1. ETH Zurich, Spring 2015 Law & Business Transactions Creditor Protection Gérard Hertig

2. I. Creditor – Debtor Conflict of Interests Creditors – Assessing debtor’s current situation = Ability to perform – Preventing subsequent changes that affect performance Loans as an example – Debtor’s ability to pay interests/reimburse principal → Look at assets and liabilities Proper representation : Omission and misrepresentation issues Correct evaluation: Market liquidity, accounting and perception issues – Debtor’s change in business plan or increase in risk taking Impact on capability to pay back loan: Increase in insolvency risk Impact on loan profitability: Lower risk adjusted returns 11.03.2015G. Hertig2 Agency Issues / Solvent Firms / Distressed Firms

3. Examples 1 – 5 : Ex Ante Issues 1.Firm A. is considering purchasing new software from IT specialist X. What should it take into account during its due diligence analysis? 2.Firm B plans to buy spare parts from a foreign manufacturer. It is concerned about adequate performance. How can it deal with this issue via contractual provisions? 3.Butcher C would like to get a SFR100’000 loan from bank D. What kind of information is bank likely to ask during contractual negotiations? 4.Corporation E also operates a meat business and is interested in getting a credit line from Bank D. Will the bank ask for different/more information from Corporation E than from Butcher C? 5.Corporation F has acquired the right to drill an oil well and needs financing to be able to start its operations. What should a lender be concerned about? 11.03.2015G. Hertig3 Agency Issues / Solvent Firms / Distressed Firms

4. Examples 6 – 10 : Ex Post Issues 6.Firm A just learned that IT specialist X is considering developing a new type of software as well as starting to sell its products abroad. Should it be concerned and amend the draft contract accordingly? 7.Firm B hears that the foreign manufacturer could be acquired by a large, service-oriented multinational company. Should it be concerned and amend the draft contract accordingly? 8.Butcher C indicates during his talks with Bank D that he is considering acquiring several neighborhood butcheries and mentions that they are for sale because they are not doing well. Should Bank D be concerned and amend the draft loan contract accordingly? 9.Corporation E indicates to Bank D that it plans to increase the dividends paid to its shareholders over the next couple of years. Should Bank D be concerned and amend the draft loan contract accordingly? 10.Corporation F is also considering using untested drill technologies if existing methods do not produce the expected results. Is that of concern for a lender? 11.03.2015G. Hertig4 Agency Issues / Solvent Firms / Distressed Firms

5. Self-Protection by Creditors Obtaining debtor information – From debtor directly Role of creditor’s bargaining power Observability and verifiability – Using third party credit analysis – Relying on reputation? Tailor-made covenants – Going beyond standard terms – Transaction costs Introducing exit opportunities – Security interests: Mortgages, financial instruments, etc. – Acceleration clauses: Debt becomes due and payable upon violation of contractual covenants Getting third parties involved – Having family and friends pledge assets or guarantee performance – Requiring a bank guarantee 11.03.2015G. Hertig5 Agency Issues / Solvent Firms / Distressed Firms

6. Taking into Account Debtor Management Management – Owner Conflicts of Interests – Owner benefits from upside if more risks are taken – Managers may be more reluctant to take risks Fixed compensation Risk aversion? Taking the risk issue into account – Bonuses and equity stakes for managers Aligns owner’s and managers’ interests Not necessarily bad for lender: Deferred compensation approaches – What about lower-rank employees? Managerial risk aversion – As creditors – As equity holders? 11.03.2015G. Hertig6 Agency Issues / Solvent Firms / Distressed Firms

7. Protecting Non-Adjusting Creditors Non-adjusting creditors – Unable to adjust the term of their exposure to the risks they bear – Victims of corporate torts as an example Exposed to opportunistic shareholders – Compensated for risk-taking – Not subject to personal liability if firm becomes insolvent Protecting non-adjusting creditors – Require firms to take insurance when engaging in risky, externality producing activities – Impose additional capital requirements (see below) – Give non-adjusting creditors priority in insolvency situations 11.03.2015G. Hertig7 Agency Issues / Solvent Firms / Distressed Firms

8. Examples 11 – 14 : Managers and Creditors 11.Owner A wants the firm to invest in a very risky research project, which may allow the firm he owes to significantly enrich its biotech patent portfolio. Both the firm’s CEO and the firm’s employees oppose this initiative because it would require taking additional bank loans and increase the firm’s debt service burden. How do you assess this resistance? 12.Bank B is willing to provide additional loans, but would like to make sure that they are used for the research project and not for other business purposes. How could it proceed? 13.The local employee union, for its part, is concerned about the patents being ending up being sold to a firm located in another region, which would have negative impact on local employment. What is your advice? 14.Various neighborghs are concerned about biotech research related air pollution in the vicinity of the firm. Is moving their only option? 11.03.2015G. Hertig8 Agency Issues / Solvent Firms / Distressed Firms

9. II. Solvent Firms Two dominant strategies adopted by lawmakers Mandatory disclosure – Reduces creditors’ costs of gathering information – Costs for smaller firms – Verification by gatekeepers Legal capital for corporations – Owners are not directly liable for losses – Minimum Capital – Distribution restrictions – Imposing actions if serious loss of capital 11.03.2015G. Hertig9 Agency Issues / Solvent Firms / Distressed Firms

