness,
due normally-but not necessarily-to furtherborrowing.This risk alteration harmscreditorsunless it is fully negotiatedfor and incorporatedin
the initial debt contractualterms.
Equityholdersare different. They do not face the sharingproblem or
the risk-alterationproblemwhen the debtor obtainsfurtherequity funds.
As for the former, corporatelaw generallytreats all equityholders(of the
same class) in equal ranking,but it also prohibitsthe corporationfrom
invitingnew equityholderswith "higherinterest." In otherwords, corporatelaw generallyrequiresthat new equity must be issued at a price equal
to the fair marketprice of the outstandingequity. Equityholdersface a
differenttype of problem,which can be called "the insufficientrisk taking
problem." Considerthe following example.
Case 4. IncorporatedDebtor undertakesbusiness with $400,000equity obtainedfrom Equityholderand with no debt. In additionto the two
business opportunitiesshown in case I above, anotheralternative(project 3) is available. Project3 will produce $800,000with 50 percent probability but result in $300,000with 50 percent probability.
In this case, if Debtor is an unincorporatedproprietorand runs business with its own funds, Debtor would choose project 3. The expected
value of project 3 is $550,000, which is more attractive than project 1
(or project 2). This result is socially efficient. If Debtor is incorporated,
however, Equityholderfaces a typical agency problem,inasmuchas the
result of the manager'sbusiness efforts goes to Equityholderand not to
the managerunless otherwise agreed.Thus, the managerhas an incentive
to shirk by not choosing project 3.6 The manageralso might be tempted
to misbehave by a variety of means, such as looking for side deals in
debt may choose project 2 because, for instance, Equityholder itself can gamble by borrowing $300,000 at the individual level. This homemade gambling, however, is unrealistic.
See, for example, Victor Brudney, The Role of the Board of Directors: The ALI and Its
Critics, 37 U. Miami L. Rev. 223, 240 (1984) (individuals and corporations have different
cost-benefit calculations). Individual equityholders might try to set up a vehicle like pension
funds to obtain home-made gambling. But this attempt would be penalized by tax law.
6 In addition,
managers who invest firm-specific human capital may want less gambling.
See John C. Coffee, Jr., Shareholders versus Managers: The Strain in the Corporate Web,
85 Mich. L. Rev. 1 (1986); but see also Jonathan R. Macey, Externalities, Firm-specific
Capital Investments, and the Legal Treatment of Fundamental Corporate Changes, 1989
Duke L. J. 173, 185-88.

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DEBTHOLDERS AND EQUITYHOLDERS

435

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.

LEGAL RULES FOR DEBTHOLDERS AND EQUITYHOLDERS

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-

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436

THE JOURNAL OF LEGAL STUDIES

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.

Absence of Preferred Debt

Preferredequity-or preferredstock in a business corporation-is well

recognized in corporate law. But "preferreddebt" cannot be created
even when debtor and creditoragree. Such an agreementis enforceable
between the debtor and the creditor but not against other creditors.12
Thus, such an agreementenables the creditorto accelerateher claimonly
if the debtor breaches the promise, and her claim would be treated as
unsecured with no priority over other creditors. The creditor can place
a negative pledge clause in the debt contract and prevent later creation
of security interest by other-typically subsequent-creditors.13 But
again, she cannotget a priority.Debtorand creditorcan agreeon subordinated debt, which makes the creditorranklower than existing and subsequent creditors,14 but they cannot agree on preferreddebt.15
The rationalefor this rule may not be immediatelyevident. The law
could offer a system that allows debtorand creditorto establishthe crediwhat arbitrary decision. For such general rules, see Robert Charles Clark, The Duties of
the Corporate Debtor to Its Creditors, 90 Harv. L. Rev. 505 (1977).
" But
they enjoy general rules protecting a corporation's creditors. See note 10 supra.
12 Compare U.C.C. ? 9-312(5) (an unperfected security interest loses against a later perfected secured creditor who has actual knowledge).
13 The enforceability of such a negative pledge clause under current law, however, is
unclear. See Douglas G. Baird & Thomas H. Jackson, Cases, Problems, and Materials:
Security Interests in Personal Property 882 (2d ed. 1987).
14 See Bankruptcy Code ? 510(a), 11 U.S.C. ? 510(a).
15 One might be able to create something approximating preferred debt by taking an
all-encompassing U.C.C. security interest. The question is, Why not allow it by a direct
path?

