Voluntary versus non-voluntary Creditors

a) Strong voluntary creditors versus weak voluntary creditors

Within the group of voluntary creditors, there are subgroups of creditors who find themselves in different positions with respect to their dealings with the corporate debtor. Thus, voluntary creditors include ‘strong’ voluntary creditors, namely those creditors who are able and also in a position to negotiate the terms of the contract on which credit is extended to the corporate debtor because they have the bargaining power to do that. This type of creditors includes primarily financial creditors, also described as ‘sophisticated creditors’.²⁰² The other type of creditors within the group of voluntary creditors are the ‘weak’ voluntary creditors, who in contrast to the former, are creditors who lack the bargaining power to protect themselves by way of covenants, security and other instruments.²⁰³ This subgroup of creditors includes primarily trade creditors, such as suppliers, and employees.²⁰⁴

Both subgroups of creditors face the risks that they would not be able to satisfy their contractual claims against the corporate debtor. The mechanisms they employ to protect themselves are different though, and this difference could also lead to conflicts of interests among the two. Some authors suggest that the weaker creditors can free-ride on the contracts of sophisticated creditors who impose restrictions on managerial actions, especially with respect to returning assets to shareholders through unlawful distributions, via bond indenture and loan covenants. The benefits from these restrictions and from the monitoring of the borrowers compliance with the terms of the covenants spill over to all creditors of the company.²⁰⁵ Thus, the sophisticated creditors are better equipped to exercise monitoring to ensure compliance and also bear the respective costs for such monitoring. Yet, this argument has been opposed. Mülbert draws attention to the shifting interests of creditors when the debtor firm approaches insolvency. While it may be true that from the compliance of the debtor firm with the restrictions imposed by the bond indentures and loan covenants, all creditors stand to benefit from the reduced risk of insolvency, when the corporate debtor violates the terms of the covenant, this picture changes as some of the clauses of these covenants, by necessity, work to the benefit of ‘strong’ and ‘sophisticated’ creditors.²⁰⁶ The covenants typically provide that debt owed to the contracting creditor matures in an accelerated

202 Enriques/Macey, Cornell Law Review, 2001, 1165, p. 1183.

203 Ferran, European Company and Financial Law Review, 2006, 178, p. 10.

204 Adams, Ökonomische Theorie des Rechts, p.247. These creditors are also known as ‘non-adjusting creditors’. See e.g. Brinkmann, European Company and Financial Law Review, 2008, 249, p. 260.

205 Enriques/Macey, Cornell Law Review, 2001, 1165, p. 1172. From the covenants imposed by the stronger sophisticated creditors to deter wrongdoing by debtor will benefit all creditors and not only those imposing these covenants.

206 Mülbert, European Corporate Governance Institute Working Paper Series in Law, 2006, p. 21; See also Mülbert/Birke, European Business Organization Law Review, 2002, 695, p. 724.

way and the creditor is entitled to the whole amount immediately when the corporate debtor violates the terms of the covenant. When the creditor chooses to enforce this clause, it risks deteriorating the financial position of the firm by draining the company’s liquidity and thus endangering the interests of weaker and smaller creditors who are not in a position to impose covenants or ask for collateral.²⁰⁷ This however seems to be a logical consequence of the fact that covenants are designed to protect the individual interests of the creditor party to the covenant, and not the interests of all the creditors. When the corporate debtor starts to experience financial stress, the contractually protected creditor will make sure to have her claims satisfied, even if that would mean that her actions could trigger a cash flow crisis leading to the insolvency of the borrower.²⁰⁸ After all, she did not spend her own funds to carefully negotiate the contract and her energies to monitor the borrower compliance just to sit back and see her claims devaluating so that the other creditors can also get to satisfy some, if not all, of their claims.

Moreover, covenants can sometimes be overly restrictive²⁰⁹ with respect to the allowable operations by the debtor, so that in extreme cases the ability of a debtor to meet her obligations under the loan comes under threat. As a result of that, the financial situation of the debtor firm is undermined rather than preserved,²¹⁰ thus endangering also the ability of the firm to make good on its promise to pay back the weaker creditors.