10. Mandatory Disclosure (1) Facilitates deals by reducing transaction costs – Contract law: Culpa in contrahendo – Corporate law: Companies must disclose basic information Closely-held corporations = Smaller firms – Keep financial accounts (US) – Prepare financial statements in accordance with accounting standards + available for public inspection – Difference not significant: Exemption for very small firms, limited enforcement, market demand 11.03.2015G. Hertig10 Agency Issues / Solvent Firms / Distressed Firms

11. Mandatory Disclosure (2) Publicly-held corporations = Larger firms – All material information – Periodically file + immediately report new developments What about creditor-oriented accounting? – In past: Focus on ‘conservative’ approach Favors understatement of assets Reduces screening costs – Nowadays: Focus on market-prices As important for creditors than for investors Many financial instrument have debt as well as equity component 11.03.2015G. Hertig11 Agency Issues / Solvent Firms / Distressed Firms

12. Examples 15 – 18 : Managers and Creditors 15.The CEO of a very large corporation has just been diagnosed with a grave illness. Should the firm make this public and, if so, why and within which timeframe? 16.A major customer just decided to switch supplier. Should the firm make this public and, if so, why and within which timeframe? 17.Gold is one of the major assets of a jewelry-maker. Gold prices have been raising significantly in past weeks. Should the firm disclose something, and if so what and when? 18. The firm’s employees have decide to strike the day after tomorrow. Should the firm make this public and, if so, why and within which timeframe? 11.03.2015G. Hertig12 Agency Issues / Solvent Firms / Distressed Firms

13. Mandatory Disclosure (3) Role of Gatekeepers = Trusted Third Parties – Auditors, credit bureaus and credit rating agencies – Their verification should enhance disclosure quality Credibility – Gatekeepers pledge their reputation – Auditor liability Creditors are foreseeable users of financial statements Creditors have special relationship with auditors Trade-off – Requiring too little from gatekeepers: Opportunism – Requiring too much from gatekeepers: No supply 11.03.2015G. Hertig13 Agency Issues / Solvent Firms / Distressed Firms

14. Legal Capital Minimum and voluntary capital – ˃ €25’000 in EU: Small in view of effective capital needs – Showing seriousness vs. Tapping less expensive sources of funding Reinforcing credibility of voluntary capital – Distributions to shareholders restrictions – Dividends, share repurchase) and hidden distributions (RPT) – Issues Accounting methodology dependence Constraining restructurings 11.03.2015G. Hertig14 Agency Issues / Solvent Firms / Distressed Firms

15. III. Distressed Firms Financially distressed firms – Firms in the vicinity of insolvency → viability ? – Incentives for owners to engage into asset substitution Legal responses – Encouraging managers to act in interest of creditors – Enlisting controlling shareholders – Requiring shareholder meeting if serious loss of capital – Insolvency triggers Net asset value is zero or below capital Managers, owners or creditors pull the trigger → 11.03.2015G. Hertig15 Agency Issues / Solvent Firms / Distressed Firms

16. Managers and Insolvency Discretion to trigger insolvency proceedings Liability – Formal and de facto managers – Creditor suffer losses due to board negligence or fraud Usefulness for creditors – Managers as owners vs. managers as employees – Rich managers vs. poor managers Enforcement risk – Higher in continental Europe and Japan? – Lower in UK and US? 11.03.2015G. Hertig16 Agency Issues / Solvent Firms / Distressed Firms

17. ‘Controlling’ Shareholder and Insolvency CS as de facto managers – Indemnifying corporation for its losses – Paying corporate debts Subordinating CS claims – Behaving inequitably (US) and automatic subordination (D) – Impact on CS willingness to rescue failing firm? Piercing the corporate veil – CS made personally liable for corporate debt – Generally for fraud or blatant opportunism 11.03.2015G. Hertig17 Agency Issues / Solvent Firms / Distressed Firms

18. Examples 19 – 21 : Shareholder Liability 19.Corporation X has made heavy losses due to the adoption of a risky business plan. The controlling shareholder has been instrumental in the designing and implementation of the strategy. Can creditors or the firm sue him and, if so, for what? 20.Controlling shareholder involvement has put the firm in financial distress. Can the firm refuse to reimburse a loan he has made and which is due on the ground that other creditors may not be reimbursed in the distant future? 21.V, the controlling shareholder of firm WW behaves as if I were the firm’s CEO. The chairman of the board indicates that he will be held personally responsible for the firm’s debt. Is this a correct assesment? 11.03.2015G. Hertig18 Agency Issues / Solvent Firms / Distressed Firms

19. Creditor and Insolvency Triggering insolvency proceedings – Single or 3 creditors: Firm is insolvent in cash-flow sense – Model 1 (traditional) Removing board from effective control over assets Appointment of administrator (crisis manager) – Model 2 (modern) Keeping board in charge Creditors can ask appointment of trustee Limited control and exit role – Courts as the principal trustee – Managers drive reorganization and sale 11.03.2015G. Hertig19 Agency Issues / Solvent Firms / Distressed Firms