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DEBTHOLDERS AND EQUITYHOLDERS

437

tor's priority over other creditors.16Alan Schwartz recently addressed

this point and argued that priority should be given the initial creditor,
whether or not such a creditoris unsecured.17
One mightexpect that such a system would give the debtoran incentive
to supplypotentialpreferredcreditorswith as much informationas possible about her business in order to get the best deal. Creditorsas a whole
would then benefit. One might also argue that subsequent creditors do
not care about preferredcreditors as long as they are notified because
they can easily adjustto the existing preferreddebt by contractualterms
such as interest.1"Existing creditors can also adjust, in theory, if they
expect subsequentcreation of preferreddebt.
These argumentsare impressive but not entirely persuasive. First, a
creditorwho wants preferredstatus is not necessarily the most efficient
creditorin the sense that the contractualterms she offers, typically highlighted by lower interest, optimallyreflect the financingopportunitiesor
If preferredstatus
value of the debtor'sbusiness, actuallyor potentially."9
one
and
another-more
to
is given
creditor,
efficient--creditor shows up
be
difficult
and
would
to
it
later,
costly renegotiatethe existing contract
to changethe priority.Moreover,the managerrepresentingequityholders
has an incentive to offer such a "super priority"to any creditorin order
to get as many risk-alterationopportunitiesas possible.
Second, other creditors are generallymade worse off by the introduction of new creditorsif their claims rankhigher.Invitingsuch new creditors does not alleviate the risk-alterationproblem and aggravates the
16 Under current
law, a creditor can get a priority over other existing creditors if they
agree on subordination.
"7Alan Schwartz, A Theory of Loan Priorities, 18 J. Legal Stud. 209 (1989). He argues
that the bargain over priority between the initial financier and the debtor is always optimal,
that the optimal priority contract between the debtor and the initial financier would rank
the initial financier first, and that other creditors, if informed, would not be worse off. He
then proposes that current law be changed accordingly.
It would not be difficult to design a mechanism to notify potential subsequent creditors
about the existence of such a "preferred creditor" in a way similar to that for security
interests under Article 9 of the Uniform Commercial Code. Compare Schwartz, id. at
218-24 (arguing that filing should be unnecessary among creditors). Such a system would
probably limit future advances that enjoy a preferred status. See Schwartz, id. at 252. See
also Peter F. Coogan, Homer Kripke, & Fredric Weiss, The Outer Fringes of Article 9:
Subordination Agreements, Security Interests in Money and Deposits, Negative Pledge
Clauses, and Participation Agreements, 79 Harv. L. Rev. 229, 263 (1965) (recommending
that the Uniform Commercial Code be amended to accommodate money as original collateral for security interest and to provide a rule for the perfection of such security interest
as proceeds).
18 Schwartz, supra note 17, at 254-55, 260-61.
19 This condition might be satisfied in situations where a small company attempts its first
borrowing from a bank.

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THE JOURNAL OF LEGAL STUDIES

438

sharingproblem. Preferreddebt does not respondin any meaningfulway

to the risk-alterationproblem other creditorsface. They are thus worse
off to the extent that the sharingproblembecomes exacerbated.20
Allowing security interests for creditors is somewhat different from
allowing preferredcreditors. Security interests may reduce the debtor's
opportunitiesfor gamblingbecause the collateralmay be worth more to
the debtor than to the secured creditor.21They also may alleviate the
monitoringproblem that creditors as a whole face.22Preferredcreditors
can hardlybe good monitors.
In sum, the currentlaw rejectingthe creation of preferreddebt might
be defensible as a correct reflection of the creditors' bargain.Creditors
as a whole would hardly agree on the creation of preferreddebt. By
contrast,contractingout the equal-rankingruleby agreeingon subordination does not create the concerns described above and therefore should
be enforceable.
The current corporate law also correctly mirrorsthe equityholders'
bargain.Existing common equityholdersdo not care about and, indeed,
welcome the injection into their venture of furtherfunds, even when the
new claimants rank higher, as long as the new equity is sold at a fair
marketrate. Those funds enable existing equityholders-and the managers representingthem-to undertakemore gamblingactivities that are
beneficialto equityholders.
B.

