106 4 Debt
- Fiduciary duties, duty of loyalty, duty of care. Generally, bondholders are not
owed the same kinds of fiduciary duties, duties of loyalty, or duties of care as
shareholders (directly or, as residual claimants of the company, indirectly). The
difference is clearer in common law jurisdictions.^92 - Dividend payment. If the firm issues bonds and the bonds are priced assuming
the firm will maintain its dividend policy, the value of the bonds is reduced by
raising the dividend rate and financing the increase by reducing investment. - Claim dilution. If the firm sells bonds, and the bonds are priced assuming that
no additional debt will be issued, the value of the bondholders’ claims is redu-
ced by issuing additional debt of the same or higher priority. - Asset substitution. If the firm sells bonds for the stated purpose of engaging in
low variance projects and the bonds are valued at prices commensurate with
that low risk, the value of shares rises and the value of the bondholders’ claim
is reduced by substituting projects which increase the firm’s variance rate. - Underinvestment. A firm with outstanding bonds can have incentives to reject
projects which have a positive net present value if the benefit from accepting
the project accrues to the bondholders.
Covenants: general contents. Some types of debt covenants have been included in
debt contracts for hundreds of years. Debt covenants will normally cover:^93
- delivery of financial and other information;
- restrictions on incurring financial indebtedness and entering into sale and lea-
seback transactions; - restrictions on making loans and giving guarantees;
- a negative pledge restricting the creation of security;
- requirements to maintain appropriate insurance;
- restrictions on making payments to equity investors, on redemption of equity,
and on issuance of new shares; - prohibition of asset disposals;
- prohibition of mergers, acquisitions, or investments in business or shares;
- prohibition of change of control;
- restrictions on changes in business; and
- prohibitions on amendments to key documents.
(^92) For US law, see Metropolitan Life Insurance Co. v. RJR Nabisco, Inc. 716 F. Supp.
- For Canadian law, see Zumbansen P, Archer SB, The BCE Decision: Reflections
on the Firm as a Contractual Organization (July 14, 2008). CLPE Research Paper No.
17/2008. Available at SSRN.
(^93) Gayle C, Acquisition Finance – Syndication Best Practice, Int Comp Comm L R 13(8)
(2002) p 304. For event risk covenants and “designated events”, see Kahan M, Klausner
M, Standardization and innovation in corporate contracting (or ‘the economics of boi-
lerplate’), Virg L R 83 (1997) pp 713–770 at pp 740–742. See also Smith CW, Warner
JB, On Financial Contracting. An Analysis of Bond Covenants, J Fin Econ 7 (1979) pp
117–161 at pp 125–131; Ferran E, Principles of Corporate Finance Law. OUP, Oxford
(2008) pp 328–329.