Financial Articulation of a Fiduciary Duty to Bondholders with ...

More documents

Recommendations

Info

CREIGHTON LAW REVIEW market, 32 and its usefulness cannot be evaluated independently of the capital market efficiency on which it is grounded. 33 In the Black-Scholes scientific conception of the corporation, the stockholders own a call option, with operational control, on the bondholders' ownership of the corporate assets and cash flow. 34 Under this view, there is a dynamic mathematical "distribution of ownership between the stockholders and bondholders. '35 The corporation's stock is a compound option when the corporation issues finite-maturity risky coupon bonds; 3 6 the stock of the combined corporation in a nonsynergistic merger is a compound option. 37 Also, in general, corporate debt capacity is synergistic in nonsynergistic mergers. 38 C. UNANTICIPATED WEALTH EXPROPRIATIONS [Vol. 20 In general: "Bond protective contractual provisions" seek to fix existing corporate conditions (under which original bond purchase prices and bond interest rates are fixed) in order to restrict possible corporate acts which might adversely affect the value of their bonds, and they seek to force a preferred remedy (such as bond buyback, bond renegotiation, or corporate bankruptcy)when the value of their bonds significantly deteriorates. 39 The contract (termed on "indenture") containing these provisions (termed "covenants") is negotiated between the corporation representing the stockholders who control it and a separate corporation (termed a "trustee") representing the bondholders. 40 "Bond pricing" is the coordinate determination 32. Galai & Masulis, supra note 27, at 54-55. "Subsequent modification of the basic Black-Scholes model ... shows that the analysis is quite robust with respect to relaxation of the basic assumptions under which the model is derived. No single assumption seems crucial to the analysis." Smith, Jr., supra note 31, at 4. 33. See Bhattacharya, Empirical Properties of the Black-Scholes Formula Under Ideal Conditions, 15 J. FIN. & QUAN. ANAL. 1081, 1081, 1095 (1980). 34. Black & Scholes, The Pricing of Options and Corporate Liabilities, 81 J. POL. ECON. 637, 649-52 (1973); Stapleton, supra note 29, at 9. 35. Smith, Jr., supra note 31, at 43. 36. Geske, supra note 31, at 542 (stating: "At every coupon date, until the final payments, the stockholders have the option of buying the next coupon or forfeiting the firm to the bondholders."). 37. K. Shastri, supra note 26, at 10. "The valuation equations ... collapse to the Black-Scholes equation in three special cases." Id. at 14. 38. In other words, the debt capacity of the combined corporation in a nonsynergistic merger is generally greater than the sum of the premerger debt capacities of the corporations merging. Stapleton, supra note 29, at 15, 18, 24-25. 39. See Black & Cox, Valuing Corporate Securities: Some Effects of Bond Indenture Provisions, 31 J. FIN. 351, 355-57 (1976); Brody, Controversial Issue, BARRON's, Sept. 19, 1983, at 15, 19, col. 1; Jensen & Meckling, supra note 20, at 337-38; Smith, Jr. & Warner, On Financial Contracting: An Analysis of Bond Covenants, 7 J. FIN. ECON. 117, 119, 153 (1979). 40. See AMER. BAR FOUND., supra note 6; AM. BAR ASS'N COMM. ON DEV. IN BUSI- NESS FINANCING, SECTION OF CORP., BANKING AND Bus. L., Model Simplified Inden-
1986] FIDUCIARY DUTY TO BONDHOLDERS regarding a bond's purchase, interest, and redemption payments. "States of nature" are eventualities or possible future outcomes. "Variance" is a measure of dispersion around the expected (mean) value of outcomes. 41 The anomaly in the rule of corporate current-market-value maximization-generalized to conditions wherein the current market value of the corporation increases, remains the same, or decreases-is the basis of the bondholder-stockholder corporate conflict of interest. 42 Bond protective contractual provisions are a signal (indicator) to the capital market that the stockholder-controlled corporation will conform to the rule of corporate current-market-value maximization and efficiently use corporate assets. In general, this signal is reflected in the market values of the corporation's securities. 43 When the original bondholders lend money to a firm, they take cognizance not only of the returns in the different states of nature of the firm under its present management but also of the chance of a take-over bid, a new management which would make an alternative set of decisions. They must take into account all the possible take-over bids, and the resulting dispersion in the possible returns from the firm 4 4 may be very large indeed. Thus, ex ante contractual specificities in bond pricing might be ex post imperfect-even if they are ex ante perfect-because of unanticipated changes in facts, possibilities, and probabilities affecting the value of the bonds. 45 Bondholder-stockholder side payments which are caused by such contractually unanticipated changes are ture, 38 Bus. LAW. 741, 751, 758-62 (1983); Smith, Case & Morison, The Trust Indenture Act of 1939 Needs No Conflict of Interest Revision, 35 Bus. LAW. 161, 163-66 (1979); Stark, The Trust Indenture Act of 1939 in the Proposed Federal Securities Code, 32 VAND. L. REV. 527, 530, 537 (1979); Note, The Trust Indenture Act of 1939: The Corporate Trustee As Creditor, 24 UCLA L. REV. 131, 131 & n.3 (1976). 41. M. SPIEGEL, PROBABILITY AND STATISTIcs 78 (1975). 42. See E. FAMA & M. MILLER, supra note 9, at 152 n.5, 179-80; Galai & Masulis, supra note 27, at 62-71; Stiglitz, supra note 10, at 460-62. 43. Scott, Jr., On The Theory Of Conglomerate Mergers, 32 J. FIN. 1235, 1241 (1977). See Fama, supra note 21, at 283-84; Gilson & Kraakman, The Mechanisms of Market Efficiency, 70 VA. L. REV. 549, 613-14 (1984). Cf. Stiglitz, supra note 10, at 461 n.l1 (stating that "a firm which must have continual recourse to the capital market must continue to worry about returns in all states [of nature]"). 44. Stiglitz, supra note 10, at 473. 45. See id.; Farrell, Takeovers and Buyouts Clobber Blue-Chip Bondholders, Bus. WK. 113, 114 (Nov. 11, 1985) (statement of Mr. Harold H. Goldberg, Senior Vice-President, Moody's Investors Service, Inc.) (stating: "There's no way to anticipate a [bondrating] downgrade from a possible future [corporate] restructuring while remaining fair to a company's current prospects."); (paraphrase of statement of Mr. Frederick H. Joseph, Vice-chairman and Chief Executive Officer, Drexel Burnham Lambert, Inc.) (stating that "there's no protective covenant that a good lawyer can't get around."). For a discussion of bond ratings, see O'Neill & Weinberger, Corporate Restructurings and Bond Ratings, 17 MERG. & AcQ. 36, - (1982) (discussing the approach of Standard
Page 1 and 2: THE FINANCIAL ARTICULATION OF A FID
Page 3 and 4: 1986] FIDUCIARY DUTY TO BONDHOLDERS
Page 5: 1986] FIDUCIARY DUTY TO BONDHOLDERS
Page 37 and 38: 19861 FIDUCIARY DUTY TO BONDHOLDERS

Financial Articulation of a Fiduciary Duty to Bondholders with ...

Create successful ePaper yourself

Delete template?

Save as template?