Absence of "Fair Price" Restrictions on Debt Issuance

While corporatelaw generally requiresthat new equity be issued at a

price equivalentto the fair marketvalue of the existing equity,23no such
restrictionsare imposed for debt. Thus, a debtor corporationis allowed
20 This statement presupposes that, among creditors at least, a creditor would agree to
rank lower only when the benefits from it exceed costs.
21 See Robert E.
Scott, A Relational Theory of Secured Financing, 86 Colum. L. Rev.
901, 927-29 (1986). See also Robert E. Scott, Rethinking the Regulation of Coercive Creditor Remedies, 89 Colum. L. Rev. 730, 748-49 (1989).
22 The academic efforts explaining why secured financing exists have been illuminative.
The importance of monitoring concerns has been recognized, but opinions are split in
understanding how security interests alleviate the monitoring concerns creditors face. See
Thomas H. Jackson & Anthony T. Kronman, Secured Financing and Priorities among
Creditors, 88 Yale L. J. 1143 (1979); Saul Levmore, Monitors and Freeriders in Commercial
and Corporate Settings, 92 Yale L. J. 49 (1982); Scott, Relational Theory, supra note 21.
See also Alan Schwartz, The Continuing Puzzle of Secured Debt, 37 Vand. L. Rev. 1051
(1984); Schwartz, supra note 17, at 243-47.
23 See,
generally, Note, Judicial Control over the Fairness of the Issue Price of New
Stock, 71 Harv. L. Rev. 1133 (1958). Of course, this rule does not exist for "rights" issues,
in which new equity is offered to the existing equityholders.

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DEBTHOLDERS AND EQUITYHOLDERS

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

It follows, therefore, that the marketprice of existing debt, if there is

such, is not the reflectionof the marketfor the entire debt, as is the case
for equity, but rather the reflection of the particulardebtholder's risk
taking, or, more accurately, the bargainbetween the debtor and the particulardebtholder.The fact that ratingagencies rate only debt-and preferred equity-and not common equity simply reflects this economics.
Prospective debtholders, particularly prospective purchasers of new
debt, do not care about the currentmarketprice of the debt as much as
prospective equityholdersdo about the current marketprice of the existing equity. Their concern is the riskiness of the debtor's present and
future gambling.They decide the terms of their commitmentaccording
to their own taste. The sharingproblem may be viewed as a price that
debtholders might be willing to pay in order to get the range of their
choice with respect to the debtor's future risk taking.
24 Note,
however, that managers would be liable to equityholders, subject to the protection by the business-judgment rule, if issuing debt with high interest does not produce
gambling opportunities, the benefits from which outweigh the costs of such borrowing.
25 See, generally, James C. Van Horne,
Optimal Initiation of Bankruptcy Proceedings by
Debtholders, 31 J. Fin. 897 (1976).
26 Both debtholders and equityholders have among themselves different tastes about the
risk that they want to take in making investments in the debtor's business. Equityholders
can satisfy their taste by building an appropriate investment portfolio. Debtholders can do
the same, but, in addition, they can also choose their commmitment to the risk alteration
in the debtor's business. Inasmuch as eliminating the possibilities of future risk alteration
in an enforceable manner is difficult and thus costly, there is reason to expect that they
make concrete arrangements with the debtor in accordance with their tastes about future
risk alteration rather than doing nothing. The availability and efficiency of the secondary
market affect their decisions but do not eliminate their concern about risk alteration.

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440

THE JOURNAL OF LEGAL STUDIES

C.

Off-the-Rack Legal Rules

The discussion above suggests that debtholdingis best created and

governed by contract. Inasmuch as debtholders' attitudes toward the
sharingand risk-alterationproblemsvary from debtholderto debtholder,
these problems are best solved by permittingthem to design their own
contractualterms.
The question of why currentlaw does not give debtholdersany protection unless they protect themselves in the contractremains. Why is this
the defaultrule? In contrast, equityholdersare given a variety of protections by corporatelaw: voting rights, fiduciaryprotections, and standing
to bring derivative suits. Assuming away, for a moment, the fact that
some of these protections for equityholdersare mandatoryand cannot
be contractedout, why are the baseline rules differentbetween two types
of investors?
The no-protectionrule for debtholders27can be viewed as a reflection
of the simple facts that debtholdersdecide the degree of their risk taking
themselves and that their individualcommitmentsvary. Under current
law, aside from seeking credit enhancementfrom third parties-such as
a third-partyguarantee-at least three contractualmeans are available
for debtholders:charginga higher interest, creating a security interest,
and placing various "covenants" in the debt contract.28Thus, each debt
contract is the tailor made productof the debtor-creditorbargain.
In contrast, corporatelaw generallyrequiresthat equity issued at different times be in the same terms, particularlycommonequity. Common
equityholdershave many protective contractualterms that are supplied
automaticallyby corporate law, even if they fail to protect themselves
throughexplict contracting.They normallyenjoy voting rights, they are
protected by the fiduciaryprinciple,29 and so on. Why does the law not
begin with the no-protectionrule here?
27 It should be
noted, however, that, as discussed below, current law offers the full-

