hen a company sells securities whether it is
equity or debt, part of what it is selling is some
control over the firm. The traditional view of
corporate governance, however, is that shareholders mainly
influence the decisions that managers make through the
company's board of directors. In fact, corporate governance
literature almost exclusively reflects this view. Creditors are
thought to be passive bystanders as long as the company is
meeting its scheduled payments.
But a recent study by University of Chicago Booth School
of Business professor Amir Sufi, Greg Nini of the University
of Pennsylvania, and David C. Smith of the University of Virginia
challenges this conventional view. In "Creditor Control
Rights, Corporate Governance, and Firm Value" the authors
find that creditors exert substantial control over a company
when its performance starts to deteriorate, but well before it
When a company borrows money from an investor, a loan
contract typically includes covenants or promises made by its
management that either guide or limit its actions. If a borrower
violates a covenant, the creditor can opt to demand
immediate repayment even though the borrower has not
defaulted. Covenant violations are common, but in practice
creditors rarely accelerate the loan. Instead, violations give
creditors an opportunity to renegotiate the credit agreement
by imposing stronger restrictions on firm behavior.
Creditors may even push to replace the firm's top executives
in exchange for waiving the violation. "The decision
whether to fire a CEO is, in some sense, the essence of corporate
control," says Sufi. Indeed, the study finds that the
probability of a CEO getting fired is about five times higher
in the year following the violation than in the year before.
This significant jump, as well as evidence that borrowing
firms become more conservative in their financial and
investment policies after a violation, suggests that creditors
play an active and influential role in directing the performance
of a company.
The authors find that creditors play a bigger role in corporate
governance than previously thought, and that covenants attached
to lending agreements are an important part of this process.
Covenants require borrowers to take certain actions or
refrain from certain activities. For example, a covenant may
ask a company to submit financial information to the lender
on a regular basis or prevent a firm from making excessive
capital expenditures. Financial covenants, in particular,
are accounting-based risk and performance limits, such as
restrictions on how much money the firm can borrow and
how much cash to set aside to cover interest payments and
When a firm violates a covenant it gives the creditors, who
are typically banks, considerable power over the borrower at
that moment because demanding an immediate repayment
could force the company into bankruptcy. Thus, the borrowing
firm must agree to the new terms of the loan—and possibly
a change in management—in order for the lender to waive
The renegotiations can lead to significant changes to the
loan as well as increased monitoring by lenders. For instance,
renegotiated loans are typically smaller, carry higher interest
rates and fees, and have a shorter maturity, which reflect
the borrower's increased credit risk. The reduction in the
number of members in a syndicated loan indicates a desire
by lenders to monitor borrowers more closely. Renegotiated
loans also are more likely to include an explicit restriction on
dividend payments, tighter limits on capital expenditures,
and a "sweeps provision" that requires cash flows from certain
activities to be used only to pay down loans.
In addition to changing the contractual terms of the
agreement, creditors may work "behind the scenes" to
change the way the company is managed. For instance, a
previous study by Douglas Baird of the University of Chicago
Law School and Robert Rasmussen of the University of
Southern California describes how Krispy Kreme Doughnut
Corporation replaced its CEO with a turnaround specialist as
a concession to creditors following a covenant violation. But
up until the study by Sufi and his co-authors, there has been
no large sample evidence that this type of creditor influence
occurs more frequently when companies are not insolvent.
The authors analyze what happens after the first time a
borrower violates a financial covenant. They compare the
changes in a company's CEO turnover, asset growth, capital
expenditures, and dividend payout policy before and after
a loan violation. Although the performance of the median
firm in their sample declines in the period leading up to
a violation, the company is far from being on the verge of
bankruptcy. This is important because corporate governance
literature has paid very little attention to creditors' involvement
in management decisions during this period, a role
thought to belong exclusively to shareholders.
The study finds that financial
covenant violations were followed
by decreases in capital expenditures
and cash acquisitions as well as
sharp reductions in the growth rate
of assets and the prospective price
earnings ratio, which suggests that
firms were engaged in asset sales and divestitures. Firms
increased their asset base by 10 percent in the four quarters
leading up to the violation, but reduced it by 6 percent four
quarters after a violation. Investments in property, plant,
and equipment also fell sharply immediately after a covenant
Similarly, the analysis suggests that creditors imposed
more constraints on the financial policy of firms after a violation.
Net debt issuance, total debt outstanding, and shareholder
payouts declined, while the firms' cash-to-assets
ratio increased. Cash balances quickly rose by 2 percent
after a covenant was violated, in contrast to firms' heavy cash
spending just prior to the violation.
Perhaps the most striking result of the analysis is that
many more CEOs were fired after a covenant violation. The
probability of a forced CEO turnover four quarters before
a violation was relatively steady at about 1.5 percent but
jumped to 8 percent four quarters after a violation. "We
know that shareholders have the ability to fire a CEO through
the board of directors but they don't seem to do anything
until the violation of the covenant, which suggests that the
lenders are exerting some kind of pressure that ultimately
leads to the CEO being fired," says Sufi.
The study also finds a significant increase in the hiring of
turnaround and restructuring specialists, who are likely to be employed by the company for at least a year after the violation.
This finding supports anecdotal evidence that suggests
that creditors have substantial influence over the decision to
hire such specialists to help improve the performance of the
company. Typically, these consultants assist with restructuring
the violators' capital structure and operations and even
take temporary roles on the firms' management teams.
Why Shareholders Benefit Too
If creditors indeed exert substantial control over the borrowing
firm, then one could argue that lenders who are looking
out for their own good might make decisions that are not
in the best interest of shareholders. For instance, creditors
may be more inclined to shut down the business and take
the company's assets, since they are paid first if the company
However, the study finds that lenders' interventions to
protect their own investment actually help the firm's performance,
which means that shareholders benefit because these
actions improve the value of the company. For instance,
although operating cash flow was deteriorating rapidly before
a covenant was violated, it rebounded quite sharply right
after the violation. Creditors seem to reduce costs in a way
that leads to better operating performance.
Overall, the study's results show that a covenant violation
leads to important changes in the firm's management,
investment, and financial policies, and ultimately its performance.
This makes it hard to ignore that creditors do
step up and have much sway over a company, which may
be one reason why previous studies find that firm performance
seems to be unaffected by a weak board of directors.
"One can imagine a situation where the board of directors
is incompetent, but the creditors are doing their job,"
More importantly, the study provides evidence that the
traditional model of equity-centered corporate governance
needs rethinking and that future research should turn its
attention to another group of investors who have equally
strong incentives to monitor their investment. "It's almost
impossible to talk about corporate governance unless we
think about the creditors," says Sufi
"Creditor Control Rights, Corporate Governance, and Firm Value."
Greg Nini, David C. Smith, and Amir Sufi.