08/01/2016

CapitalIdeas:LendersinChargeMarch2011TheRoleofCreditorsinCorporateGovernance

LendersinCharge
TheRoleofCreditorsinCorporate
Governance
Researchby
AmirSufi
AmirSufiisassociateprofessoroffinanceattheUniversity
ofChicagoBoothSchoolofBusiness.

Largelyoverlooked,creditorsexertmorecontrolovercompaniesthanpreviouslythought.
W
henacompanysellssecuritieswhetheritisequityordebt,partofwhatitissellingissomecontroloverthefirm.The
traditionalviewofcorporategovernance,however,isthatshareholdersmainlyinfluencethedecisionsthatmanagers
makethroughthecompany'sboardofdirectors.Infact,corporategovernanceliteraturealmostexclusivelyreflectsthis
view.Creditorsarethoughttobepassivebystandersaslongasthecompanyismeetingitsscheduledpayments.
ButarecentstudybyUniversityofChicagoBoothSchoolofBusinessprofessorAmirSufi,GregNinioftheUniversityof
Pennsylvania,andDavidC.SmithoftheUniversityofVirginiachallengesthisconventionalview.In"CreditorControl
Rights,CorporateGovernance,andFirmValue"theauthorsfindthatcreditorsexertsubstantialcontroloveracompany
whenitsperformancestartstodeteriorate,butwellbeforeitgoesbankrupt.
Whenacompanyborrowsmoneyfromaninvestor,aloancontracttypicallyincludescovenantsorpromisesmadebyits
managementthateitherguideorlimititsactions.Ifaborrowerviolatesacovenant,thecreditorcanopttodemand
immediaterepaymenteventhoughtheborrowerhasnotdefaulted.Covenantviolationsarecommon,butinpractice
creditorsrarelyacceleratetheloan.Instead,violationsgivecreditorsanopportunitytorenegotiatethecreditagreementby
imposingstrongerrestrictionsonfirmbehavior.
Creditorsmayevenpushtoreplacethefirm'stopexecutivesinexchangeforwaivingtheviolation."Thedecisionwhether
tofireaCEOis,insomesense,theessenceofcorporatecontrol,"saysSufi.Indeed,thestudyfindsthattheprobabilityof
aCEOgettingfiredisaboutfivetimeshigherintheyearfollowingtheviolationthanintheyearbefore.Thissignificant
jump,aswellasevidencethatborrowingfirmsbecomemoreconservativeintheirfinancialandinvestmentpoliciesaftera
violation,suggeststhatcreditorsplayanactiveandinfluentialroleindirectingtheperformanceofacompany.
BreakingPromises

Theauthorsfindthatcreditorsplayabiggerroleincorporategovernancethanpreviouslythought,andthatcovenants
attachedtolendingagreementsareanimportantpartofthisprocess.
Covenantsrequireborrowerstotakecertainactionsorrefrainfromcertainactivities.Forexample,acovenantmayaska
companytosubmitfinancialinformationtothelenderonaregularbasisorpreventafirmfrommakingexcessivecapital
expenditures.Financialcovenants,inparticular,areaccountingbasedriskandperformancelimits,suchasrestrictionson
howmuchmoneythefirmcanborrowandhowmuchcashtosetasidetocoverinterestpaymentsandotherexpenses.
Whenafirmviolatesacovenantitgivesthecreditors,whoaretypicallybanks,considerablepowerovertheborrowerat
thatmomentbecausedemandinganimmediaterepaymentcouldforcethecompanyintobankruptcy.Thus,theborrowing
firmmustagreetothenewtermsoftheloanandpossiblyachangeinmanagementinorderforthelendertowaivethe
violation.
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CapitalIdeas:LendersinChargeMarch2011TheRoleofCreditorsinCorporateGovernance

Therenegotiationscanleadtosignificantchangestotheloanaswellasincreasedmonitoringbylenders.Forinstance,
renegotiatedloansaretypicallysmaller,carryhigherinterestratesandfees,andhaveashortermaturity,whichreflect
theborrower'sincreasedcreditrisk.Thereductioninthenumberofmembersinasyndicatedloanindicatesadesireby
lenderstomonitorborrowersmoreclosely.Renegotiatedloansalsoaremorelikelytoincludeanexplicitrestrictionon
dividendpayments,tighterlimitsoncapitalexpenditures,anda"sweepsprovision"thatrequirescashflowsfromcertain
activitiestobeusedonlytopaydownloans.
Inadditiontochangingthecontractualtermsoftheagreement,creditorsmaywork"behindthescenes"tochangethe
waythecompanyismanaged.Forinstance,apreviousstudybyDouglasBairdoftheUniversityofChicagoLawSchooland
RobertRasmussenoftheUniversityofSouthernCaliforniadescribeshowKrispyKremeDoughnutCorporationreplacedits
CEOwithaturnaroundspecialistasaconcessiontocreditorsfollowingacovenantviolation.ButupuntilthestudybySufi
andhiscoauthors,therehasbeennolargesampleevidencethatthistypeofcreditorinfluenceoccursmorefrequently
whencompaniesarenotinsolvent.
MakingChanges

