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LEVERAGE IN THE BOARD ROOM:
THE UNSUNG INFLUENCE OF PRIVATE LENDERS
IN CORPORATE GOVERNANCE
Frederick Tung
The influence of banks and other private lenders pervades public companies.
From the first day of a lending arrangement, loan covenants and built-in contingency
provisions affect managerial decisionmaking. Conventional corporate governance
analysis has been slow to notice or account for this lender influence. Traditionally,
corporate governance discourse has focused only on corporate law arrangements.
The few existing accounts of creditors’ influence over firm managers emphasize the
drastic actions creditors take in extreme cases—when a firm is in serious trouble—but
in fact, private lender influence is a routine feature of corporate governance even
absent financial distress.
While lenders of course intervene when their borrowers encounter distress,
recent empirical work demonstrates private lender influence at much earlier points
in the debtor-creditor relationship. In addition to the effects of covenant constraints
and other initial loan terms, a subsequent covenant violation may trigger active
lender intervention, including imposition of additional limits on managerial discretion.
Covenant violations and lender intervention, however, do not typically signal the
borrower’s financial distress. Instead, this interactive response to ex post contingency is
routine. Both borrower and lender expect future modification of their deal terms,
and they contract in anticipation of it. Initial covenants and subsequent violations
effectively reallocate degrees of control from managers to lenders, in a fluid process
that commences with the inception of the lending arrangement.
In this Article, I explain the regularity of lender influence on managerial
decisionmaking—“lender governance”—comparing this routine influence to
conventional governance arrangements and boards of directors in particular. I show
that the extent of private lender influence rivals that of conventional governance
mechanisms, and I discuss the doctrinal and policy implications of this unsung
influence. Accounting for lender governance requires a new examination of corporate
fiduciary duties, debtor-creditor laws, and the regulatory reform proposals that have
- Robert T. Thompson Professor of Law and Business, Emory University School of Law. For helpful comments, I owe thanks to Bobby Ahdieh, Douglas Baird, David Bederman, Bill Buzbee, Harry DeAngelo, Mitu Gulati, Michelle Harner, Fred Lambert, Kay Levine, John Mittelbach, Jonathan Nash, John Pottow, Larry Ribstein, Tina Stark, Eric Talley, Bill Wang, and Albert Yoon, as well as workshop participants at Emory Law School, the University of Illinois College of Law, Hastings College of the Law, the Canadian Law and Economics Association 2008 Annual Meeting, the American Law and Economics Association 2009 Annual Meeting, and the 2009 Law and New Institutional Economics Workshop for Law Professors.
116 57 UCLA L AW R EVIEW 115 (2009)
emerged to address the current financial crisis. I also discuss the implications of
- INTRODUCTION .................................................................................................................... private lender influence for future corporate governance research.
- I. BACKGROUND AND A FRAMEWORK FOR ANALYSIS....................................................
- A. Shareholder-Centered Corporate Law................................................................
- B. Creditor Governance: Banks Are Special ..........................................................
- C. Gauging Influence: Private Lenders vs. Directors ..............................................
- Directors’ Special Place in Corporate Governance Reform.......................
- Comparing Influence...................................................................................
- II. THE STRUCTURE OF LENDER GOVERNANCE ...............................................................
- A. Loans and Loan Covenants.................................................................................
- Financial Covenants....................................................................................
- Investment Constraints ...............................................................................
- Fundamental Changes .................................................................................
- B. Institutional Practices and Information Access..................................................
- III. THE DYNAMICS OF LEVERAGE .....................................................................................
- A. Durability of the Banking Relationship: The Certainty of Renegotiation........
- B. The Stages of Lender Influence...........................................................................
- Initial Covenant Settings: Controlling Agency Costs ...............................
- Built-in Contingency...................................................................................
- Honor in the Breach: Covenant Violations ...............................................
- C. Important Areas of Influence ..............................................................................
- Financial Policy............................................................................................
- Investment Policy ........................................................................................
- CEO Turnover .............................................................................................
- D. Operational Consequences and Governance Implications................................
- IV. THE LIMITS OF LENDER GOVERNANCE: CREDIT MARKET EFFECTS ...........................
- A. Market Liquidity ..................................................................................................
- B. Risk Transfer ........................................................................................................
- Loan Syndication and Secondary Market Transactions ............................
- Credit Derivatives........................................................................................
- C. Assessing the Limits.............................................................................................
- V. IMPLICATIONS OF LENDER GOVERNANCE ...................................................................
- A. Fiduciary Duties for Private Lenders?..................................................................
- B. Optimal Debtor-Creditor Law ............................................................................
- C. Financial Regulatory Reform and Lender Governance......................................
- Governance Research.......................................................................................... D. Is Lender Governance Efficient? And Other Empirical Corporate
- CONCLUSION .......................................................................................................................
