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Privileged Lending

Syndicate Loans and Inside Information

Research by
Abbie J. Smith and Regina Wittenberg-Moerman

Abbie J. Smith is Boris and Irene Stern Distinguished Service Professor of Accounting at the University of Chicago Booth School of Business.

Regina Wittenberg-Moerman is assistant professor of accounting and Neubauer Family Faculty Fellow at the University of Chicago Booth School of Business.

Participating in a syndicated loan may be far more valuable to institutional investors than simply the return on lending money.

W

hen a group of lenders—often called a syndicate— provides loans to companies, borrowers typically have to share information with lenders about their financial performance and future plans. The information is usually confidential and could potentially change the current price of a company's stocks. Thus, syndicate members who are privy to this inside information might be tempted to use it to trade the borrowing company's stocks to their advantage.

This suspicion has been growing in recent years as private lending practices in the United States have changed dramatically along with the explosive growth of the syndicated loan market. Historically, private lending has been under the purview of banks. These banks have so-called "Chinese walls" so that traders, salespeople, and analysts on the public securities side do not receive private information even if it is available somewhere else in the same organization. Big banks, in particular, may be more successful at separating the activities of the private lending group from the equity group because of their size and considerable experience in handling loans.

More recently, however, non-bank institutional investors have joined banks as major participants in syndicated lending groups and there is a concern that Chinese walls in these institutions may be less effective in preventing information leaks. Hedge funds, for instance, are typically much smaller than banks, so it would not be unusual for employees who trade equities and those who trade syndicated loans to sit beside each other or for the same employee to trade both. Moreover, press reports note that hedge funds tend to purchase very small amounts of syndicated loans mainly to access a borrower's confidential information. "It's enough to buy a very small proportion of a loan to get private information," says University of Chicago Booth School of Business professor Regina Wittenberg-Moerman.

To find out whether there is some truth to these speculations, a recent study by Wittenberg-Moerman with University of Chicago Booth School of Business professor Abbie Smith and Robert Bushman of The University of North Carolina titled "Price Discovery and Dissemination of Private Information by Loan Syndicate Participants," investigates how quickly private information is incorporated in the price of the borrowing company's stock when syndicate lenders have early access to confidential information.

The authors identify certain features of a lending contract or characteristics of a borrower or lender that allow investors to receive private information sooner or more frequently than others. If a loan contract includes a financial covenant, for example, borrowers would have to regularly submit reports to assure lenders that they are meeting all performance obligations stipulated in the covenant. If investors trade on this information, the price of the borrowing firm's stock should change more quickly than the stock price of other companies that have no financial covenants written in their loan contracts.

Indeed, the study finds that lenders' access to private information drives the speed of price discovery in the equity market, but only if non-bank institutional investors such as hedge funds are part of the syndicate. This suggests that nonbank lenders use inside information obtained through the syndicate to trade a company's stocks. Moreover, the results imply that banks are more effective at separating the public and private sides of the information wall.

Early vs. Late Dissemination of Private Information

Like many private debt contracts, syndicated lending depends crucially on the flow of confidential information between borrowers and lenders throughout the life of a loan. This information typically includes regular financial disclosures, covenant compliance reports, amendment and waiver requests, financial projections, and plans for acquisitions and divestitures.

However, given that it is illegal to trade in the stock market using private information, this privileged access is an issue for syndicated lenders who want to retain an option to trade a borrower's stocks while simultaneously receiving private information under the credit agreement. Institutional investors, in particular, are typically smaller and less experienced in private lending than most big banks and thus may be less adept at making sure that information from syndicated loans will not be used in the equity market. Indeed, previous research on insider trading by institutional syndicate lenders finds evidence to support this claim.

One study examines the stock trading of institutional lenders who also hold syndicated loans in their portfolio at the time of a loan renegotiation—an event that allows the lender to demand more information from borrowers. The study finds that these institutional managers outperformed the stock trades of other managers who did not have access to such private information. Another study finds that short sales of a borrower's stocks prior to a loan's start date were significantly larger for firms with hedge fund lenders compared to the stocks of firms that borrowed from banks. Both papers, however, look only at certain events to identify insider trading so the sample of lenders that they investigate is naturally very small.

