Taking Control Rights Seriously

Abstract

It is common to observe that investors receive both cash flow rights and control rights against a borrower. The crucial differences between these two “rights” is rarely focused on. Cash flow rights are rights in that they are legal entitlements. Outside of bankruptcy, failure to pay entitles a lender to resort to a legal remedy against the borrower. Inside of bankruptcy, the Bankruptcy Code structures the way in which these legal entitlements will be adjusted. Control rights are different. They do not confer direct power over the business, nor do they provide lenders with a judicial remedy that allows them to assert control. Rather, they work indirectly. The Bankruptcy Code, in turn, pays scant attention to a lender’s control rights. The reason for this disparate treatment stems from the lending contract. That agreement provides enforceable rights to cash – and as we have seen in recent years – there is little limit to the creativity in dividing up cash flow rights. The same contract, however, does not place control in the hands of a lender, even on a contingent basis. Lenders shy away from contracting on control because legal doctrines threaten creditors who put their hands on the levers of power. Outside of bankruptcy, while lender liability doctrine may be quiescent, its lingering shadow leads lawyers to counsel clients to avoid contracting for control upon a borrower’s default. Inside of bankruptcy, lenders that exercise what a court finds to be excessive control face the threat of having their claims equitably subordinated. In addition to these threats, it is far from clear that a bankruptcy court would enforce a contract that gave direct control to the debtor’s lenders should the debtor default. This environment causes lenders to try to do indirectly what they cannot do directly. These restrictions on contracting, however, are questionable, and opening up the contract space for direct contracting on control could increase contracting surplus.