Does Corporate Governance Make Financial Reports Better or Just Better for Equity Investors?

The following post comes to us from Shai Levi of the Department of Accounting at Tel Aviv University, Benjamin Segal of the Department of Accounting at Fordham University and The Hebrew University, and Dan Segal of the Interdisciplinary Center (IDC) Herzliyah and Singapore Management University. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

Financial reports should provide useful information to both shareholders and creditors, according to U.S. accounting principles. However, directors of corporations have fiduciary duties only toward equity holders, and those fiduciary duties normally do not extend to the interests of creditors. In our paper, Does Corporate Governance Make Financial Reports Better or Just Better for Equity Investors?, which was recently made publicly available on SSRN, we examine whether this slant in corporate governance biases financial reports in favor of equity investors. We show that the likelihood that firms will manipulate their reporting to circumvent debt covenants is higher when directors owe fiduciary duties only to equity holders, rather than when they owe fiduciary duties also to creditors. Covenants limit the amount of new debt that the firm issues, for example, and by that reduce bankruptcy risk, and allow creditors to avoid bankruptcy costs, and to recover more from the borrowing firm in case it approaches insolvency. When managers manipulate financial reports to circumvent these debt covenants, they transfer wealth from creditors to shareholders. Our results suggest that when corporate governance is designed to protect only equity holders, firms’ financial reports serve equity holders’ interests at the expense of other stakeholders. We find that when the legal regime requires directors to consider creditors’ interests, firms are less likely to use structured transactions designed to skirt debt covenant limits, particularly if the board of directors of the firm is independent.

We use the 1991 Delaware court ruling in the Credit Lyonnais v. Pathe Communications case as a setting to test the effect of directors’ fiduciary duties on the financial reporting of firms. This court ruling increased directors’ fiduciary duties toward creditors. Historically, the position of U.S. courts was that fiduciary duties are owed strictly to equity holders but not to creditors in solvent firms. In this case, the Delaware court ruled that when a firm is close to insolvency, directors are not merely the agent of the shareholders but should consider the interests of creditors as well. The ruling was widely viewed as having created a new obligation for directors of Delaware firms, and evidence suggests this ruling reduced the debt-equity conflicts in Delaware firms (Becker and Stromberg, 2012).

Using a difference-in-differences analysis around the Credit Lyonnais ruling, we find that after 1991 Delaware firms reduced their use of structured transactions designed to evade debt covenant limits. We examine the change in issuances of mandatory redeemable preferred shares, preferred shares with a debt-like maturity feature that requires issuers to redeem the invested amount by a specific future date. These structured debt securities were reported as equity in financial reports, and were used by firms to lower their reported leverage and circumvent debt covenants. Following the 1991 court ruling, directors in Delaware firms that are close to insolvency owed fiduciary duties to creditors, and their firms reduce their issuances of such structured debt. All other firms, Delaware firms with low leverage and firms incorporated elsewhere, did not experience a change in structured debt issuance around 1991. These results suggest that when managers and directors face legal fiduciary duty toward creditors, they are less likely to use structured debt transactions to lower reported leverage and manipulate financial reports.

We also examine the effect of board independence on firms’ use of structured transactions designed to circumvent debt covenants. Prior literature shows that board independence is associated with better audit quality, higher reporting quality, and fewer financial reporting frauds and misstatements. We find that board independence improves the quality of reporting from the creditors’ perspective, only when directors owe fiduciary duties to creditors. Specifically, we find that board independence is associated with lower structured debt issuances only in Delaware firms that were close to insolvency. We find no relation between board independence and structured debt issuances in non-Delaware firms and low-leverage Delaware firms, where directors are not required to protect creditors’ interests.

Finally, we use a general covenant slack distribution test to examine the extent to which firms manage their reporting to avoid violation of debt covenants. Covenant slack is the difference between the limit set by the debt covenant, e.g. the maximum level of debt-to-cash flows that the covenant allows, and the actual debt-to-cash flows based on the financials reported by the firm. Managers usually have limited ability to manipulate their firms’ financials, and they use it when the true performance is just below the covenant limit, in order to report numbers that meet the threshold and avoid violation. When such manipulations occur, the slack distribution shows few observations just below zero and many observations just above zero. We find such discontinuity around zero only in the covenant slack distribution of non-Delaware firms. The results of the covenant slack distribution test indicate that after the Credit Lyonnais ruling, Delaware firms are not manipulating their reports to avoid debt covenant violation.

The full paper is available for download here.

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