ETH Zurich, Spring 2015
Law & Business Transactions
Creditor Protection
Gérard Hertig
Agency Issues / Solvent Firms / Distressed Firms
I. Creditor – Debtor Conflict of Interests
• Creditors
– Assessing debtor’s current situation = Ability to perform
– Preventing subsequent changes that affect performance
• Loans as an example
– Debtor’s ability to pay interests/reimburse principal →
Look at assets and liabilities
• Proper representation : Omission and misrepresentation issues
• Correct evaluation: Market liquidity, accounting and perception
issues
– Debtor’s change in business plan or increase in risk taking
• Impact on capability to pay back loan: Increase in insolvency risk
• Impact on loan profitability: Lower risk adjusted returns
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Agency Issues / Solvent Firms / Distressed Firms
Examples 1 – 5 : Ex Ante Issues
1.
2.
3.
4.
5.
Firm A. is considering purchasing new software from IT specialist X.
What should it take into account during its due diligence analysis?
Firm B plans to buy spare parts from a foreign manufacturer. It is
concerned about adequate performance. How can it deal with this
issue via contractual provisions?
Butcher C would like to get a SFR100’000 loan from bank D. What kind
of information is bank likely to ask during contractual negotiations?
Corporation E also operates a meat business and is interested in
getting a credit line from Bank D. Will the bank ask for different/more
information from Corporation E than from Butcher C?
Corporation F has acquired the right to drill an oil well and needs
financing to be able to start its operations. What should a lender be
concerned about?
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Agency Issues / Solvent Firms / Distressed Firms
Examples 6 – 10 : Ex Post Issues
6. Firm A just learned that IT specialist X is considering developing a new type
of software as well as starting to sell its products abroad. Should it be
concerned and amend the draft contract accordingly?
7. Firm B hears that the foreign manufacturer could be acquired by a large,
service-oriented multinational company. Should it be concerned and
amend the draft contract accordingly?
8. Butcher C indicates during his talks with Bank D that he is considering
acquiring several neighborhood butcheries and mentions that they are for
sale because they are not doing well. Should Bank D be concerned and
amend the draft loan contract accordingly?
9. Corporation E indicates to Bank D that it plans to increase the dividends
paid to its shareholders over the next couple of years. Should Bank D be
concerned and amend the draft loan contract accordingly?
10. Corporation F is also considering using untested drill technologies if
existing methods do not produce the expected results. Is that of concern
for a lender?
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Agency Issues / Solvent Firms / Distressed Firms
Self-Protection by Creditors
• Obtaining debtor information
– From debtor directly
• Role of creditor’s bargaining power
• Observability and verifiability
– Using third party credit analysis
– Relying on reputation?
• Tailor-made covenants
– Going beyond standard terms
– Transaction costs
• Introducing exit opportunities
– Security interests: Mortgages, financial instruments, etc.
– Acceleration clauses: Debt becomes due and payable upon violation
of contractual covenants
• Getting third parties involved
– Having family and friends pledge assets or guarantee performance
– Requiring a bank guarantee
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Agency Issues / Solvent Firms / Distressed Firms
Taking into Account Debtor Management
• Management – Owner Conflicts of Interests
– Owner benefits from upside if more risks are taken
– Managers may be more reluctant to take risks
• Fixed compensation
• Risk aversion?
• Taking the risk issue into account
– Bonuses and equity stakes for managers
• Aligns owner’s and managers’ interests
• Not necessarily bad for lender: Deferred compensation approaches
– What about lower-rank employees?
• Managerial risk aversion
– As creditors
– As equity holders?
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Agency Issues / Solvent Firms / Distressed Firms
Protecting Non-Adjusting Creditors
• Non-adjusting creditors
– Unable to adjust the term of their exposure to the risks they
bear
– Victims of corporate torts as an example
• Exposed to opportunistic shareholders
– Compensated for risk-taking
– Not subject to personal liability if firm becomes insolvent
• Protecting non-adjusting creditors
– Require firms to take insurance when engaging in risky,
externality producing activities
– Impose additional capital requirements (see below)
– Give non-adjusting creditors priority in insolvency situations
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Agency Issues / Solvent Firms / Distressed Firms
Examples 11 – 14 : Managers and Creditors
11. Owner A wants the firm to invest in a very risky research project, which
may allow the firm he owes to significantly enrich its biotech patent
portfolio.
Both the firm’s CEO and the firm’s employees oppose this initiative
because it would require taking additional bank loans and increase the
firm’s debt service burden. How do you assess this resistance?
12. Bank B is willing to provide additional loans, but would like to make sure
that they are used for the research project and not for other business
purposes. How could it proceed?
13. The local employee union, for its part, is concerned about the patents
being ending up being sold to a firm located in another region, which
would have negative impact on local employment. What is your advice?
14. Various neighborghs are concerned about biotech research related air
pollution in the vicinity of the firm. Is moving their only option?
