Contracts, Markets, and Laws in the US and Japan
Edited by Zenichi Shishido
Chapter 5: The role of debt in the governance of US business corporations
For the most part, the study of corporate governance in the US has focused on the control mechanisms of shareholders: particularly their right to vote for and replace directors, to solicit proxies, and to acquire voting control through takeover bids. Yet, debtholders have their own control rights that should be incorporated in analyses of corporate governance. The essence of a debt contract gives the debtholder a contingent right to remove assets and possibly to force liquidation in the event of the borrower’s default. The contract lists the obligations and covenants whose violation constitutes an event of default. In addition, debtholders control the firm’s access to capital in two ways. First, debt contracts typically require the borrower to make periodic payments of interest and principal, which removes internal capital and thereby might compel the borrower to seek external financing for new projects. Second, the priority of debt claims (particularly secured or senior claims) can impede the future ability of the firm to raise capital from outside investors. Insolvency lawyers (and scholars) are more closely familiar with the levers of creditor control than their corporate law counterparts, because these levers are more significant when the corporation is financially distressed. Debtholder control assumes different forms depending on whether the distressed firm is also in bankruptcy proceedings. Outside of bankruptcy, distressed debtors may be in default or in imminent danger of default, and they are either insolvent or on the verge of insolvency.
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