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Exploring the Limits of Contract Design in Debt Financing

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.