Contingent Control Rights and Managerial Incentives: The Design of Long-term Debt

Abstract

This paper investigates the optimal design of long-term financial contracts when future investments are non-contractible ex-ante. We show that creditors are willing to write long-term debt if they are granted the right to replace the manager, extend debt maturity and take over the company as a going concern upon default. It is the combination of these control rights that makes these contracts sustainable. The threat of dismissal induces the manager to comply with the contract and make appropriate investments during the life of the contract even when these investments cannot be contracted upon. But it is the creditors' ability to extend the maturity of the contract upon default that makes this threat credible. We further show that if equity and debt has the same concentration, equally strong legal rights and if there are no tax benefits of holding debt, then a project that can raise long-term debt can also raise outside equity but the reverse is not true: there are projects that cannot issue debt but may still obtain outside equity financing. This is so because of the nature of the debtholders' control rights in no-default states. Since debtholders have contingent control rights, they cannot exercise control unless default has occurred. Hence, the manager can plan his strategic default ahead of time and milk the assets prior to default. For this reason, strategic default is more profitable for the manager when debt is used. Hence, the manager demands a higher compensation threshold in the case of debt financing. This is an endogenous indirect bankruptcy cost. The presence of this cost provides a rationale for a tax code that favors debt. With a code that allows for the tax-deductibility of interest, competition among investors increases since investors can trade off this bankruptcy cost against the tax benefits of debt. When interest is tax-deductible, projects with safe cash flows will strictly prefer to raise debt and projects with more volatile cash flows will issue outside equity.