Volume 161, Issue 7 
June 2013
Articles

The Technology of Creditor Protection

Barry E. Adler & Marcel Kahan

Contract is the primary means through which creditors control a firm’s debt– equity conflict. There is an irony here, however. Actions that may render a debtor insolvent are the events against which creditors contract. Yet when a breach of contract yields a debtor’s insolvency, the debtor cannot fully satisfy its creditors. Thus, a general creditor’s contractual remedy against a debtor cannot be fully effective, and anticipation of this shortcoming may increase a debtor’s cost of capital. A solution to this conundrum, proposed here, would permit creditors and debtors to contract for creditor remedies against third parties—other creditors, shareholders, and corporate affiliates—who may have benefitted from a debtor’s breach, provided that the creditor gave actual or constructive notice of its right to seek such remedies. This solution would offer creditors protection akin to that now afforded contractually through secured credit and now afforded by legal rule through the laws of voidable preference and fraudulent conveyance. Because the proposed protection would be contractually based, it could be tailored to the needs of individual firms and could thus improve, and to some extent obviate the need for, the protections now provided by law.


Note: Marcel Kahan would like to thank the Milton and Miriam Handler Foundation for financial support.


A Theory of Preferred Stock

William W. Bratton & Michael L. Wachter

Should preferred stock be treated under corporate law as an equity interest in the issuing corporation or under contract law as a senior security? Should a preferred certificate of designation be subsumed in the corporate charter and treated as an incomplete contract filled out by fiduciary duty, or should it be treated as a complete contract with the drafting burden on the party asserting the right, as would occur with a bond contract? Is preferred stock equity or debt? This Article shows that preferred stock is both corporate and contractual—neither all one nor all the other. It sits on a fault line between two great private law paradigms, corporate and contract law, and draws on both. The overlap brings two competing grundnorms to bear when interests of preferred and common stockholders come into conflict: on the one hand, managing to the common stock as residual interest holder maximizes value; on the other hand, holding parties to contractual risk allocations maximizes value. When questions arise concerning the relative rights of preferred and common stock, the norms hold out conflicting answers. Delaware courts have taken the lead in confronting these questions by seeking to synchronize the law of preferred stock with the rest of corporate law—a project that has led to both innovation and stress.

This Article examines recent cases about preferred stock to show two facets of Delaware law coming to bear as the synchronization process proceeds: first, reliance on independent directors for dispute resolution, and second, the common stock– value maximization norm. These trends cause the law to tilt toward corporate norms, thereby disrupting allocated risks in heavily negotiated transactions, particularly in the venture capital sector. The Article makes three recommendations that would promote the goal of restoring balance between the corporate and contract paradigms. First, the meaning and scope of preferred contract rights should be determined by courts, rather than by issuer boards of directors. Second, conflicts between preferred and common should not be decided by reference to a norm of common stock–value maximization. Instead, the goal should be the maximization of the value of the equity as a whole. Third, independent-director determinations of conflicts between preferred and common should not be accorded ordinary business judgment review. Instead, a door should be left open for good faith review tailored to the context. This review would require a showing of bad faith treatment of the preferred where the integrity of a deal has been undermined, with the burden of proof on the board.


Adapting to the New Shareholder-Centric Reality

Edward B. Rock

After more than eighty years of sustained attention, the master problem of U.S. corporate law—the separation of ownership and control—has mostly been brought under control. This resolution has occurred more through changes in market and corporate practices than through changes in the law. This Article explores how corporate law and practice are adapting to the new shareholder-centric reality that has emerged.


Because solving the shareholder–manager agency cost problem aggravates shareholder–creditor agency costs, I focus on implications for creditors. After considering how debt contracts, compensation arrangements, and governance structures can work together to limit shareholder–creditor agency costs, I turn to available legal doctrines that can respond to opportunistic behavior that slips through the cracks: fraudulent conveyance law, restrictions on distributions to shareholders, and fiduciary duties. To sharpen the analysis, I analyze two controversies that pit shareholders against creditors: a hypothetical failed LBO, and the attempts by shareholders of Dynegy Inc. to divert value from creditors through the manipulation of a complex group structure. I then consider some legal implications of a share- holder-centric system, including the importance of comparative corporate law, the challenges to the development of fiduciary duties posed by the awkward divided architecture of U.S. corporate law, the challenges for Delaware in adjudicating shareholder–creditor disputes, and the potential value of reinvigorating the tradi- tional “entity” conception of the corporation in orienting managers and directors.


Responses

How to Avoid Implementing Today's Wrong Policies to Solve Yesterday's Corporate Governance Problems

Colin Mayer
In response to Barry E. Adler & Marcel Kahan, The Technology of Creditor Protection, 161 U. Pa. L. Rev. 1773 (2013), and Edward B. Rock, Adapting to the New Shareholder-Centric Reality, 161 U. Pa. L. Rev. 1907 (2013).

