Matt Levine / Money Stuff: Debt and equity

Old_Joe

There are two main ways for companies to finance themselves, debt and equity. Debt financing means that you borrow money and promise to pay it back on some set schedule with some set interest rate. Your creditors are entitled to exactly what you owe them, and if they don’t get it then they can sue you for the money, or put you into bankruptcy if you don’t have it.

Equity financing means that you sell stock to investors and you never have to pay it back. Your shareholders are not entitled to anything specific; there is no particular amount of money that they have to get back or any schedule for when they get it. But they are in some loose sense part-owners of the company, they have a residual claim on its cash flows, and they vaguely hope to one day get their money back through dividends or stock buybacks or mergers. They can’t make you share the profits in any direct way, but a share of the profits is what they want. And while there is no guarantee of what they’ll get, there is also no limit to it: If they buy 1% of the stock when the company is worth $10 million, they put in $100,000; if they then sell when the company is worth $100 billion, they get back $1 billion. That’s hard to do with debt.

These different economics come with different legal regimes. Broadly speaking, creditors have a specific contract — a bond indenture or loan agreement — saying how much they are owed, and they are entitled to what’s in the contract. If the company breaches the contract — if it doesn’t pay them what it owes when it owes them, or if it doesn’t do something else required by the agreement — then the creditors can sue and get their money back or put the company in bankruptcy. But if the company doesn’t breach the contract, then the creditors can’t complain.

And so we have talked occasionally around here about various sorts of debt shenanigans, where a company’s lawyers (or some of its creditors) read the debt contracts cleverly and say “hey, technically, this contract allows us to make life much worse for some of our creditors, we can work with that.” Generically, the way that this often works is that the company takes some value from 49% of its creditors and gives it to the other 51%, in exchange for more money or flexibility. And then the 49% creditors sue, saying “that’s not fair, you can’t do that, that’s not allowed by the agreement,” and the company says “no, actually, this paragraph says we can do that,” and there is a highly technical argument over what precisely the language of the contract allows.

Equity is different. Shareholders have much less in the way of contractual rights; they don’t have much legal right to force the company to do anything specific. But there are broad fiduciary duties requiring company executives not to put one over on shareholders, to treat shareholders fairly, to run the business on behalf of all of the shareholders equally. The shareholders are not entitled to specific stuff, but they are entitled to general fairness.

Last year, in this column, I wrote about a weird merger deal where a buyer was trying to pay some of the target shareholders more than others. My basic point was that you mostly can’t do that — there are some exceptions, but generally speaking the board of directors of a company has an obligation to treat its shareholders fairly, and courts will get annoyed if it doesn’t. And then in the next section of that column, we talked about some lawsuits over distressed debt shenanigans. “In debt, the rule is different,” I wrote. Treating creditors unfairly is generally fine:

The basic question in these cases is: Can you just read the debt documents as craftily as possible, do whatever is strictly allowed by the text, and benefit some creditors at the expense of others? Or is there some background requirement of fairness or “oh come on it can’t have meant that,” so that your craftiest readings don’t actually work? The traditional view is that shareholders are entitled to fiduciary duties — which is why mergers have to be more or less fair to all shareholders — while creditors are entitled only to the letter of their contract. That traditional view has given rise to, you know, all this: a whole industry of distressed-debt cleverness built on structuring transactions to exploit the documents as much as possible. I suppose it is possible to take it too far, though: If creditors get too good at ruthlessly exploiting each other, eventually courts might step in and say “oh come on it can’t have meant that.” If a rule like “creditors are only entitled to what their contract explicitly says” always leads to absurd results, it might stop being the rule.

Here is a fascinating paper, and a related blog post, by Jared Ellias and Elisabeth de Fontenay about “Law and Courts in an Age of Debt”:

Highly leveraged firms are now commonplace in many U.S. industries. Shifting from equity to debt financing is not simply a matter of optimizing a firm’s cost of capital, however. It also has profound implications for the firm’s behavior and investor outcomes.

In Law and Courts in the Age of Debt, we describe one underappreciated feature of the shift from equity to debt, which is that courts resolve disputes among shareholders and among creditors using strikingly different rules and decision frameworks. Shareholder disputes are typically resolved using equitable doctrines such as fiduciary duties, with the explicit goal of reaching a substantively fair result. In creditor disputes, by contrast, courts tend to limit their role to formal contract interpretation and procedural oversight, often reaching results at odds with both market expectations and notions of fairness. For example, a controlling stockholder attempting a minority freezeout faces punishing scrutiny aimed at ensuring fair terms for the minority stockholders, while majority creditor groups today can, and increasingly do, receive judicial blessing for transactions that simply extract wealth from other creditors (an outcome colorfully referred to by practitioners as “lender-on-lender violence”).

This disparate approach is increasingly difficult to justify. We argue that it rests on antiquated paradigms of powerless shareholders, in the one case, and all-powerful banks, in the other. Judges compound this error by incorrectly assuming that creditors can prevent all opportunistic behavior solely through contract language, when they make no such assumption in the case of shareholders.

There is no easy fix for this doctrinal confusion, however. By increasing their leverage, firms have typically also increased the complexity of their capital structure, creating more opportunities for conflicting incentives among investors and thus more potential for disputes. We simply suggest that, under the current judicial approach to creditor disputes, we should expect to witness more opportunistic investor behavior, rather than less.

One interesting thing to think about is whether some of the causation might run the other way: Are highly leveraged firms now commonplace because they allow for more opportunistic behavior? If you are the owner of a company that needs financing, and you are choosing whether to issue more equity or more debt, you will have a series of considerations:

• 1) There are, as it were, first-order corporate finance considerations: Selling equity gives up more ownership of your company, and thus more upside if things go right; if you are optimistic you will not want to sell equity. Selling debt requires repayment, though, and if things go poorly having too much debt can destroy your company. You will want to raise only as much debt as you can safely pay off.

• 2) There are various considerations that come from existing market and social and legal structures. You might not want to sell stock to meddling venture capitalists, or in a public offering where it will end up in the hands of activist investors and short-term-focused institutions. You might want to sell debt because interest payments on debt are tax-deductible and the cost of equity is not.

• 3) There is, also, the potential for opportunism. If you sell stock, you mostly cannot be opportunistic in your treatment of your shareholders; they can sue you for breach of fiduciary duty and come to court and say “this wasn’t fair” and a court will agree with them. If you sell debt, you can be very opportunistic in your treatment of your creditors; they can sue you for breach of contract and come to court and say “this wasn’t fair” and you will say “hahahahaha gotcha, in section 19.37(c)(ii) it says I can do whatever I want,” and the court will say “that’s true it does” and let you do whatever you want.

If you are confident in your ability to write and interpret contracts in a way that allows you to be opportunistic (and prevents your creditors from being opportunistic), and willing to put one over on your creditors to maximize value for yourself, you might be inclined to issue relatively more debt and relatively less equity. You get some option value by having more contracts that you can interpret opportunistically, which you don’t get from issuing equity that requires you to act fairly.

If I ran, oh, just for instance a private equity firm that employed a lot of very smart capital-structure experts and retained the best lawyers and got lots of repeat experience buying companies and raising financing for them and doing clever stuff to make money off of them, I might prefer to finance those companies with a lot of debt not only for the favorable tax treatment but also precisely because debt financing is a way for me to express and make money from my cleverness. You can’t be too clever with your shareholders! You can be very clever indeed with your creditors.