Law and Courts in an Age of Debt

Highly leveraged firms are now commonplace in many U.S. industries. Shifting from equity to debt financing is not simply a matter of optimizing a firm’s cost of capital, however. It also has profound implications for the firm’s behavior and investor outcomes.

In Law and Courts in the Age of Debt, we describe one underappreciated feature of the shift from equity to debt, which is that courts resolve disputes among shareholders and among creditors using strikingly different rules and decision frameworks. Shareholder disputes are typically resolved using equitable doctrines such as fiduciary duties, with the explicit goal of reaching a substantively fair result. In creditor disputes, by contrast, courts tend to limit their role to formal contract interpretation and procedural oversight, often reaching results at odds with both market expectations and notions of fairness. For example, a controlling stockholder attempting a minority freezeout faces punishing scrutiny aimed at ensuring fair terms for the minority stockholders, while majority creditor groups today can, and increasingly do, receive judicial blessing for transactions that simply extract wealth from other creditors (an outcome colorfully referred to by practitioners as “lender-on-lender violence”).

This disparate approach is increasingly difficult to justify. We argue that it rests on antiquated paradigms of powerless shareholders, in the one case, and all-powerful banks, in the other. Judges compound this error by incorrectly assuming that creditors can prevent all opportunistic behavior solely through contract language, when they make no such assumption in the case of shareholders.

There is no easy fix for this doctrinal confusion, however. By increasing their leverage, firms have typically also increased the complexity of their capital structure, creating more opportunities for conflicting incentives among investors and thus more potential for disputes. We simply suggest that, under the current judicial approach to creditor disputes, we should expect to witness more opportunistic investor behavior, rather than less.

A more fulsome description of the argument follows.  Over the past several decades, American companies have increasingly funded their activities with debt instead of equity.   While no single factor drove this shift, innovations in debt contract and deal structure such as “junk bonds,” syndicated lending and securitization played an important role in increasing the supply of debt capital for large corporations.   On the demand side, the rise of private equity ownership of U.S. companies has translated into an insatiable appetite for debt capital to fund acquisitions and boost returns.   Some consequences of this shift from equity to debt financing are widely understood.  For example, large companies are more likely to file for Chapter 11 bankruptcy when financed with debt instead of equity and large firms may pay lower taxes than they would otherwise thanks to favorable tax treatment of debt.

In this Essay, we discuss an underappreciated aspect of the rise of debt finance for American capitalism: a shift in the relationship between large corporations and the law.  While the rise of corporate debt has meant many things, it has fundamentally not changed a fact of nature, which is that investors often have conflict with the corporations that imperfectly steward their capital and with other investors who have incentives to behave opportunistically.   Courts are often asked to mediate and resolve these disputes.  In this Essay, we show that the bodies of law that courts bring to bear are very different when the investment is structured as debt instead of equity.

In particular, the transition from equity to debt finance means that many disputes that might have been adjudicated using equitable doctrines like fiduciary duty law instead become breach-of-contract disputes, governed by the policy goals of contract law, which can lead to very different outcomes.   Moreover, because debt increases bankruptcy risk, many of these disputes are swept into bankruptcy courts, where the transactional focus of bankruptcy practice can bias judicial processes towards settlement and fresh start.   In short, the rise of debt financing has changed the role of judges, who now intervene in many corporate disputes to make sure the rules were followed instead of ensuring that the outcome is the right one.   The growth of debt financing is an underappreciated reason why investor disputes are increasingly adjudicated by judges who police procedure instead of searching for substantive fairness.

In this brief Essay, we discuss the drivers and consequences of the shift.  We begin by presenting the traditional theoretical framework for the protection of shareholders and creditors, respectively.  We then briefly describe the core difference between the legal tools that judges deploy to protect shareholders and creditors and contrast their focus.  Next, we offer two motivating case studies that demonstrate this contrast in practice.  We examine how judges treat an allegation by a minority investor that a majority investor has unfairly appropriated value that should have been shared, under both regimes.  As an illustrative dispute among shareholders, we examine the fairness-centered judicial approach in the 2021 “squeeze out merger” case of Empire Resorts, Inc.   As a dispute among creditors, we examine the formalist analysis in the 2022 bankruptcy case In re TPC Group Inc.

Finally, we argue that these contrasting approaches lack justification, given what we know of the debt markets today.  In a world of concentrated shareholder power on the one hand, and dispersed creditors on the other, the traditional rationales for treating shareholder and creditor disputes differently lose their force.  We close by considering and critiquing potential alternative approaches to disputes among creditors, including a revival of older contract law doctrines such as the implied duty of good faith and fair dealing, or changes to judges’ default approach in interpreting debt contracts, when the “four corners of the contract” lead to results that are deeply at odds with investor expectations.

The full paper is available for download here.