118 57 UCLA L AW R EVIEW 115 (2009)
Traditionally, the central challenge has been to design governance arrange-
ments optimally to close the gap between ownership and control: to channel
managers’ discretion to benefit one specific class of investor—common share-
holders. Corporate law has been the preferred vehicle for effecting this
alignment of interests. This shareholder-centered approach is understandable.
Shareholders, as the firm’s residual claimants, feel most keenly the benefits
and burdens of the firm’s successes and failures. So for efficiency’s sake,
governance should rightly focus on shareholder interests.
In the standard rendering, shareholder-owners essentially “hire” managers
to run the firm on shareholders’ behalf. They accomplish this through their
elected board of directors, to whom shareholders entrust the authority to
manage the firm. The board in turn appoints officers, who are charged with
managing the business on a day-to-day basis. Directors and officers,
however, may not always act with shareholders’ best interests at heart.
They may shirk, or they may steal. 2 In innumerable ways, managers may favor
themselves at shareholders’ expense—consuming perquisites and leisure,
insulating themselves from takeover risk with entrenching provisions, building
empires for their own benefit, stacking boards with friendly directors who will
defer to management, or giving sweetheart deals to friends and relatives.
For their part, shareholders enjoy avenues for disciplining management.
Besides annually electing the board of directors, shareholders are entitled to
vote on important corporate transactions; they may offer their own quali-
fying proposals for a shareholder vote through the firm’s proxy process; they
are the beneficiaries of managerial fiduciary duties and may sue to enforce
these duties; they may propose amendments to the firm’s bylaws. Moreover,
the market for corporate control—by which acquirers may seek to displace
existing management—may perform a disciplining role. The threat of ouster
by hostile acquisition may focus managerial efforts.
Creditors have little or no role in this standard account of corporate
governance. 3 Unlike shareholders, creditors’ rights are defined primarily by
- This is not to say that all managers are knaves or thieves. Shareholders, however, are not often well positioned to identify knaves and thieves or to detect their theft or knavery. Governance mechanisms are therefore useful.
- “According to [the] conventional account, creditors receive no special rights against the corporation. The creditors’ power is limited to suing the debtors when they fail to pay as promised. Creditors do not have their hands on the levers of power.” Douglas G. Baird & Robert K. Rasmussen, Private Debt and the Missing Lever of Corporate Governance , 154 U. PA. L. REV. 1209, 1215 (2006). All acknowledge that the existence of debt in the capital structure plays some disciplining role, insofar as payment obligations reduce the amount of free cash managers have on hand to squander. See Michael C. Jensen, Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers , 76 AM. ECON. REV. 323, 324 (1986).
Private Lenders and Corporate Governance 119
their credit contracts.
4 Creditors enjoy no special status under corporate law.
They are outsiders to the firm and generally have no say in how the firm is
run. Creditors are presumed to passively observe corporate wealth creation
while they collect their interest payments, to be stirred from their torpor only
in extreme circumstances—to enforce their contract rights only if the firm
falters and repayment is imperiled. “Neither their credit provision function
nor their limited equity ownership provide banks with sufficient power and
incentive to monitor. As a result, the monitoring role in the American corpo-
rate governance system is relegated to those who provide only equity capital
to the corporation—the shareholders.” 5 In the standard telling, creditors are
passive. They are simply not a part of the classic corporate governance story.
6
It turns out, however, that bank creditors and other private lenders often
enjoy significant oversight and influence over managerial decisions.
7 Banks
monitor investment, financing, and operational decisions as a matter of course.
Banks not only constrain these managerial decisions but on occasion dictate
them. The case of Warnaco offers a telling example.
8 Warnaco’s CEO was
firmly entrenched. She chaired the board of directors and packed the board with
- See N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 99 (Del. 2007); Prod. Res. Group, L.L.C. v. NCT Group, Inc. 863 A.2d 772, 787 (Del. Ch. 2004).
- Ronald J. Gilson & Reinier Kraakman, Investment Companies as Guardian Shareholders: The Place of MSIC in the Corporate Governance Debate , 45 STAN. L. REV. 985, 989–90 (1993) (footnote omitted). Especially when the discussion turns to comparative assessment of U.S. corporate governance with the bank-centered systems of Japan and Germany, scholars emphasize that in market-oriented financial systems like the U.S., banks have only a limited role to play in corporate governance. JONATHAN P. CHARKHAM, KEEPING BETTER COMPANY: CORPORATE GOVERNANCE TEN YEARS ON 255 (2005); see LUTGART VAN DEN BERGHE, CORPORATE GOVERNANCE IN A GLOBALISING WORLD: CONVERGENCE OR DIVERGENCE? 43 (2002); Andrei Shleifer & Robert W. Vishny, A Survey of Corporate Governance , 52 J. FIN. 737, 753–58 (1997).
