Rethinking Corporate Governance for a Bondholder Financed, Systemically Risky World

In Rethinking Corporate Governance for a Bondholder Financed, Systemically Risky World, I re-envision, for systemically important firms, the shareholder-primacy model of corporate governance. The Federal Reserve recently acknowledged that shareholder primacy lacks sufficient incentives for those firms to take precautions against their own failures. I argue that including bondholders in their governance not only could help to reduce systemic risk but also is merited by crucial changes in the bond markets.

I identify two bond-market changes. First, bondholders—like shareholders—now typically trade their securities instead of holding them to maturity. In 2014, for example, the average daily trading volume of corporate bonds reached a record of $26.7 billion, a 50% increase from 2002’s average trading volume of $17.8 billion. That same year, the average turnover rate for corporate bonds was approximately twice that of equity securities. Bond trading ties bond prices to the firm’s performance. Therefore bondholders, like shareholders, have a vested interest in that performance.

Second, bond issuances now dwarf equity issuances as the source of corporate financing. For example, newly issued corporate bonds raised approximately $1.49 trillion in 2014, compared to only $175 billion (i.e., $0.175 trillion) raised by newly issued shares of stock. Indeed, since 2006, new corporate bond issuances have exceeded new issuances of equity more than eight-fold.

Including bondholders in corporate governance makes sense not only from a bond-market standpoint but also, for systemically important firms, as a way to reduce systemic risk. Being more risk averse than shareholders, bondholders could help to reduce such a firm’s risk-taking. In a world of bond trading, the reason why bondholders are more risk averse than shareholders goes beyond the traditional view (which is associated with holding bonds to maturity) that a bondholder is only entitled to principal and interest and therefore does not benefit from the firm’s profitability. Instead, bondholder risk aversion is more closely tied to bond ratings, which signal the issuing firm’s creditworthiness and therefore is critical to the bond’s trading price. The rating agency providing the rating, such as Moody’s or Standard & Poor’s, typically monitors the firm issuing the rated bonds. If the firm’s creditworthiness remains stable, the bond rating should be preserved. But if the firm’s creditworthiness declines, the bond rating could be downgraded, causing the bonds to fall in value. Although theoretically a firm whose creditworthiness increases should see an upgrade in its bond rating, that seldom happens in practice. A bond’s trading price is therefore more likely to fall if the firm issuing the bond does poorly than to rise if the firm does well, making bondholders less likely to share in the upside of success than in the downside of failure (and to that extent more risk averse than shareholders of the firm).

For these reasons, bondholders should be included in the governance of systemically important firms if that could be done without impairing legitimate corporate profit-making. The article examines two ways to accomplish that: by enabling bondholders and shareholders to directly share governance, and by requiring a firm’s managers to balance a dual duty to both bondholders and shareholders. The sharing-governance approach would offer bondholders a more direct voice in management than the dual-duty approach. The article proposes that bondholders should have a minority representation but with supermajority voting power when a management decision could significantly harm them. Under the dual-duty approach, all managers would have a duty to consider bondholder interests. Although the primary duty of managers would usually be to shareholders, that duty should shift when a management decision could significantly harm bondholders (unless the overall benefit to shareholders would be expected to considerably outweigh the harm to bondholders).

Both governance approaches face the same practical threshold question: When could a management decision significantly harm bondholders? Under the sharing-governance approach, the article proposes that the bondholders’ representatives would make that determination. Under the dual-duty approach, any manager could make that determination. In making their determination, the relevant managers might consider, for example, whether management is contemplating a transaction that could be highly profitable but, if unsuccessful, would be likely to cause the firm’s bond rating to be downgraded. In analyzing that, those managers would presumably take into account rating-agency criteria for downgrading bond ratings. So long as they use at least slight care in this process, the managers should be protected by the business judgment rule.

The article also compares these governance approaches with recent regulatory experiments, especially outside the United States, to try to harness bondholder risk aversion through contingent capital regulation—requiring certain debt claims against systemically important firms to convert to equity upon specified (deteriorating) financial conditions. The article argues that such regulation not only would have higher costs but also would reduce systemic risk-taking less effectively than the proposed governance approaches.

Finally, because bondholder interests are not fully aligned with the interests of the public, the article acknowledges that its governance approaches represent second best solutions to the problem of systemic risk. Only something like a “public governance” duty of managers not to engage firms in excessive risk-taking that could lead to systemic externalities—which I analyze in Misalignment: Corporate Risk-Taking and Public Duty, 92 Notre Dame L. Rev. 1 (forthcoming Nov. 2016, available here)—could fully align those interests.

The full article is available for download here.