Distress-Triggered Liabilities and the Agency Costs of Debt

Abstract

This chapter discusses distress-triggered liabilities: contingent obligations of a corporate debtor that are likely to be triggered by the debtor’s own financial distress. Three common examples of such liabilities are loan default penalties, loan prepayment fees such as make-whole premiums, and intragroup guarantees. Because the risk that a distress-triggered liability will become payable correlates positively with the debtor’s insolvency risk, the incurring of the liability shifts expected losses onto the debtor’s general creditors. The result is an incentive-distorting value transfer from creditors to shareholders that generates the agency costs of debt. Bankruptcy courts could prevent these costs by subordinating distress-triggered claims to general creditor claims. Subordination would preserve the positive economic functions of distress-triggered claims, which in most instances require only that the claims be enforceable to the extent the debtor is solvent. A subordination rule would be consistent with both the purpose and the text of the Bankruptcy Code.