- “Corporate law has focused too long on shareholders as the sole investors in the corporation, the sole recipients of director duties and energies, and the sole hope for constraining the managers of other people’s money.” Douglas G. Baird & M. Todd Henderson, Other People’s Money , 60 STAN. L. REV. 1309, 1343 (2008) (arguing that the complexity of modern capital structures has rendered traditional corporate fiduciary duties unworkable, and that managers instead should hew to the terms of the firm’s investment contracts).
- Throughout this Article, for ease of exposition, I use of the term “bank” to include nonbank private lenders as well. The most common nonbank private lenders include finance companies, insurance companies, investment banks, hedge funds, and mutual funds. Nonbank lenders typically hold riskier debt than banks, Mark Carey, Mitch Post & Steven A. Sharpe, Does Corporate Lending by Banks and Finance Companies Differ?: Evidence on Specialization in Private Debt Contracting , 53 J. FIN. 845, 846 (1998); David J. Denis & Vassil T. Mihov, The Choice Among Bank Debt, Non-Bank Private Debt, and Public Debt: Evidence From New Corporate Borrowings , 70 J. FIN. ECON. 3, 5 (2003); Greg Nini, How Non-Banks Increased the Supply of Bank Loans: Evidence From Institutional Term Loans 3–4 (Mar. 18, 2008) (unpublished manuscript, on file with author), available at http://ssrn.com/ abstract=1108818, though they typically enjoy the same contractual features as other private corporate loans. See Nini, supra , at 2_._
- See Baird & Rasmussen, supra note 3, at 1226–27.
Private Lenders and Corporate Governance 121
important doctrinal and policy considerations of this unsung influence.
13
Moreover, possible conflict with equity holders is not the only potential
drawback to lender governance. Even if lender governance is efficient, it is
susceptible to being frustrated or hijacked, 14 as are traditional governance
mechanisms. Regardless, appreciation for the role of private lenders in cor-
porate governance is crucial for a complete understanding of the influence
that investors wield over firm management. Private lending is, after all, the
single largest source of external financing for public corporations, larger than
public debt and equity combined , 15 and eighty percent of public companies
maintain private credit agreements. 16
Understanding lender governance is especially important in the current
milieu, as the global financial crisis directly affects the nature of lender gov-
ernance in two important respects. First, to state the obvious, borrowers may
be financially unstable, and banks are nervous. This mutual insecurity has
caused lenders to intensify their monitoring efforts, including tightening up
on covenants
17 —financial benchmarks that borrowers are required to meet
on a regular basis. Tighter covenants mean less slack for borrowers, which
means more regular lender intervention—that is, more active lender govern-
ance. Second, the coming transformation of U.S. financial regulation will
have important effects on lenders’ incentives and behavior. Changes in the
regulatory regime will cause changes in lender governance. Tighter cove-
nants and regulatory reform will each affect the way nonfinancial firms—the
- I focus on banks’ influence as creditors. Banks have recently been shown to affect govern- ance through other avenues as well. Banks may systematically affect the market for corporate control, stimulating takeovers of their borrower firms by transmitting private information about their borrowers to potential acquirers. Victoria Ivashina et al., Bank Debt and Corporate Governance , 22 REV. FIN. STUD. 41 passim (2009). Banks may play this matchmaking role in order to cause more creditworthy acquirers to acquire less creditworthy targets, thereby reducing credit risk and enhancing the strength of banks’ loan portfolios. Id. at 72. Banks may also affect corporate managers through the voting rights they exercise as trustees for their banking clients’ trust portfolios. Joao A.C. Santos & Kristin E. Wilson , Does Banks’ Corporate Control Benefit Firms?: Evidence From U.S. Banks’ Control Over Firms’ Voting Rights (AFA 2007 Chicago Meetings Paper, EFA 2007 Ljubljana Meetings Paper, 2008), available at http://ssrn.com/abstract=891671.
- See infra Part IV.
- Gary Gorton & Andrew Winton, Financial Intermediation , in HANDBOOK OF THE ECONOMICS OF FINANCE: VOLUME 1A CORPORATE FINANCE 433 (George M. Constantinides et al. eds., Elsevier 2003); Michael R. Roberts & Amir Sufi, Renegotiation of Financial Contracts: Evidence From Private Credit Agreements 1 (July 31, 2008) (unpublished manuscript, on file with author), available at http://ssrn.com/abstract=1017629.
- Greg Nini, David C. Smith & Amir Sufi, Creditor Control Rights and Firm Investment Policy 1–2 (Apr. 2008) (unpublished manuscript, on file with author), available at http://ssrn.com/ abstract= 928688.
- Anousha Sakoui, Covenants in Spotlight as Banks Reduce ‘Headroom’ on Company Debt , FIN. TIMES, Aug. 21, 2008, at 18, available at http://www.ft.com/cms/s/0/47f39a76-6ecf-11dd-a80a- 0000779fd18c.html.
122 57 UCLA L AW R EVIEW 115 (2009)
borrowers—are run.
