Benjamin Segal investigates whether the fiduciary duty to creditors reduces debt covenant violation avoidance behavior.

Benjamin Segal and co-authors have a paper in Journal of Business Finance and Accounting titled, “Does fiduciary duty to creditors reduce debt covenant violation avoidance behavior?” After pointing out that directors normally owe fiduciary duties to equity holders and not creditors, they examine whether this 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. They 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. They 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, the results suggest that unless directors are required to protect creditors’ interest, they are likely to take actions to circumvent debt covenant violations.