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

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DEBTHOLDERS AND EQUITYHOLDERS

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Again, the economic nature of equityholdingoffers an answer. Since

equityholdersare residual claimaintsand do not face the risk-alteration
problem, their individualattitudes toward the risk taking in the venture
are identical:they want gamblingthat will maximizethe net presentvalue
of the venture. As the numberof equityholdersincreases, the liquidity
of equity is enhanced. They also sharethe insufficientrisk takingproblem
and, therefore,want the most effective arrangementfor monitoringmanagers' behavior. Voting rights and fiduciaryrules thus can be viewed as
a reflectionof the fact that most equityholderswant these protections.30
D.

Limits on Contractual Freedom

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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THE JOURNAL OF LEGAL STUDIES

tual terms unless otherwise agreed in advance.34 No one has explained

why.
The economic nature of debtholdingand equityholdingoffers an answer. Because equityholders face the insufficient risk-takingproblem,
they want day-to-dayrenegotiationin orderto monitorand enforce their
bargainwith managers. Gamblingopportunitiestend to vary from time
to time. In particular,these opportunitieschange whenever the venture
incursfurtherborrowing.Requiringequityholders'unanimousconsent to
managers'conduct in every instancewould lessen the chances of producing the best gambling.But allowingchanges of the manager-equityholder
contractwithoutthe unanimousconsent of equityholderswould risk misbehaviorby the majorityequityholders.Also, whether or not unanimity
is required,ex post renegotiationalways faces opportunismand thus is
costly. Consequently, opinions might well be split as to whether departure from the standardfiduciaryrule by majorityconsent should be permitted.
Debtholders are different. They face the risk of the debtor's future
excessive risk takingfrom the outset and fix their attitudestoward their
commitment at the outset in a clear and easily enforceable manner.
Changes of the initially negotiated terms then simply mean changes in
their commitment, or new debtholding.The current law, which begins
with the defaultrule requiringall debtholders'consent for changes of the
contractualterms, is thus understandable.
IV.

NORMATIVE IMPLICATIONSFOR THE LEGAL TREATMENT OF

DEBTHOLDERS AND EQUITYHOLDERS

This section examines the recent argumentsthat corporatelaw should

offer greaterprotectionsto bondholders.I will show that these arguments
are only partiallycorrect and then offer better solutions to the problem.
Again, the analysis is limited to publicly held corporations.
A. The Need for GreaterDebtholderProtections
Corporatetakeovers and leveraged buyouts frequently produced restructuringtransactionsof corporatecapital.These restructuringtransactions have sometimes brought losses to bondholdersin the form of an
unexpecteddecrease in the value of their investment.35Thus, not surpris34 For debts issued to the general public, the federal law limits the freedom to change
the unanimity rule. See the Trust Indenture Act of 1939, ? 316, 15 U.S.C. ? 77ppp (1991).
35 See McDaniel, Bondholders and Stockholders, supra note 1; Schwartz, supra note 17.

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DEBTHOLDERS AND EQUITYHOLDERS