18 This Article is the first to analyze the effects of impending
regulatory reform on the governance of nonfinancial firms. I focus on
proposals for regulation of credit default swaps—so central to the financial
crisis 19 —and their trading. Though firm predictions as to the ultimate contours
of the financial regulatory framework are elusive, it is useful nonetheless to
identify potential corporate governance spillovers from reforms that are
sure to affect private lenders’ operations and monitoring incentives. More
generally, my discussion of lender governance offers one illustration of the
increasing complexity of corporate capital structures and the thorny governance
implications of this complexity. As financial innovation increasingly blurs
the traditional line between debt and equity, a singular focus on shareholder-
centered governance may well be obsolete.
The Article is organized as follows. Part I offers background, reviewing
the financial and legal literature on banks’ special monitoring abilities. It
also recounts the conventional corporate law framework for firm governance,
highlighting the director’s role and proposing a framework for assessing the
degree of private lender influence by comparing directors’ influence. Part II
outlines the contractual and institutional structure of lender governance,
describing important loan covenants and banks’ institutional practices that
facilitate monitoring and governance. Part III explains the dynamics of private
lenders’ leverage over firm management. It describes the durable nature of
the banking relationship, the incentive structure built into the initial lending
agreement, and the range of bank responses to covenant violations. It also
discusses the recent empirical learning in three important areas of private
lender influence: financial policy, investment policy, and CEO replacement.
Part IV discusses the limits of lender influence. Credit market effects—liquidity
and risk transfer opportunities—may dampen lenders’ monitoring incentives and
their influence. Part V discusses the implications of lender governance for
corporate law, financial regulation, and governance research.
- To offer one concrete example, tighter covenants may reduce nonfinancial firms’ levels of capital investment. See infra Part III.C.2. At the same time, financial regulatory reform may augment or diminish lenders’ incentives to police capital investment restrictions diligently. See infra Part V.C.
- “Any honest assessment [of the origins of the financial crisis] must include the role that credit default swaps have played in this mess: it’s the elephant in the room, the $30 trillion market that people do not want to talk about.” Gretchen Morgenson, Time to Unravel the Knot of Credit- Default Swaps , N.Y. TIMES, January 24, 2009, at BU1, available at http://www.nytimes.com/2009/ 01/25/business/25gret.html?_r=1&scp=2&sq=morgenson&st=cse.
124 57 UCLA L AW R EVIEW 115 (2009)
A. Shareholder-Centered Corporate Law
Corporate governance scholars and policymakers focus primarily on
relations among firm managers and equity holders, relying on corporate law
arrangements to align managers’ incentives with shareholder interests and to
mediate relations among small and large shareholders. The central project is
to calibrate the right amount of shareholder, director, and market oversight
for optimal governance. Important recent corporate governance debates
focus on shareholder concerns as expressed through traditional corporate
law mechanisms: shareholder influence in corporate elections, 24 the role and
responsibilities of activist institutional shareholders, 25 the scope and nature of
directors’ fiduciary duties to shareholders,
26 amounts and forms of executive
compensation, 27 board composition, 28 and the decoupling of voting rights
from economic rights.
29 These debates illustrate the corporate-law-focused,
shareholder-centered nature of corporate governance discourse, an understand-
able focus given shareholders’ traditional centrality in corporate law as
“principals,”
30 “owners,”
31 and residual claimants.
32
- Compare Lucian Arye Bebchuk, The Case for Increasing Shareholder Power , 118 HARV. L. REV. 833 (2005) (arguing for reform of director election process to empower shareholders), and Lucian A. Bebchuk, The Myth of the Shareholder Franchise , 93 VA. L. REV. 675 (2007) [hereinafter Bebchuk, Myth of the Shareholder Franchise ] (same), with Stephen M. Bainbridge, The Case for Limited Shareholder Voting Rights , 53 UCLA L. REV. 601 (2006) (defending the existing limited role for shareholders), and Stephen M. Bainbridge, Director Primacy and Shareholder Disempowerment , 119 HARV. L. REV. 1735 (2006) (discussing the same).
- See Iman Anabtawi & Lynn Stout, Fiduciary Duties for Activist Shareholders , 60 STAN. L. REV. 1255 (2008).
- See Stephen M. Bainbridge, Star Lopez & Benjamin Oklan, The Convergence of Good Faith and Oversight , 55 UCLA L. REV. 559 (2008) (critiquing Stone ex rel. AmSouth Bancorporation v. Ritter , 911 A.2d 362 (Del. 2006) (en banc), for its confusing analyses of good faith and the duty of oversight); Claire A. Hill & Brett H. McDonnell, Disney, Good Faith, and Structural Bias , 32 J. CORP. L. 833 (2007) (arguing that courts should be sensitive to structural bias on boards of directors when analyzing good faith).
