Does fiduciary duty to creditors reduce debt covenant violation avoidance behavior?

Shai Levi, Benjamin Segal*, Dan Segal

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

1 Scopus citations

Abstract

Financial reports should provide useful information to shareholders and creditors. Directors, however, normally owe fiduciary duties to equity holders and not creditors. We examine whether this slant in fiduciary duties affects the extent to which firms use financial engineering to circumvent debt covenant violation. By avoiding debt covenant violation, firms prevent creditors from taking actions to reduce bankruptcy risk and recover their investment, and allow the firm to continue operating for the benefit of equity holders. We find that a Delaware court ruling that imposed fiduciary duties toward creditors led to a decrease in financial engineering and debt covenant avoidance in Delaware firms. We also show that board quality lowers financial engineering and debt covenant avoidance by firms only when their directors owe a legal fiduciary duty to creditors. Collectively, our results suggest that unless directors are required to protect creditors’ interest, they are likely to take actions to circumvent debt covenant violations.

Original languageAmerican English
Pages (from-to)929-953
Number of pages25
JournalJournal of Business Finance and Accounting
Volume48
Issue number5-6
DOIs
StatePublished - 1 May 2021

Bibliographical note

Publisher Copyright:
© 2020 John Wiley & Sons Ltd

Keywords

  • board independence
  • debt structuring
  • director fiduciary duties

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