The Role of Debt in Interactive Corporate Governance

Abstract

Most of the corporate governance literature rests on a premise that the interests of various stakeholder groups conflict and that managerial loyalty is more likely to be captured by shareholders than any other constituency. Yet, stakeholder interests do converge in the objective of controlling managerial slack and non-equity constituents have substantial influence over firm decisions. Although the study of governance has taken early steps to abandon its preoccupation with equity-centered solutions and identify interdependencies existing among a broader range of stakeholders, governance scholars have missed an important element of interactivity. A stakeholder reacts to the actions of others and thereby contributes to the collective interest in controlling slack. Each stakeholder has a window on the firm through which it can acquire some type of information at lower cost than other stakeholders. When a stakeholder detects an unsatisfactory state of affairs, it reacts by choosing to exit or exercise voice. The exercise of either the voice or exit option may pressure management to correct the unsatisfactory state of slack. More to the point, however, a stakeholder's exit bears important information for other stakeholders, at least some of whom may be better placed to take action that corrects the slack.This Article describes an interactive system of corporate governance and provides a stylized theory of the role of lenders within this system. The divergence in the interests of these lenders and other stakeholders does not preclude interactive governance, but it does threaten to reduce the net benefits from the process. Therefore, the authors identify a number of legal and institutional mechanisms that help to channel the efforts of the lender toward the common goal of containing and correcting managerial slack.The interactive perspective thus permits new explanations for phenomena such as debt covenants, bankruptcy preference rules and lender liability laws. For example, the definition of debt covenants and events of default in lending agreements raise the likelihood that the lender exit is prompted by slack rather than lender opportunism and thereby enhances the informational value of the exit. Bankruptcy preference rules encourage early exit before the firm becomes insolvent, thereby enabling remaining stakeholders to take action before the firm's condition becomes irreparable. Thus, debt covenants and preference rules provide a window that increases the value of lender exit in prompting the correction of managerial slack. Disciplines Law CommentsReprinted

Trade credit and bank credit as alternative governance structures in South Africa: evidence from banking sector development

“…There are legal and institutional mechanisms that assist to direct the efforts of the lender toward containing and correcting managerial slack and have impact on firm level corporate governance (Triantis & Daniels, 1995). Research reveals the critical importance of banks in financing industrial growth and the corporate governance of firms (Levine, 2004).…”

Creditors and Debt Governance

“…Balanced against greater liquidity, public debt typically has less restrictive covenants in light of the public availability of information, the higher cost to directly monitor and enforce compliance, and a decline in the ability (or, for higher-quality borrowers, the need) to mitigate credit risk through contract. (Smith & Warner 1979;James 1987;Carey et al 1993;Triantis & Daniels 1995;Amihud et al 1999;Rauh & Sufi 2010). Consequently, a firm that initially issues public debt may see a decline in its share price -reflecting a drop in debt governance, which can be even more pronounced if, at the same time, the borrower reduces bank monitoring (perhaps by paying down its bank debt).…”

“…To that end, covenants act as early warning "trip wires" (Triantis & Daniels 1995) that enable lenders to reassess a borrower's credit risk under weakened financial conditions and mitigate loss by renegotiating loans (and reducing leverage) following a breach. (Fischel 1989;Hart & Moore 1998;Dichev & Skinner 2002).…”

“…(Triantis & Daniels 1995). Covenant violations are not uncommon, but typically do not result in lenders accelerating repayment of the loan or taking control of the borrower.…”

The Costs and Benefits of Secured Creditor Control in Bankruptcy: Evidence from the UK

“…All-encompassing secured credit facilitates control by the secured lender, especially when combined with revolving overdraft facilities and extensive loan covenants (Scott, 1986;Franks and Sussman, 2005;Baird and Rasmussen, 2006;Armour, 2006). Thus a concentrated secured lender is in a position to assist in keeping the debtor's management under control (Triantis and Daniels, 1995;Baird and Rasmussen, 2002).…”