The Toxic Side Effects of Shareholder Primacy

Lynn A. Stout
In response to Barry E. Adler & Marcel Kahan, The Technology of Creditor Protection, 161 U. Pa. L. Rev. 1773 (2013), and Edward B. Rock, Adapting to the New Shareholder-Centric Reality, 161 U. Pa. L. Rev. 1907 (2013).

The past two decades have seen a dramatic shift in the U.S. corporate landscape. Many and possibly most public companies now embrace a shareholder-centered vision of good corporate governance that emphasizes “maximizing shareholder value” over all other corporate goals. Recent Articles, one by Edward Rock and one by Marcel Kahan and Barry Adler, point out that increasing shareholders’ power and influence in public companies can lead managers to operate firms in ways that benefit shareholders by harming the interests of corporate creditors. This Response argues that the problems associated with changing corporate law and practice to encourage managers to focus on “maximizing shareholder value” may be much larger. There is reason to suspect that the modern embrace of shareholder value as the sole corporate objective may be threatening the health of public companies and harming not only creditors but also employees, consumers, taxpayers, and shareholders themselves.


Poor Pitiful or Potently Powerful Preferred

Leo E. Strine, Jr.
In response to William W. Bratton & Michael L. Wachter, A Theory of Preferred Stock, 161 U. Pa. L. Rev. 1815 (2013).

Exploring the Limits of Contract Design in Debt Financing

George Triantis
In response to Barry E. Adler & Marcel Kahan, The Technology of Creditor Protection, 161 U. Pa. L. Rev. 1773 (2013) and Edward B. Rock, Adapting to the New Shareholder-Centric Reality, 161 U. Pa. L. Rev. 1907 (2013).

The alignment of shareholder and manager interests over the past several decades, along with increases in the financial leverage in U.S. corporations, has shifted scholarly attention to the agency conflict between shareholders and debtholders. This Response reviews the distinctive contractual means by which this conflict is addressed: notably, through covenants, acceleration rights, and collateral. Recent empirical studies indicate that debt investors believe that these protections mitigate agency costs, leaving an open question as to whether improvements in design might further reduce these costs and lower capital costs. In their contributions to this Symposium Issue, Professor Rock and Professors Adler and Kahan propose changes in corporate, bankruptcy and contract law that would enable such improvements. Rock suggests expanding the scope of duties imposed by regulation, while Adler and Kahan propose that firms be able to impose liability on third parties who facilitate or benefit from breach, including future creditors. In this Response, I raise doubts as to the magnitude of the incremental gain from these proposals over existing contract tools, particularly the broad potential of termination rights and security interests. I also illuminate some of the offsetting costs the proposals would impose in capital markets. Before concluding, I explore the possibility that the constraints preventing further mitigation of agency costs are not in the underlying legal rules or contracting technology, but in the incentives of borrowers to work at the frontier of contract design.


Comments

Protecting Search Terms as Opinion Work Product: Applying the Work Product Doctrine to Electronic Discovery

Sean Grammel

Music Piracy and Diminishing Revenues: How Compulsory Licensing for Interactive Webcasters Can Lead the Recording Industry Back to Prominence

Neil S. Tyler

This Comment suggests that Congress should amend the Copyright Act to ensure that promising new music-based technologies are able to survive. The establishment of a compulsory license for interactive webcasters will help ensure that sound recording copyright owners are properly compensated for their recordings and performances, while also guaranteeing that the public will be able to utilize these copyrighted works to their greatest benefit. As a result of the recording industry’s failed efforts to combat music piracy over the past two decades, Congress must concern itself with the interests and future viability of the entire music industry. By expanding compulsory licensing to cover both noninteractive and interactive webcasters, the dual purposes of copyright law envisioned in the Constitution can best be achieved.

Part I of this Comment provides a discussion of the severe problems music piracy has generated for the recording industry over the past two decades and the many ways in which the recording industry has failed to combat the piracy epidemic. Part II outlines the advancement of music in the digital age, with a particular focus on the importance of streaming technology in the future. Part III chronicles the history of copyright protection for sound recordings, from the initial structure of the digital performance right to the current tripartite framework of the public performance right in sound recordings. Part IV provides further details of the noninteractive webcasting royalty proceedings, detailing the key shortcomings of the current rate structure and the issues that industry participants have been grappling with for the past two decades. Part V argues that compulsory licensing should be congressionally established for interactive webcasters and outlines the general structure that should be adopted. Lastly, Part VI provides a detailed discussion of the economic benefits an interactive webcasting compulsory license rate will have for the recording industry so long as Congress and the major record labels fully embrace streaming technology and interactive webcasting.


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