Further, contractual negotiations are not perfect²¹¹ and creditor monitoring is not always effective. Sophisticated financial creditors, such as banks, may apply lax monitoring practices as a matter of policy choice which relies more on loan portfolio diversification strategies rather than active monitoring to manage risks.²¹²

There is another reason why it is suggested that sophisticated creditors might not be willing to get too much involved in monitoring and controlling the corporate debtor to ensure compliance

207 Mülbert, European Corporate Governance Institute Working Paper Series in Law, 2006, p. 21 and Mülbert/Birke, European Business Organization Law Review, 2002, 695, p. 724 add that the sophisticated creditor, in case of violation of the covenant terms by the corporate debtor, may also negotiate for collateral, in which case the asset pool of the debtor would shrink, and thus constitute a disadvantage to the interests of the unsecured, ‘weak’ or ‘non-adjusting’ creditors. See also Krolak, Der Betrieb, 2009, 1417, p. 1419.

208 Ferran, European Company and Financial Law Review, 2006, 178, p. 11.

209 On certain cases, when the terms of the loan covenant with a creditor cause the borrower to breach its contracts with other creditors, such as employees, suppliers as well as other creditors, the former creditor may also face legal liability towards the borrower as well as towards the damaged creditors. For more see Smith Jr./Warner, Journal of Financial Economics, 1979, 117, p. 147.

210 Ferran, European Company and Financial Law Review, 2006, 178, p. 11.

211 Bratton, The Law and Economics of Creditor Protection, p.43; Schmidt, European Business Organization Law Review, 2006, 89, p. 89.

212 Ferran, European Company and Financial Law Review, 2006, 178, p. 11.

with the terms of the covenants. Sophisticated financial creditors, such as banks as well as other bondholders, may become liable to both the firm and the other creditors of the firm for losses incurred as a result of certain of their actions.²¹³ Thus liability may arise when a creditor who controls the firm is responsible for the mismanagement, as a result of which other creditors have incurred losses.²¹⁴ When sophisticated financial creditors get involved in the management of the debtor’s entire business, this involvement might also be accompanied by an equivalent responsibility for their actions towards other creditors of the firm.²¹⁵ This potential liability towards other creditors of a debtor firm, might limit the ability of sophisticated financial creditors to exercise adequate monitoring, despite their informational advantage regarding the financial situation of the debtor.²¹⁶

It follows from the above discussion, that ‘weak’ creditors cannot simply free-ride on the contracts of sophisticated creditors or on their monitoring skills. Because the financial means of a debtor firm at insolvency are not sufficient to satisfy all the debtors’ claims, creditors are prone to taking a ‘me first’ approach.²¹⁷ In these situations, ‘strong’ creditors are usually better placed to realise their claims, even if that would mean that the claims of ‘weak’ creditors would go unsatisfied.

b) Non-voluntary creditors

Non-voluntary creditors face the risk that they won’t be able to satisfy their claims against the company when the claims come into existence. Because these creditors cannot adjust the terms on which credit is extended, firms’ owners may benefit at the expense of non-voluntary creditors by externalising the costs for their activities and internalising the benefits.²¹⁸ In contrast to consensual or voluntary creditors who can decide²¹⁹ to lend or not to the corporate debtor, and if yes, how much and under what conditions, non-voluntary creditors find themselves in a position where they did not and could not decide either the terms of the credit or the time when the claim

213 The key concept for this kind of liability includes the shadow director’s liability.

214 Smith Jr./Warner, Journal of Financial Economics, 1979, 117.

215 Note, Yale Law Journal, 1938, 1009, p.1014. See also, Mankowski, in: Lutter (Hrsg.), Legal capital in Europe, 2006, p. 401.

216 Ibid., p. 402. Risk-averse creditors will avoid adopting strategies that would grant them too much influence over the debtor for fear of liability towards other creditors.