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Agency Issues / Solvent Firms / Distressed Firms
II. Solvent Firms
• Two dominant strategies adopted by lawmakers
• Mandatory disclosure
– Reduces creditors’ costs of gathering information
– Costs for smaller firms
– Verification by gatekeepers
• Legal capital for corporations
–
–
–
–
Owners are not directly liable for losses
Minimum Capital
Distribution restrictions
Imposing actions if serious loss of capital
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Agency Issues / Solvent Firms / Distressed Firms
Mandatory Disclosure (1)
• Facilitates deals by reducing transaction costs
– Contract law: Culpa in contrahendo
– Corporate law: Companies must disclose basic information
• Closely-held corporations = Smaller firms
– Keep financial accounts (US)
– Prepare financial statements in accordance with
accounting standards + available for public inspection
– Difference not significant: Exemption for very small firms,
limited enforcement, market demand
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Agency Issues / Solvent Firms / Distressed Firms
Mandatory Disclosure (2)
• Publicly-held corporations = Larger firms
– All material information
– Periodically file + immediately report new developments
• What about creditor-oriented accounting?
– In past: Focus on ‘conservative’ approach
• Favors understatement of assets
• Reduces screening costs
– Nowadays: Focus on market-prices
• As important for creditors than for investors
• Many financial instrument have debt as well as equity component
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Agency Issues / Solvent Firms / Distressed Firms
Examples 15 – 18 : Managers and Creditors
15. The CEO of a very large corporation has just been diagnosed
with a grave illness. Should the firm make this public and, if so,
why and within which timeframe?
16. A major customer just decided to switch supplier. Should the
firm make this public and, if so, why and within which
timeframe?
17. Gold is one of the major assets of a jewelry-maker. Gold prices
have been raising significantly in past weeks. Should the firm
disclose something, and if so what and when?
18.
The firm’s employees have decide to strike the day after
tomorrow. Should the firm make this public and, if so, why and
within which timeframe?
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Agency Issues / Solvent Firms / Distressed Firms
Mandatory Disclosure (3)
• Role of Gatekeepers = Trusted Third Parties
– Auditors, credit bureaus and credit rating agencies
– Their verification should enhance disclosure quality
• Credibility
– Gatekeepers pledge their reputation
– Auditor liability
• Creditors are foreseeable users of financial statements
• Creditors have special relationship with auditors
• Trade-off
– Requiring too little from gatekeepers: Opportunism
– Requiring too much from gatekeepers: No supply
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Agency Issues / Solvent Firms / Distressed Firms
Legal Capital
• Minimum and voluntary capital
– ˃ €25’000 in EU: Small in view of effective capital needs
– Showing seriousness vs. Tapping less expensive sources of
funding
• Reinforcing credibility of voluntary capital
– Distributions to shareholders restrictions
– Dividends, share repurchase) and hidden distributions (RPT)
– Issues
• Accounting methodology dependence
• Constraining restructurings
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Agency Issues / Solvent Firms / Distressed Firms
III. Distressed Firms
• Financially distressed firms
– Firms in the vicinity of insolvency → viability ?
– Incentives for owners to engage into asset substitution
• Legal responses
– Encouraging managers to act in interest of creditors
– Enlisting controlling shareholders
– Requiring shareholder meeting if serious loss of capital
– Insolvency triggers
• Net asset value is zero or below capital
• Managers, owners or creditors pull the trigger →
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Agency Issues / Solvent Firms / Distressed Firms
Managers and Insolvency
• Discretion to trigger insolvency proceedings
• Liability
– Formal and de facto managers
– Creditor suffer losses due to board negligence or fraud
• Usefulness for creditors
– Managers as owners vs. managers as employees
– Rich managers vs. poor managers
• Enforcement risk
– Higher in continental Europe and Japan?
– Lower in UK and US?
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Agency Issues / Solvent Firms / Distressed Firms
‘Controlling’ Shareholder and Insolvency
• CS as de facto managers
– Indemnifying corporation for its losses
– Paying corporate debts
• Subordinating CS claims
– Behaving inequitably (US) and automatic subordination (D)
– Impact on CS willingness to rescue failing firm?
• Piercing the corporate veil
– CS made personally liable for corporate debt
– Generally for fraud or blatant opportunism
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Agency Issues / Solvent Firms / Distressed Firms
Examples 19 – 21 : Shareholder Liability
19. Corporation X has made heavy losses due to the adoption of a
risky business plan. The controlling shareholder has been
instrumental in the designing and implementation of the
strategy. Can creditors or the firm sue him and, if so, for what?
20. Controlling shareholder involvement has put the firm in
financial distress. Can the firm refuse to reimburse a loan he has
made and which is due on the ground that other creditors may
not be reimbursed in the distant future?
21. V, the controlling shareholder of firm WW behaves as if I were
the firm’s CEO. The chairman of the board indicates that he will
be held personally responsible for the firm’s debt. Is this a
correct assesment?
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Agency Issues / Solvent Firms / Distressed Firms
Creditor and Insolvency
• Triggering insolvency proceedings
– Single or 3 creditors: Firm is insolvent in cash-flow sense
– Model 1 (traditional)
• Removing board from effective control over assets
• Appointment of administrator (crisis manager)
– Model 2 (modern)
• Keeping board in charge
• Creditors can ask appointment of trustee
• Limited control and exit role
– Courts as the principal trustee
– Managers drive reorganization and sale
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