Lenders have long been a vital a part of the checks and balances essential to good corporate governance, but in recent years many have begun to abandon their role. This dereliction of duty has gone largely unnoticed and under theorized, but has enormous consequences: it heralds the disappearance of a vital source of fiscal discipline and governance at a moment when U.S. corporations carry more debt than at any time in history, totaling half of GDP. This text presents the first theoretical and empirical examination of this dramatic change in corporate governance (or more accurately, non-governance) and its implications for corporate law and financial regulation.
When Scott Livengood, the CEO of Krispy Kreme doughnut company, was unceremoniously fired in 2005, scholars and industry watcherstook note. Livengood had been an exemplary CEO, successfully expanding his company from a largely regional chain of doughnut shops to a nationwide phenomenon. He was also legendary for his loyalty to the brand, even having his wedding cake made entirely out of Krispy Kreme donuts. His firing seemed puzzling at first, but the reason soon became clear: the company had breached a small technicality in a loan agreement, and the lenders, who decided the company needed a change in direction after a few months of bad results, became empowered to take drastic action and replaced the CEO.
This suggests that scholars and practitioners have overlooked an important consideration with respect to corporate governance and lenders’ role in corporate management in particular. Financial engineering introduces a powerful force into corporate governance that existing theories fail to account for. As this Article shows for the first time, important elements of corporate governance are a function of financial markets, and financial innovations in recent years have left lenders with little motive to fulfill their traditional roles. The empirical evidence presented in the Article bears out what a theory of interactivity that takes corporate finance into account would predict: that lenders have begun to abandon their role as corporate monitors for an important and gro wing class of corporate relationships.
Lenders’ Role in Corporate Governance
Corporations depend on debt to finance their activities. Broadly, corporate debt takes one in every of two forms: bank loans evidenced by contracts between lenders and company borrowers, and debt securities like bonds which will be traded among investors. Bonds, like other forms of securities, are relatively impersonal; investors have little direct relationship with the borrowers and may usually only affect the borrower if they hold a high percentage of face value of the bonds, usually a minimum of 50%.
Lenders, governance and agency costs
For the past several decades, the study of corporate law has focused on the separation of ownership and control, and also the agency cost problems that arise when the interests of shareholder-owners diverge from the interests of corporate manager-agents. This might happen for variety of reasons, like management’s desire to entrench itself, empire building, excessive compensation, over consumption of corporate perquisites, or simple incompetence. Remedying these agency costs is usually seen because the goal of corporate governance.
Lenders and enhanced firm value
On the other hand, lenders can influence firm governance in ways that lead to increased value for all stakeholders. Scholars have framed the benefits of lender intervention using a theory of interactive corporate governance. According to this theory, instead of a conflict between equity holders and debt holders as described above, both equity and debt holders have a common interest in containing agency costs by management. All stakeholders benefit from mechanisms that discipline management to be financially responsible, take appropriate (but not outsized) risks and restrict wastefulness, sometimes referred to as managerial “slack.” Lenders have superior expertise with regard to debt management and fiscal responsibility, and they provide their expertise by interacting with internal corporate stakeholders.
Corporate debt and leveraged loans
A trend that is indirectly undermining lenders’ influence in governance is the expansion of the leveraged loan market, which in turn is driven by the expansion of structured finance. Leveraged loans are a staple of corporate finance, providing the dominant means for corporations to obtain funding for M&A activity and leveraged buyouts, among other things.
The market for leveraged loans has changed dramatically in recent years. Before 2010, loans were arranged and distributed in a manner similar to some types of securities offerings. The lead bank performed due diligence on the borrower, analysed the borrower’s credit and negotiates the loan terms, including the covenants which provide the mechanism for influencing corporate governance.
Structured Finance and CLOs
Structured finance is a primary factor driving increased demand for leveraged loans, and in turn, the move toward cov-lite loans. Structured finance vehicles, in particular, CLOs, have emerged as the dominant investors in the corporate loan market, and are estimated to hold over half of all non-investment grade loans, driving a large part of the market for them.