443

ingly, argumentshave emerged to the effect that corporate law should

offer greaterprotections to bondholders.
These argumentscan be summarizedas follows.36Bondholderssuffer
economic loss if their corporationincurs furtherrisky-or high yieldborrowing.Contractualprovisions in bond trust indenturesdo not sufficiently protect them because predicting future events is difficult and
costly. Their attempt to renegotiatethe contractualterms after they notice the restructuringtoward a more risky venture is neither easy nor
practical. Consequently,corporatelaw should provide bondholderswith
greater protections. Specifically, directorsand officers should bear fiduciary duties to bondholders, and bondholdersshould be given standing
to bringderivative suits. These ex post rules would complementunsatisfactory ex ante price adjustmentsand other contractingprocesses between bondholdersand the debtor corporation.37
These argumentsstress the economic similaritybetween bondholders
and stockholdersratherthan the differencein theirlegal status and assert
that corporatelaw should treat similareconomic actors alike. The arguments also assert that the value of the firmis not the value of the equity
but, rather, the value of the equity plus debt and that managersshould
be obligedto maximizethe value of the firm,not the value of the equity.38
These assertions are correct only in that debtholderscan suffer unexpected loss as a result of insufficient contracting. Although empirical
studies show that bond covenants serve to control conflictbetween debtholders and equityholders,39dispersed debtholders face three familiar
contractingand enforcementproblems, which make contractualprotections only partiallyeffective. First, they face lack of informationwhen
they negotiate for desirable contractual terms. The debtor's managers
cannotbe expected to supply debtholderswith optimalinformation,inasmuch as they are tainted by their self-interest, and thus cannot be exNotably, in McDaniel, Bondholders and Stockholders, supra note 1.
Id. Thus far, fiduciary duties to bondholders have not been recognized in courts. See,
for example, Simons v. Cogan, 549 A.2d 300, 302-4 (Del. Supr. 1988).
For the presentation and criticism of an argument that managers' fiduciary duties should
be extended more broadly to cover all "nonstockholder constituencies," see Macey, supra
note 6; and Jonathan R. Macey, An Economic Analysis of the Various Rationales for
Making Shareholders the Exclusive Beneficiaries of Corporate Fiduciary Duties, 21 Stetson
L. Rev. 23 (1991).
38 McDaniel, Bondholders and Stockholders, supra note 1.
39 See Fischer Black & John C. Cox, Valuing Corporate Securities: Some Effects of
Bond Indenture Provisions, 31 J. Fin. 351 (1976); Clifford W. Smith, Jr., & Jerold B.
Warner, On Financial Contracting: An Analysis of Bond Covenants, 7 J. Fin. Econ. 117
(1979); Avner Kalay, Stockholder-Bondholder Conflict and Dividend Constraints, 10 J. Fin.
Econ. 211 (1982).
36

37

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THE JOURNAL OF LEGAL STUDIES

444

pected to represent equityholders even though rational equityholders

want to agree on some covenants to restrict excessive risk taking. Second, disperseddebtholdersmay not be able to evaluate the risk involved
in the debtor's venture even if informationon the venture's riskiness is
perfectlysuppliedto them. Third,even if these two problemsdo not exist
or are resolved, debtholdersface a typical coordination-or collective
action-problem. Because each individualdebtholder'sstake is smalland
she has many other "colleagues," each debtholdertends to free ride on
the others' activities, which is likely to both result in less desirablecovenant provisions in the first place and lead to undermonitoringand underenforcementof debt contracts.40 As a result, debtholderssufferloss. The
differenteconomic natures of debtholdingand equityholding,however,
suggest differentsolutions between these two investors.
B.

The Fiduciary Principle with Multiple Beneficiaries

Situations in which an agent is obliged to act for the best interest of

more than one principalare not uncommon.A classical trustee can serve
more than one set of beneficiaries. A lawyer can have more than one
client. Thus, managerscan serve two masters: debtholdersand equityholders. Indeed, if one investor owned the entire equity and debt of the
venture, she would naturally ask the managerto act to maximize the
combined value of the debt and equity. In publicly held corporations,
however, there is reason to think that the fiduciaryprincipleshould be
structuredfor the benefit of one set of beneficiaries:residualclaimants.
Interactionsbetween one agent and multipleprincipalsare highlycomplex.41In publicly held corporations,the costs of monitoringand enforcing the fiduciaryduties owed to multiplebeneficiariesare high. Whether
the manager'sday-to-dayconduct meets such fiduciarycriteriais hardly
observable.For dispersedinvestors, this would surelylead to undermonitoring and underenforcement.It is much easier for the principals-and
the court-to look at the manager'sbehaviorfrom the standpointof one
criterionratherthan many. True, this does not necessarilymean that the
beneficiariesenjoyingthe fiduciaryprotectionsshouldonly be equityholders. There are, however, two reasons to think that equityholders are
normallythe best candidatesto be the beneficiaries.
Levmore, supra note 22, at 53-54. Dispersed equityholders face the same problems.
See Kenneth J. Arrow, Economics of Agency, in Pratt & Zeckhauser eds., supra note
29, at 37, 42-46. See also Sanford J. Grossman & Oliver D. Hart, The Costs and Benefits
of Ownership: A Theory of Vertical and Lateral Integration, 94 J. Pol. Econ. 691 (1986).
40

