Creditors and Debt Governance

This chapter, from the forthcoming Research Handbook on the Economics of Corporate Law (Claire Hill & Brett McDonnell, eds.), provides an introduction to the law and economic theory relating to creditors and debt governance. The chapter begins with a look at the traditional role of debt, focusing on the impact of debt on corporate governance and, in particular, the effect of an illiquid credit market on creditors' reliance on covenants and monitoring. It then turns to changes in the private credit market and their effect on lending structure. Greater liquidity raises its own set of agency costs. In response, loans and lending relationships have adjusted to mitigate those costs, providing new means by which debt can influence corporate governance. Going forward, a firm's decision to borrow must increasingly take account of the costs and benefits of a liquid credit market. How firms are governed is closely related to how they raise capital. Managers who maximize firm value can finance their business at lower cost than managers who pursue personal goals. Thus, actions that affect a firm's credit quality are likely to be reflected in changes in the secondary price at which its loans and other credit instruments trade. Those changes, in turn, may affect a borrower's cost of capital, providing managers with a real incentive to minimize risky behavior. The intuition, described at the end of the chapter, is that a liquid private credit market may begin to provide a discipline that complements the traditional protections of contract