- See LUCIAN BEBCHUK & JESSE FRIED, PAY WITHOUT PERFORMANCE: THE UNFULFILLED PROMISE OF EXECUTIVE COMPENSATION (2004); Jesse M. Fried, Hands-Off Options , 61 VAND. L. REV. 453 (2008).
- See Sanjai Bhagat & Bernard Black, The Uncertain Relationship Between Board Composition and Firm Performance , 54 BUS. LAW. 921 (1999); April Klein, Firm Performance and Board Committee Structure , 41 J.L. & ECON. 275 (1998).
- See infra note 253 and accompanying text.
- E.g. , Lucian Arye Bebchuk, Jesse M. Fried & David I. Walker, Managerial Power and Rent Extraction in the Design of Executive Compensation , 69 U. CHI. L. REV. 751, 761 (referring to shareholders as principals and corporate managers as their agents).
- N. Am. Catholic Educ. Programming Found. v. Gheewalla, 930 A.2d 92, 101 (Del. 2007) (referring to shareholders as the “owners” of the corporation).
- EASTERBROOK & FISCHEL, supra note 22, at 36, 91.
Private Lenders and Corporate Governance 125
B. Creditor Governance: Banks Are Special
In contrast to corporate governance scholars and policymakers, finance
scholars have known for some time that banks are special. Banks enjoy insti-
tutional advantages over other investors that make them ideal monitors.
Their institutional arrangements facilitate their garnering of private
information about their borrower firms at lower cost than other investors,
33
and banks have strong incentives to monitor these firms and influence mana-
gerial decisionmaking when necessary.
In its lending contract with the borrower, the lender includes a number
of covenants that constrain the borrower’s financial, investment, and operating
activities.
34 The bank also enjoys access to private information about the
borrower’s business activities, including periodic reports from the borrower and
access to the borrower’s management and books and records. The bank may
enjoy specialized expertise concerning the borrower’s industry. A covenant
violation triggers the lender’s right to cut off further credit to the borrower and
demand immediate repayment of outstanding debt.
35 The borrower’s manage-
ment therefore has strong incentives to comply with its covenants.
Because of banks’ special monitoring abilities, they are often effectively
delegated by other investors to monitor on their behalf. As detailed below,
banks enjoy covenant protection and information access that other investors
do not, but those other investors may free ride on the bank’s monitoring and
price their capital accordingly. 36 This theory of delegated monitoring enjoys
strong empirical support. For example, event studies consistently show that
positive abnormal stock returns accompany firms’ public announcements of
bank loans. 37 That is, the announcement of a bank loan is generally good
- See Douglas W. Diamond, Financial Intermediation and Delegated Monitoring , 51 REV. ECON. STUD. 393, 393 (1984); Eugene F. Fama, What’s Different About Banks? , 15 J. MONETARY ECON. 29, 36–38 (1985); see also Tim S. Campbell & William A. Kracaw, Information Production, Market Signalling, and the Theory of Financial Intermediation , 35 J. FIN. 863, 864 (1980) (theorizing that financial intermediaries emerge to produce information because of the complementarity of infor- mation production, confidentiality, and the provision of transactional and other intermediary services).
- The structure of creditor governance is described more fully in Part II.
- Many loans to public companies take the form of a revolving loan, which allows the borrower to repay and reborrow over the life of the loan. See infra Part II.A. Because firms rely on the revolving loan to help manage their cash flows, cutting off further credit may be a severe sanction. See Baird & Rasmussen, supra note 3, at 1229.
- See Frederick Tung, The New Death of Contract: Creeping Corporate Fiduciary Duties for Creditors , 57 EMORY L.J. 809, 836–37 (2008) (explaining the theory of delegated monitoring).
- See Christopher James, Some Evidence on the Uniqueness of Bank Loans , 19 J. FIN. ECON. 217, 219 (1987); Myron B. Slovin, Shane A. Johnson & John L. Glascock, Firm Size and the Information Content of Bank Loan Announcements , 16 J. BANKING & FIN. 1057, 1058 (1992); Ronald Best & Hang Zhang, Alternative Information Sources and the Information Content of Bank Loans , 48 J.
Private Lenders and Corporate Governance 127
valuable information to one another, thereby enhancing stakeholders’ collective
ability to discipline management. 41
The reactions of a stakeholder are in many cases observable by others
who will in turn choose among their own set of available reactions.
Thus, governance in the modern corporation is akin to a system of
relays: stakeholders generate, collect, and analyze valuable information
on managerial slack, and then pass it to those stakeholders who are
better situated to take direct action to address the problem.
42
The bank is the central monitor under this theory. Its specialized monitoring
abilities make it the low-cost monitor, 43 and because the borrower and credi-
tors, as a group, care about minimizing total monitoring costs, the borrower
willingly grants covenant protections to the bank that it may not grant other
creditors. The bank’s contract rights and ongoing monitoring enable it both
to deter managerial slack and to detect it early. Upon detection, it may
either exit or intervene, even to the point of having management replaced.