41

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DEBTHOLDERS AND EQUITYHOLDERS

445

First, as noted above, debtholdershave differentcommitmentsto the

venture, and, thus, the value of the debtor's business to debtholders
varies among debtholderswho hold debt instrumentsissued at different
times. If the fiduciaryduties were created for the benefit of debtholders,
the criteriafor such duties would vary among debtholders.As a result,
there would be confusion when monitoringand enforcingsuch a fiduciary
principle. Debtholders are better off with more concrete contractual
terms, which enable them to monitorand enforce their tailor-madecommitments.
Second, equityholdersall have the same goal: the best gambling.They
also share the insufficientrisk takingproblem. It is difficultto determine
whether managersare engagingin the best gamblingfor equityholdersat
all times, simply because gambling opportunitiestend to change over
time. Potentialconflicts of interestare also difficultto detect. Thus, equityholdersexpect the marketfor corporatecontrol and other mechanisms
to monitorand enforce the manager-equityholder
bargain.If the fiduciary
to
maximize
the
of equityholders'invalue
principlerequires managers
enables
to
enforce
the manager-equityit
also
vestment,
equityholders
holder bargain.
The discussion above suggests that the beneficiaryof the fiduciaryprinciple in corporate law should be residual claimants. Thus, not surprisingly, the currentlaw providesthat the managerordinarilyowes fiduciary
duties to shareholdersonly but that in corporate insolvency, managers
owe fiduciaryduties to creditors ratherthan equityholders,inasmuchas
creditorsare normallyresidualclaimantsin the debtor's insolvency.42
C. ContractualSolutions
The problems faced by dispersal debtholderscan be minimizedbest
through improving market environments for contracting, monitoring,
and enforcement. Rating agencies-notably Standard and Poor's and
Moody's-act as informationprocessors, and they have incentives to
produce the information necessary for debt contracting. Investment
bankers who seek underwritingrevenues have incentives to offer the
optimal contractualterms to attract new issuers and debtholders. Both
groups have made enormous investments in their reputationalcapital,
which gives them the incentive to make efforts to acquirethe necessary
42 See Douglas G. Baird & Thomas H. Jackson, Cases, Problems, and Materials on
Bankruptcy, 208-10 (Supp. 1989). See also In re Central Ice Cream Co., 836 F.2d 1068,
1072 (7th Cir. 1987).

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446

THE JOURNAL OF LEGAL STUDIES

informationfor investors. The "shelf registration" system under the

Securities Act of 1933producedhighly competitive environmentsfor investment bankers. As for monitoring and enforcement, the indenture
trustee might serve as a representativefor dispersed debtholders.43Further improvementof these marketenvironmentswould encourageprivate
contracting,monitoring,and enforcement.
The insufficientrisk taking problemfaced by equityholders,however,
cannot be easily solved through intermediariessuch as rating agencies
and investmentbankers. Rather,the voting-rightand fiduciaryprinciples
require managers to maximize the value of the equityholders' investments.44This is the legal apparatusthat enables equityholdersto enforce
the manager-equityholder
bargain.
The debt contractcan "contractin" fiduciaryrules if the partieswant.
Then, for instance, the debtor would be requirednot to engage in excessive risk taking. As noted above, however, debtholderspresumablydo
not want such fiduciary rules simply because it is difficult to enforce
them. The criteria for determiningwhether the debtor's particularrisk
takingis excessive are difficultto formulate.Debtholders,therefore,want
more concrete contractualterms.45
In this light, currentlaw, which does not recognize fiduciaryrules for
preferredequityholders,also makes sense.46Commonequityholdersand
preferredequityholdersare differentmasters. The more preferredequityholders' investment returns have fixed elements, the more they want
specific contractualterms to fix their commitment.Thus, for preferred
equityholders,the default rule should probablybegin with no fiduciary
duties and full protection for changes in their contract. Protections for
such equityholdersand for equityholdersof a class differentfrom common stock both should be assigned to private contracting.
43 Compare Stewart M. Robertson, Debenture Holders and the Indenture Trustee: Controlling Managerial Discretion in the Solvent Enterprise, 11 Harv. J. L. & Pub. Pol. 461
(1988).
4 Easterbrook & Fischel, Corporate Control Transactions, supra note 32; Easterbrook
& Fischel, Voting in Corporate Law, supra note 32.
45 Compare William W. Bratton, Jr., The Economics and Jurisprudence of Convertible
Bonds, 1984 Wis. L. Rev. 667; William W. Bratton, Jr., The Interpretation of Contracts
Governing Corporate Debt Relationships, 5 Cardozo L. Rev. 371 (1984); William W. Bratton, Jr., Corporate Debt Relationships: Legal Theory in a Time of Restructuring, 1989 Duke
L. J. 92; Dale B. Tauke, Should Bonds Have More Fun? A Reexamination of the Debate
over Corporate Bondholder Rights, 1989 Colum. Bus. L. Rev. 1; Macey, supra note 37
(suggesting solutions through contract interpretations).
46 See, for example, Robinson v. T.I.M.E.-DC, Inc., 566 F. Supp. 1077, 1081 (N.D. Tex.
1983). See also Jedwab v. MGM Grand Hotels, 509 A.2d 584, 593-94 (Del. Ch. 1986).

