If we may allude to the biblical injunction that no one can serve two masters, for example, fiduciary duties to bondholders would create a two masters problem. When shareholder and bondholder interests conflict, which interests do the directors pursue? A closely related concern is the potential that directors would camouflage self-interested decisions by aligning themselves with the affected group whose interests mirror their own.
In addition, the underwriting process ensures that the indenture will contain efficient protections for bondholders. Some argue that the underwriters have a pecuniary interest in pleasing the issuer, not the bondholders,[1] but the relationship between underwriters and bondholders is a classic repeat transaction phenomenon. Underwriters will not sully their reputation with bondholders for the sake of one issuer.[2] In a firm commitment underwriting, moreover, the underwriters buy the securities from the issuer. If the indenture does not provide adequate levels of protection, the underwriters will be unable to sell the bonds.[3]
Portfolio theory further suggests that bondholders are fully compensated for the risks posed by potential breaches of fiduciary duty. Arguably such risks are unsystematic in nature, so that the bondholders can eliminate them by holding a diversified portfolio. Even if such risks are characterized as systematic risks, moreover, the pricing mechanism will ensure a rate of interest that compensates the bondholders for those risks.
Consequently, the better view is that neither the corporation itself nor its officers and directors owe fiduciary duties to bondholders, as the leading cases hold.[4] Instead, “the relationship between a corporation and the holders of its debt securities, even convertible debt securities, is contractual in nature.”[5] The indenture thus both defines and confines the scope of the corporation’s obligations to its bondholders.
[1] See, e.g., Lawrence E. Mitchell, The Fairness Rights of Corporate Bondholders, 65 N.Y.U. L. Rev. 1165, 1183 (1990); see also Dale B. Tauke, Should Bonds Have More Fun? A Reexamination of the Debate Over Corporate Bondholder Rights, 1989 Colum. Bus. L. Rev. 1, 24-26 (noting potential conflicts of interest on the part of underwriters). For an instructive critique of the contractarian position, see Eric W. Orts, Shirking and Sharking: A Legal Theory of the Firm, 16 Yale L. & Pol’y Rev. 265 (1998).
[2] Marcel Kahan, The Qualified Case against Mandatory Terms in Bonds, 89 Nw. U. L. Rev. 565, 591-92 (1995).
[3] The issuer’s board and management has a strong self-interest in holding down the corporation’s cost of capital—e.g., avoiding takeovers, maximizing personal wealth, and avoiding the adverse consequences of firm failure. Because directors and managers cannot diversify away the risk of firm failure, as shareholders may, they are more risk averse than shareholders with respect to conduct that could raise the firm’s cost of debt capital. If directors and managers pursue shareholder wealth at the expense of bondholders, however, such conduct will come back to haunt management the next time it uses the bond market to raise capital. Coupled with the fact that their nondiversifiable interest in firm failure means that board and officer risk preferences typically are closer to those of creditors than of shareholders, their self-interest provides significant protections for bondholders.
[4] See, e.g., Metropolitan Life Ins. Co. v. RJR Nabisco, Inc., 716 F. Supp. 1504, 1524-25 (S.D.N.Y. 1989); Simons v. Cogan, 549 A.2d 300, 304 (Del. 1988); Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173, 182 (Del. 1986).
[5] Katz v. Oak Indus. Inc., 508 A.2d 873, 879 (Del. Ch. 1986).