In either case, the bank’s action signals other stakeholders, who may also act
to protect their interests. While classic finance theory focuses on the con-
flicts between debt holders and equity holders, 44 especially as the firm nears
distress, Triantis and Daniels remind us that the bank lender and other
stakeholders may have good reason to work toward the firm’s recovery as a
going concern.
45
Douglas Baird and Robert Rasmussen recently renewed the focus on
creditors’ role in corporate governance, describing creditor control as the
“missing lever” in the corporate governance literature.
46 They note the under-
appreciated role that banks and bank-loan covenants play in corporate
governance when a firm defaults. At that point, the bank’s ability to disci-
pline management is much greater than traditional governance devices.
47
The bank may seize control by taking control of the firm’s cash as part of a
- George G. Triantis & Ronald J. Daniels, The Role of Debt in Interactive Corporate Governance , 83 CAL. L. REV. 1073 (1995).
- Id. at 1079.
- For example, the bank enjoys better information than other creditors, and its business model generates monitoring economies not available to other creditors. See id. at 1083–84.
- See Jensen & Meckling, supra note 11, at 335.
- For example, the prospect of repeat business with the firm may serve to align the bank’s interests with those of equity holders as to investment policy and the firm’s recovery. Triantis & Daniels, supra note 41, at 1100–01.
- See Baird & Rasmussen, supra note 3.
- Compare, for example, bank monitoring with monitoring by shareholders—the firm’s traditional “owners.” Banks enjoy far better information about the firm, and exercise far more oversight and control over the firm’s affairs, than shareholders. See id. at 1217. The corporate charter is a short document; the loan agreement can easily exceed one hundred pages. See id.
128 57 UCLA L AW R EVIEW 115 (2009)
debt restructuring. Through a combination of a revolving credit facility,
48
security interests in the borrower’s cash and other assets, and modern cash
management technology, the lender obtains the ability to cut off the bor-
rower’s cash, an arrangement that gives the bank the finest vantage point
from which to monitor the borrower’s business,
49 as well as a veto over any
transaction or course of action not to the bank’s liking.
50
The other important control device for the bank is its leverage to cause
the replacement of management, a tactic that becomes available when the
borrower is in serious trouble and in need of a debt restructuring. Either
implicitly or explicitly, the lender may demand appointment of a turnaround
specialist, typically tasked as a Chief Restructuring Officer, to run the busi-
ness, 51 a power that shareholders almost never enjoy. Similarly, the market
for corporate control has only a weak disciplining effect on management
compared to bank discipline. Firms may erect takeover defenses to deter hos-
tile takeovers, but once they take on private debt, they have little defense
against creditor control.
52
While these important papers by Triantis and Daniels and Baird and
Rasmussen focus on the distress context, in a recent article I and my co-
authors investigate the potential governance benefits of bank monitoring for
public companies more generally, with a focus not limited to the distress
- See infra note 79 and accompanying text.
- See Baird & Rasmussen, supra note 3, at 1226–30.
- Id. at 1227.
- Id. at 1233–34; see also Sadi Ozelge, The Role of Banks and Private Lenders in Forced CEO Turnovers 5 (Jan. 15, 2008) (unpublished manuscript, on file with author), available at http://ssrn.com/abstract=1031814 (finding that for an underperforming firm, an average level of bank debt implies a 25 percent to 46 percent increase in the probability of forced CEO turnover compared to a firm with no bank debt, and if the underperforming firm also violates a loan covenant, the result is a 75 percent to 102 percent increase in the probability of forced CEO turnover).
- Baird & Rasmussen, supra note 3, at 1244. Simply paying off the loan is typically not a ready option. The authors note: In theory, a business can rid itself of a creditor who presses too hard by repaying the loan, but a business that encounters difficulty with a private creditor is likely to have trouble replacing it with another. Any new lender has to worry about the private information held by the existing lender. The existing lender may want to withdraw for reasons that are not yet plain to outsiders. Any new lender is in any event bound to insist upon its own control rights to protect itself. Id. Like Triantis and Daniels, Baird and Rasmussen resist the finance canon on the agency costs of debt, which focuses on the conflicts among different investor classes that preclude efficient investment when the firm is in distress. Baird and Rasmussen describe the incentives of the senior lender—typically the bank—to pursue even risky projects to maximize firm value. Id. at 1246–47.
130 57 UCLA L AW R EVIEW 115 (2009)
directors—autonomous from sometimes self-seeking managers—are ideally
situated to safeguard shareholders’ interests.
The concept of independence is straightforward: An independent
director has no significant relationships with the firm or its management
that might affect her judgment.
