The Paradox of Alignment: Agency Problems and Debt Restructuring

Traditional agency theory predicts that when a large company is trading solvently, shareholders will align their interests with those of the directors, but that this may also mean that when the company is financially distressed, directors will prefer shareholder interests to those of the creditors (even if there is no residual value for the shareholders in the company). Both the law and the market respond to this problem, and to date the situation has been held in some sort of approximate balance. However, this article examines the consequences of alignment of shareholder and director interests when a large private equity company is in financial distress, in light of the debt restructuring which is likely to be in contemplation and the type of director who is often retained. It argues that in these cases directors may have an incentive to support creditors' debt restructuring plans, and, paradoxically, the closer the alignment of their interests and those of the shareholders when the company is trading solvently, the greater this incentive to prefer creditors may be (even if there is still a residual interest for the shareholders in the company). The implications of this for the law and for the market are explored.