Theauthorsanalyzewhathappensafterthefirsttimeaborrowerviolatesafinancialcovenant.Theycomparethechanges
inacompany'sCEOturnover,assetgrowth,capitalexpenditures,anddividendpayoutpolicybeforeandafteraloan
violation.Althoughtheperformanceofthemedianfirmintheirsampledeclinesintheperiodleadinguptoaviolation,the
companyisfarfrombeingonthevergeofbankruptcy.Thisisimportantbecausecorporategovernanceliteraturehaspaid
verylittleattentiontocreditors'involvementinmanagementdecisionsduringthisperiod,arolethoughttobelong
exclusivelytoshareholders.
Thestudyfindsthatfinancialcovenantviolationswerefollowedbydecreasesincapitalexpendituresandcashacquisitions
aswellassharpreductionsinthegrowthrateofassetsandtheprospectivepriceearningsratio,whichsuggeststhatfirms
wereengagedinassetsalesanddivestitures.Firmsincreasedtheirassetbaseby10percentinthefourquartersleading
uptotheviolation,butreduceditby6percentfourquartersafteraviolation.Investmentsinproperty,plant,and
equipmentalsofellsharplyimmediatelyafteracovenantwasviolated.
Similarly,theanalysissuggeststhatcreditorsimposedmoreconstraintsonthefinancialpolicyoffirmsafteraviolation.
Netdebtissuance,totaldebtoutstanding,andshareholderpayoutsdeclined,whilethefirms'cashtoassetsratio
increased.Cashbalancesquicklyroseby2percentafteracovenantwasviolated,incontrasttofirms'heavycashspending
justpriortotheviolation.
PerhapsthemoststrikingresultoftheanalysisisthatmanymoreCEOswerefiredafteracovenantviolation.The
probabilityofaforcedCEOturnoverfourquartersbeforeaviolationwasrelativelysteadyatabout1.5percentbutjumped
to8percentfourquartersafteraviolation."WeknowthatshareholdershavetheabilitytofireaCEOthroughtheboardof
directorsbuttheydon'tseemtodoanythinguntiltheviolationofthecovenant,whichsuggeststhatthelendersare
exertingsomekindofpressurethatultimatelyleadstotheCEObeingfired,"saysSufi.
Thestudyalsofindsasignificantincreaseinthehiringofturnaroundandrestructuringspecialists,whoarelikelytobe
employedbythecompanyforatleastayearaftertheviolation.Thisfindingsupportsanecdotalevidencethatsuggests
thatcreditorshavesubstantialinfluenceoverthedecisiontohiresuchspecialiststohelpimprovetheperformanceofthe
company.Typically,theseconsultantsassistwithrestructuringtheviolators'capitalstructureandoperationsandeven
taketemporaryrolesonthefirms'managementteams.
WhyShareholdersBenefitToo

Ifcreditorsindeedexertsubstantialcontrolovertheborrowingfirm,thenonecouldarguethatlenderswhoarelookingout
fortheirowngoodmightmakedecisionsthatarenotinthebestinterestofshareholders.Forinstance,creditorsmaybe
moreinclinedtoshutdownthebusinessandtakethecompany'sassets,sincetheyarepaidfirstifthecompanygoes
bankrupt.
However,thestudyfindsthatlenders'interventionstoprotecttheirowninvestmentactuallyhelpthefirm'sperformance,
whichmeansthatshareholdersbenefitbecausetheseactionsimprovethevalueofthecompany.Forinstance,although
operatingcashflowwasdeterioratingrapidlybeforeacovenantwasviolated,itreboundedquitesharplyrightafterthe
violation.Creditorsseemtoreducecostsinawaythatleadstobetteroperatingperformance.
Overall,thestudy'sresultsshowthatacovenantviolationleadstoimportantchangesinthefirm'smanagement,
investment,andfinancialpolicies,andultimatelyitsperformance.Thismakesithardtoignorethatcreditorsdostepup
andhavemuchswayoveracompany,whichmaybeonereasonwhypreviousstudiesfindthatfirmperformanceseems
tobeunaffectedbyaweakboardofdirectors."Onecanimagineasituationwheretheboardofdirectorsisincompetent,
butthecreditorsaredoingtheirjob,"saysSufi.
Moreimportantly,thestudyprovidesevidencethatthetraditionalmodelofequitycenteredcorporategovernanceneeds
rethinkingandthatfutureresearchshouldturnitsattentiontoanothergroupofinvestorswhohaveequallystrong
incentivestomonitortheirinvestment."It'salmostimpossibletotalkaboutcorporategovernanceunlesswethinkabout
thecreditors,"saysSufi
"CreditorControlRights,CorporateGovernance,andFirmValue."GregNini,DavidC.Smith,andAmirSufi.
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CapitalIdeas:LendersinChargeMarch2011TheRoleofCreditorsinCorporateGovernance

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