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DEBTHOLDERS AND EQUITYHOLDERS

D.

447

Optimality of Incorporated Business

As noted above, there are reasons that managersshould be fiduciaries

for one set of beneficiaries:equityholders.This does not mean, however,
that maximizingthe value of the equityholders'investments is socially
optimal. The examples in Section II clearly demonstratethis. In case 3,
equityholderswant the managersto choose project 2, but this choice is
not socially efficient. In such cases, should the law require-or at least
encourage-managers to choose the most socially efficientbusiness? The
recent argumentsin favor of fiduciaryrules for bondholdersassert that
it should.
I submit three responses to this line of thinking. First, restructuring
the fiduciaryprinciplefor bondholderswould produce large monitoring
and enforcementcosts. True, the rule imposingthe primaryobligationof
managersto equityholdersdoes have costs: it imposes draftingand other
costs on the debtholders.While such a rule has lower costs than the rule
requiringthe managersto make the most socially efficient decisions, the
issue awaits empirical study. By the same token, an effort to liberalize
standing to bring derivative suits may produce difficult policing problems.47Second, currentlaw may alreadyembracea numberof rules that
can be understoodas encouragingmanagersto choose the most socially
efficient business. Certain limitations on equityholders'limited liability
and dividend restrictionsin corporatelaw may serve this goal. Fraudulent-conveyance law48and accelerationclauses in the debt contract may
do as well. Third, maximizing the residual value may be, in most
instances, the best proxy for choosing the most socially efficientproject.49
V.

CONCLUSION

Debtholding and equityholdingare different. The current law offers

differentdefault rules for debtholdersand equityholdersand reflects the
47 Compare Note, Creditors' Derivative Suits, supra note 1, with Levmore, supra note
22.
48 See, generally, Clark, supra note 10; Douglas G. Baird & Thomas H. Jackson, Fraudulent Conveyance Law and Its Proper Domain, 38 Vand. L. Rev. 829 (1985); Douglas G.
Baird, Fraudulent Conveyances, Agency Costs, and Leveraged Buyouts, 20 J. Legal Stud.
1 (1991).
49 Tying managers to shareholders in solvent corporations is a close proxy for the rule
requiring managers to make decisions a sole owner would make. In insolvent corporations,
the creditors, as the residual claimants, benefit from good decisions but pay the costs of
bad ones. Those cases in which the residual claimaints are the shareholders when one
choice is made but the creditors when a different choice is made present difficulties. See
In re Central Ice Cream Co., supra note 42.

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THE JOURNALOF LEGAL STUDIES

is bestgovernedby privatecondifferencebetweenthetwo. Debtholding

tractingwith the no-protectiondefaultrule for the sharingand riskruleforfuturechangesin conalterationproblemsandthefull-protection
tracts.
Existingbondcontractsmaybe insufficientfor the bargainthatdebtholderswant.Thisproblem,however,shouldbe solvedthroughimproving marketenvironmentswithinwhichprivatecontracting,monitoring,
areundertaken.
andenforcement
Creatingby lawa fiduciaryrelationship
betweenmanagersanddebtholderswouldproducenew problemsrather
thansolve existingones.

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