57 In addition to generalized hopes that inde-
pendent directors might serve as vigilant monitors, corporate law tasks
independent directors to shoulder special burdens in cases of clear conflicts of
interest. Special litigation committees composed entirely of independent
directors must decide whether to pursue, settle, or dismiss derivative litigation
brought against other members of the board in the company’s name. 58 Recent
corporate governance reforms similarly place independent directors front and
center in the march toward improved corporate governance.
Following accounting scandals at Enron, WorldCom, Tyco, Adelphia,
and a host of other public companies, and the demise of the public
accounting firm Arthur Anderson, Congress passed the Sarbanes-Oxley Act
(SOX),
59 and the stock exchanges tightened their listing rules, all in an effort
to improve management accountability. These new rules demand that central
governance roles be reserved for independent directors. For public company
- See Ira M. Millstein et al., Ten Things That Every Director Should Know for 2004 , BUS. & SEC. LITIGATOR (Weil, Gotshal, & Manges LLP, New York, N.Y.), Jan. 2004, at 2–3, available at http://www.weil.com/wgm/cwgmhomep.nsf/Files/BSLJan04/$file/BSLJan04.pdf (stating “by definition, independent directors are outsiders who lack significant relationships to the company”). Reforms have made the requirements for independence more specific. For example, post–Sarbanes-Oxley (SOX), New York Stock Exchange (NYSE) listing rules specify a number of automatic disqualifications from independent status. A director is not independent if, among other things, she (i) is an employee of the company; (ii) has an immediate family member who is an executive officer; (iii) receives, or has an immediate family member who receives, more than $100,000 per year in direct compensation from the company; (iv) is affiliated with or employed by the company’s present or former internal or external auditor. NYSE, LISTED COMPANY MANUAL § 303A.02(b) (2009), available at http://nysemanual.nyse.com/LCM/Sections/. NYSE listing rules also require a three-year “cooling off” period, counting a director as independent only after three years have elapsed following the termination of the affiliation(s) that tainted independent status. Id. SOX adds its own specific independence requirements for audit committee members. See 15 U.S.C. § 78j-1(m)(3)(B) (2006) (prohibiting audit committee members from taking consulting, advisory or compensatory fees from the issuer, and requiring that they not be an affiliated person of the issuer or any subsidiary of the issuer).
- See Davis, supra note 56, at 1306 (critiquing courts’ deference to special litigation committees’ dismissal decisions); see also Minor Myers, The Decisions of Corporate Special Litigation Committees: An Empirical Investigation 3, (Brooklyn Law School, Legal Studies Paper No. 112, 2008), available at http://ssrn.com/abstract=1162858 (finding that special litigation committees do not uniformly dismiss derivative suits).
- Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (2002) (codified in scattered sections of 15 and 18 U.S.C.).
Private Lenders and Corporate Governance 131
boards, a majority of directors are required to be independent.
60 In addition,
three crucial board committees are required to be comprised solely of inde-
pendent directors: the audit committee,
61 which hires and manages the firm’s
outside auditor; the compensation committee, 62 which sets executive compen-
sation; and the nominating committee,
63 which selects director nominees. Given this faith in independent directors as fundamental corporate moni-
tors, the degree of director influence on management may justifiably serve as a
useful benchmark against which to compare private lender influence.
- Comparing Influence
My comparison runs along four dimensions: information, incentives,
expertise, and enforcement powers. A putative monitor would seem to need
some measure of each in order to be effective, 64 and private lenders generally
do better across all four measures than do directors. Therefore, we can fairly
expect private lenders to be at least as effective as directors at monitoring, if
not more so.
To be clear, this analysis is not meant to suggest that private lender
monitoring is necessarily efficient or that it should replace traditional
shareholder-centered monitors. After all, lender concerns may not always
coincide with those of shareholders, and their actions may not always enhance
value. Lenders monitor for themselves; directors have fiduciary duties to
monitor on behalf of shareholders and the firm. So directors and lenders may
focus on different issues in their monitoring. The point instead is that private
lender influence is sufficiently serious that it deserves mainstream attention
from corporate governance policymakers.
Table 1 summarizes the comparisons.
- See NYSE, supra note 57 § 303A.01; NASDAQ OMX GRP., INC., NASDAQ STOCK MARKET RULES, EQUITY RULES § 5605 (b)(1)(2009), available at http://nasdaq.cchwallstreet.com/ NASDAQ/Main/.
- Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, § 301, 116 Stat. 745, 775–77 (codified at 15 U.S.C. § 78j-l (2006)).
- NYSE, supra note 57 § 303A; NASDAQ OMX GRP., INC., supra note 60, § 5605(b).
- Id.
- Cf. Peter M. DeMarzo, Michael J. Fishman & Kathleen M. Hagerty, Self-Regulation and Government Oversight , 72 REV. ECON. STUD. 687 (2005) (considering information, expertise, incentives, and enforcement powers in modeling the efficacy of self-regulatory organizations in securities regulation).
Private Lenders and Corporate Governance 133
jobs are not well positioned to gather and assess company information with
the intensity of a private lender.
