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E-MailThe following post comes to us from Greg Nini of the Insurance and Risk Management Department at the University of Pennsylvania, David Smith of the School of Commerce at the University of Virginia, and Amir Sufi of the Finance Department at the University of Chicago.
In the paper, Creditor Control Rights, Corporate Governance, and Firm Value, which was recently made publicly available on SSRN, we provide evidence that creditors play an active role in the governance of corporations well outside of payment default states. By examining the SEC filings of all U.S. nonfinancial firms from 1996 through 2008, we document that, in any given year, between 10 percent and 20 percent of firms report being in violation of a financial covenant in a credit agreement.
We show that violations are followed immediately with a decline in acquisitions and capital expenditures, a sharp reduction in leverage and shareholder payouts, and an increase in CEO turnover. The changes in the investment and financing behavior of violating firms coincide with amended credit agreements that contain stronger restrictions on firm decision-making; changes in the management of violating firms suggest that creditors also exert informal influence on corporate governance. Finally, we show that firm operating and stock price performance improve following a violation. We conclude that actions taken by creditors on average increase the value of the violating firm.
We offer evidence that firms in violation of a covenant in a private debt agreement change senior management, become more conservative in their financial and investment policy, and improve performance. Given the well-documented set of control rights given to creditors following a covenant violation, we interpret the evidence as suggesting that creditors serve a corporate governance role that helps increase the value of the firm. These changes occur despite the fact that violators are not on the verge of bankruptcy or payment default; creditors play an important corporate governance role even outside of payment default states. Taken together, our results provide a unique look into an aspect of corporate governance that has been largely overlooked by the traditional corporate governance literature.
We strengthen the extant evidence of Roberts and Sufi (2009) and Nini, Smith, and Sufi (2009), who find that contract terms can become more restrictive following a covenant violation, and that the new restrictions influence firm behavior. Creditors can also influence firm behavior through behind-the-scenes pressure on managers and force CEO turnover. We also demonstrate that creditor influence extends beyond affecting debt issuance and capital expenditures—violations of financial covenants lead to important changes in virtually every dimension of investment and financing by firms.
These results are consistent with the extensive literature showing that financial intermediaries are valuable as delegated monitors, especially when there are unresolved conflicts of interest between managers and the providers of finance in public companies. A fruitful area for future empirical research would be to document the full set of control rights that creditors can use to discipline management and how they interact with the tools available to equity-holders. On the theoretical side, models of corporate governance should recognize the control rights available to creditors in the optimal governance structure.
The full paper is available for download here.