CLOs bundle leveraged loans—relatively risky loans from debtladen borrowers—and convert them into “safe” securities. The loans that go into CLOs are term loans—TLAs, TLBs and so on. Although each of the underlying loans in a CLO portfolio is individually rated, the attraction of the CLO to investors is the tranched structure: interests in the collateral pool are sold as debt instruments, such as notes, issued by the SPV, but these notes carry different risks of loss compared to the underlying pool of loans.
In most such securitizations, the first losses suffered by the collateral pool (for instance, when the first borrowers default) are borne by the lowest tranches of notes; meanwhile, the highest tranches are the last to lose anything. In addition to giving banks incentives to lend by increasing demand, CLOs allow banks to engage in regulatory arbitrage that allows them to lend more. Before the widespread use of structured finance, corporate loans were often held on the lenders’ balance sheets, providing an incentive to screen and monitor borrowers. Securitizing the loans—in essence, selling both the right to payment and the risk of default to a CLO—allows lending banks to finance them off of their balance sheets. This has benefits for banks’ management of their regulatory capital.
EMPIRICAL CASE STUDY IN NON-GOVERNANCE: DATA AND ANALYSIS
This article searches and analyzes a large original dataset of corporate loans that provides evidence of the extent of corporate governance interventions that lenders take, and how these interventions change with the changing supply of credit due to securitization. The empirical analysis consists of three parts. In the first part, I investigate whether the lender governance interventions that were documented in the period before the financial crisis are still apparent. Following the methods used in prior research, I seek to establish whether patterns that held before the financial crisis still hold today. I do this using a first-difference approach (an approach that allows for changes in a company over time, as per the older studies), and controlling for the financial covenants that both violators and non-violators are subject to. The goal is to see how indicia of good management change following a violation. If there is a notable improvement, as was observed in the pre-crisis era, it is an indication that lender interventions were effective at improving a company’s governance and management.
Loan and covenant violation data
In order to separate the true positives from false positives, I manually coded 1,000 of the filings, and used a machine learning algorithm to separate true positives from false positives. In order to do this, I used 600 of the 1,000 hand-coded filings to iteratively train a deep neural net to classify the remaining filings. After the classifier was run on the remaining data, I performed a further check on 200 randomly selected filings to test for accurate classification. I found that the classifier had correctly identified each one. The result was a sample of 3,581 firm-quarters for which a new covenant violation was reported, involving 1,343 borrowing companies. The entire dataset was then matched with long-term bond rating data from Standard & Poor’s for each company in each quarter.
Analysis of financial indicators
Research on lender intervention has found that that lenders intervene after a covenant violation, and that the intervention leads to better performance, as measured by a number of indicators. That research also found that covenant violations frequently result in renegotiation of the loan agreement shortly after the violation, indicating the lender placing more restrictions on the borrower.
The Relationship Between Structured Finance and Corporate Non Governance
The findings support the connection between structured finance and lenders’ abdication of their corporate governance role. The withdrawal of lenders from corporate governance exposes a gap in the common understanding of how corporate governance functions, and this gap has real consequences. A large and important body of scholarship has focused on agency costs and how the mechanisms of corporate governance either contain or exacerbate them. Corporate governance scholars have focused largely on failures of internal governance mechanisms: for example, negligence (usually framed in terms of corporate directors’ duty of care), self-dealing and independence (in the context of directors’ duty of loyalty), shareholder collective action problems, and large shareholder influence.
Amidst the debates about the actions of large institutional shareholders in corporate governance, important stakeholders like lenders sometimes receive less attention. As this paper documents, lenders’ important role in corporate governance has begun to erode with respect to companies who may benefit most from it. As the credit market has heated up and corporate borrowers have gained outsized leverage in negotiations with lenders, problematic practices have begun to emerge. The change in bargaining power driven by CLOs is increasingly associated with weakening lender protections, but an unintended consequence is weakening of governance. This may create problems for individual companies, but may also lead to increased risk for the financial products driving this trend in the first place.
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