217 Ibid., p. 401: “The dog race is on, and the professionals definitely bark louder.”

218 Armour, Modern Law Review, 2000, 355, p. 363. E.g. through undercapitalisation of the firm or of its subsidiaries.

219 Adams, Ökonomische Theorie des Rechts, p. 241.

would be due.²²⁰ The problems that arise to non-voluntary creditors as a result of limited liability have been widely discussed in literature.²²¹

The existence of asymmetric information exacerbates the problems faced by this type of creditors. Although the problem of information asymmetry is not limited only to non-voluntary creditors,²²² because of the fact that they could not know in advance about the firm against which a claim would arise,²²³ they stand to experience major expropriation from the debtor, as the party which has an opportunity to redistribute wealth from the less informed party to itself.²²⁴ Usually, when the claims of non-voluntary creditors come into existence, the corporate debtor may already be insolvent and thus assets of the firm may be less than the value of an obligation that might be imposed on the firm. Further, the problem of information asymmetry, when coupled with the principle of limited liability and separate legal personality, may impair further the position of non-voluntary creditors vis-à-vis the debtor firm.

The corporate debtor could make use of the practice of ‘judgment proofing’, that is undercapitalising either the firm or the subsidiary conducting, for instance, high-risk activities against which third parties could file a claim. Thus firm’s owners may shift the assets to other persons so as to make them unavailable for the payment of claims in the event of default, or they may establish subsidiaries with limited assets and the costs of any harm it generates as a result of business failures are transferred uncompensated to this class of creditors.²²⁵ Limited liability provides an incentive for firm’s owners to engage in this kind of behaviour, because they can externalise the costs and internalise the benefits from this behaviour. Additionally, limited liability provides firm’s owners with the option to liquidate the firm and distribute its assets before the liability for the firm’s activities attaches. Because firm’s liability for tortuous acts may rise a long time after the acts have been committed, non-voluntary creditors, in this case

220 Hansmann/Kraakman, Yale Law Journal, 1991, 1879, p. 1991; Adams, Ökonomische Theorie des Rechts, p. 242; Merkt, Zeitschrift für Unternehmens- und Gesellschaftsrecht, 2004, 305, p. 320;

Wiedemann, Zeitschrift für Unternehmens- und Gesellschaftsrecht, 2006, 240, p. 247.

221 See Halpern/Trebilcock/Turnbull, University of Toronto Law Journal, 1980, 117;

Hansmann/Kraakman, Yale Law Journal, 1991, 1879; Leebron, Columbia Law Review, 1991, 1565;

Pettet, Current Legal Problems, 1995, 125; Bebchuk/Fried, Yale Law Journal, 1996, 857; Mankowski, in: Lutter (Hrsg.), Legal capital in Europe, 2006, p. 396 ff; Armour et al. in: Kraakman et al., The Anatomy of Corporate Law, p. 116.

222 Because real credit markets are imperfect, information about borrowers cannot be obtained without costs, and therefore there will always be a class of creditors (even contractual ones) who remain

“rationally ignorant” of relevant information. See Armour, Modern Law Review, 2000, 355, p. 359.

223 Mankowski, in: Lutter (Hrsg.), Legal capital in Europe, 2006, p. 396.

224 Armour, Modern Law Review, 2000, 355, p. 359.

225 Ibid., p. 363. Also Halpern/Trebilcock/Turnbull, University of Toronto Law Journal, 1980, 117,) p. 145.

tort creditors as long-term creditors, face the prospects that they will not be compensated for the losses incurred as a result of the firm’s actions.²²⁶

Last but not least, the risk that claims of non-voluntary creditors against an insolvent corporate debtor might go unsatisfied increases when the debtor has secured creditors. Because the claims of non-voluntary creditors rank the same with those of general creditors of a company, namely lower in priority than the claims of secured creditors, non-voluntary creditors would have to share on a pro-rata basis with general creditors the remaining assets of the corporate debtor.

Thus, the existence of secured creditors has the potential to reduce substantially, especially in the case of closely held firms, the ability of a firm to meet its obligations towards non-voluntary creditors.²²⁷