Incentives. Banks and their lending officers have direct financial stakes
in policing borrowers carefully. Directors by contrast do not depend on their
director positions or director fees for their livelihood. They are basically part-
time players who meet only a handful of times each year to consider firm
affairs. They may own shares in the borrower firm, but again, these stakes are
likely to be small relative to their total wealth. Directors may have some
reputational stake in appearing vigilant, and potential fiduciary duty liability
may offer some weak incentives to monitor. On the other hand, especially
for nonindependent directors, they may be beholden to managers for their
board positions, so their ability to check managerial excesses may be limited.
Granted, banks’ incentive to monitor may depend on the firm’s finan-
cial condition. A healthy and profitable firm is unlikely to draw much
scrutiny from its lender, who is far more concerned about downside risk than
upside performance. This is likely to be true for directors as well, though.
They are likely to give the CEO a free hand when the sailing is smooth.
Moreover, even a healthy and profitable firm may run afoul of a loan
covenant. As more fully explained in Part III,
69 covenant violations are
common, and though they rarely portend distress, a violation does trigger
lender scrutiny and the possibility of tighter covenants.
Expertise. Private lenders typically cultivate industry expertise. Their
lending relationships with multiple firms in an industry generate scale economies
that enable them to price, monitor, and manage loans at lower cost than a
less focused lending pattern. 70 By contrast, though it may seem counterintui-
tive, directors may not have much expertise in the firm’s industry beyond what
they learn from being a director to the one firm.
71 Instead, expertise within the
firm likely resides with executive officers and other full-time employees, 72
who are typically thought of as the targets of monitoring, and not as the
- See infra Part III.B.3.
- See Randall S. Krozner & Philip E. Strahan, Bankers on Boards: Monitoring, Conflicts of Interest, and Lender Liability , 62 J. FIN. ECON. 415, 436 (2001) (finding that banks specialize in lending to industries in which they enjoy board participation).
- See Roel C. Campos, Remarks of SEC Commissioner , 55 CASE W. RES. L. REV. 527, 534 (2005) (complaining about the lack of industry expertise of many outside directors); Laura Lin, The Effectiveness of Outside Directors as a Corporate Governance Mechanism: Theories and Evidence, 90 NW. U. L. REV. 898, 914 (1996) (noting the problem of outside directors’ lack of expertise); Dale A. Oesterle, Are Leveraged Buyouts a Form of Governance Arbitrage? , 3 BROOK. J. CORP. FIN. & COM. L. 53, 71 (2008) (explaining how independence rules make it difficult to use industry experts as outside directors).
- More generally, those with industry expertise are likely to be full-time employees of the firm or one of its competitors. Employees of the firm’s competitors, of course, are disqualified from serving as directors of the firm.
134 57 UCLA L AW R EVIEW 115 (2009)
monitors themselves. Because of this insider expertise, directors are likely to
defer to the judgment of insiders on issues where expertise matters. This
dependence on insider expertise tends to weaken directors’ monitoring effi-
cacy.
Enforcement. Private lenders have fairly direct means for remedying
slack or mismanagement. Covenant violations are common, even among
well-run companies. 73 A violation rarely signals financial distress. Instead,
lenders use covenants as trip wires to force managers to check in regularly.
The violation triggers a conversation between the lender and the firm’s
management. To the extent it feels that certain changes should be made,
the lender has strong leverage to effect the change. Technically, a violation
triggers the lender’s right to accelerate the loan and demand immediate
repayment. While lenders generally do not accelerate precipitously, the
option to accelerate upon a covenant violation gives the lender significant
leverage over management. Lenders are also subject to reputational con-
straints. They will wish to avoid developing reputations for unreasonable
interference with management, lest they lose future business to more
reasonable competitors. When market conditions favor borrowers over
lenders, for example, when liquidity is high and money is cheap, lenders may
feel constrained by market competition from pressing managers so aggres-
sively that they refinance with a different lender.
74 Conversely, however,
tighter credit conditions allow lenders to be more aggressive.
Directors, by contrast, have varied enforcement effectiveness. Boards
are susceptible to “capture” by management,
75 as their involvement with
management causes a loss in objectivity and an allegiance to corporate policy
decisions that directors participated in formulating. Even a strong-willed
director with good monitoring intentions may be stymied by information and
expertise deficits from challenging insiders. 76 Directors may also suffer collec-
tive action problems in maintaining a coalition to challenge management.
77
In an extreme situation, a director might resign to protest a particular
management decision, but these cases are rare, and this sort of director resig-
nation is a drastic step not often taken.
Along each of these four important dimensions—information, incen-
tives, expertise, and enforcement—private lenders generally do better than
directors. Private lenders are therefore likely to perform at least as well as
- See infra Part III.B.3.
- See infra Part IV.A.
- MACEY, supra note 68, at 57–61.
- See id. at 60–61.
- Id. at 62.
