Creditor Control Rights and Board Independence

Daniel Ferreira is Professor of Finance at the London School of Economics; Miguel Ferreira is Banco BPI Chair in Finance at Nova School of Business and Economics; and Beatriz Mariano is Lecturer in Banking at Cass Business School. This post is based on their recent article, forthcoming in the Journal of Finance.

After a loan covenant violation, creditors can use the threat of accelerating loan payments and/or terminating credit agreements to extract concessions from borrowers in exchange for contract renegotiation. In practice, creditors rarely need to carry out such threats; most covenant violations lead to contract renegotiation. However, covenant violations enhance creditors’ bargaining position in renegotiations and such an improvement in creditors’ bargaining power is described as an increase in “creditor control rights.”

In our article, Creditor Control Rights and Board Independence, we show that covenant violations trigger profound changes on a firm’s governance. By changing governance, covenant violations can thus affect firm policies many years after the event, implying that current and past credit agreements have a long-lasting impact on a firm’s governance.

Our main finding is that firms tend to appoint new independent directors to their boards following covenant violations. The new directors typically do not replace outgoing directors, which implies that board size increases as new directors are appointed. The effect of covenant violations on the number of independent directors is sizable as it leads to a 24% increase in the number of independent directors.

The finding that loan covenant violations lead to the appointment of new directors to the board raises a number of questions: Who are these directors? Are they related to creditors? and if so, How are they related? We show that directors appointed post-violation are similar to other directors in all but one respect. Specifically, the new directors are much more likely to hold positions in other firms that borrow from the same banks. What do these new directors do? We find that firms that appoint new directors after covenant violations are more likely to change firm policies that require board initiative. Such firms are more likely to raise new equity through seasoned equity offerings (SEOs) and to invest than firms that violate covenants but do not change their boards, which suggests that reformed boards are in a better position to address debt overhang problems. In addition, reformed boards appear to take actions that decrease payout and operational risk, which alleviates concerns about risk-shifting problems. We also find that the structure of CEO compensation changes after violations. In firms that appoint new independent directors after violations cash bonuses fall and equity-based pay increases more than in firms without such appointments.

To summarize, we find that new directors are more likely to have links to creditors and that reformed boards are more likely to adopt creditor-friendly policies. We also show that firms with stronger lending relationships with their creditors appoint more directors in response to violations than firms without such relationships. However, this evidence does not settle the question of whether creditors explicitly intervene in corporate governance issues. It is true that creditors trigger the process that leads to board changes by declaring a covenant in breach. But the process that follows could be largely in the hands of management or large shareholders who push for changes in board composition. For example, it could be the case that, to improve its negotiation stance, a firm chooses to hire a director who has experience dealing with a particular bank.

The reasons for creditors to care about board composition are not obvious. Even if creditors can influence board appointments, directors still have a fiduciary obligation to shareholders. In addition, explicit intervention by creditors may force them to have a fiduciary obligation to shareholders or, in the case of bankruptcy, make them subject to equitable subordination (i.e., courts may treat their claims as subordinate on equitable grounds). Thus, debt contracts typically do not give creditors explicit rights over board appointments. However, this does not mean that creditors abstain from corporate governance activism. In fact, our evidence shows that a consequence of a change in control rights is the appointment of new “monitors” to the board. The evidence thus suggests that enhanced creditor control rights strengthen the monitoring role of the board of directors.

The complete article is available here.

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