The study by Bushman, Smith and Wittenberg-Moerman, on the other hand, involves a much larger sample because their analysis is not limited to specific events. Firms are grouped according to whether their lenders have early access to confidential information, for instance, because of reports that borrowers have to regularly file with lenders. The authors then examine whether investors exploit this private information in the stock market.

The authors' research design allows insider trading to take place not only during big credit events like defaults or renegotiations but also more frequently in regular earnings cycles, whenever there is an opportunity to obtain information that is not available to the public. Moreover, the authors can capture misuse of confidential information even if institutional lenders do not use the information themselves but forward it to other investors with whom they share the profits.

The authors consider four factors that can determine how quickly private information is disclosed to lenders: financial covenants, the credit risk of a borrower, relationship lending, and the reputation of the financial institution arranging the syndicate loan.

If a loan includes a financial covenant, then companies must provide syndicate lenders with regular reports to ensure that borrowers are complying with their performance requirements. Earnings-based covenants, in particular, give lenders frequent information about upcoming earnings news before it is released to the public. In addition, covenants may serve as "trip wires" that allow lenders to intervene and extract private information about the borrower's current circumstances when these covenants are violated. U.S. firms do not have to publicly disclose covenant violations at the time they are breached but only at the next quarterly or annual filing of financial statements with the Securities and Exchange Commission, which gives syndicate lenders a significant advantage.

Syndicate groups with very risky borrowers will naturally demand more frequent updates about a borrower's financial situation than if they were lending to a company with a low risk of defaulting on its debt. Thus, borrowers with a high credit risk, as indicated by their senior debt rating, hasten the flow of confidential information to syndicate participants.

Likewise, members of a syndicate can get information more quickly if the group is led by an arranger who has one or more prior lending relationships with a borrower. The syndicate's lead arranger, usually a bank, is the member responsible for structuring and administering the loan. Because relationship lending involves repeated interactions between a lender and a borrower, these lenders have extensive knowledge of a borrower's operations and have well-developed channels of communication with a firm's managers.

Moreover, if the syndicate's lead arranger has a good reputation then that could be a signal of its ability to obtain important information from borrowers in a timely fashion. Thus, syndicate lenders who belong to a group led by a reputable arranger can expect to receive confidential information well ahead of other stock traders.

The Speed of Price Discovery

Any investor who owns a part of a syndicated loan is entitled to receive a borrower's confidential information, and these investors are allowed to trade loans based on that knowledge. In fact, lenders are encouraged to disclose private information to the other parties in a transaction. Thus, it is likely that the dissemination of private information is what drives the changes in loan prices in the secondary loan market. It is also possible that the speed with which private information is reflected in the price of a loan depends on factors that accelerate the flow of this information to syndicate participants.

Indeed, the study finds that all four factors—financial covenants, credit risk, relationship lending and the reputation of the arranger—are associated with quicker price discovery in the secondary loan market. For loans with financial covenants, for instance, the price of such loans tends to change more quickly than the price of loans that do not include a covenant. This suggests that syndicate members—banks and non-banks alike—use confidential information that they get through financial covenants when trading loans. In particular, information from earnings-based covenants, or covenants that ensure that borrowers have enough cash flow to cover their debt, matter more than other types of covenants.

However, the authors find that the opposite is true in the equity market. None of these factors, except for a borrower's credit rating, are significantly related to the speed of price discovery in the stock market. For instance, a borrowing firm's stock price does not change faster when a financial covenant is written in the loan contract. Thus, it would appear that lenders do not use their inside information when trading stocks.

But when the authors restrict the analysis to the sample of firms that borrow from non-bank institutions such as hedge funds, thus excluding firms that borrow only from banks, the results change completely. When non-bank lenders are part of a syndicate group, the authors find that early dissemination of confidential information either because of financial covenants, the credit risk of the borrower, relationship lending, and the reputation of the arranger lead to faster price discovery in the equity market.

This is especially true when private information comes from firms that do not routinely give management forecasts or firms that issue relatively few press releases. Moreover, the inclusion of earnings-based covenants in a loan contract seems to give institutional lenders a significant advantage in the stock market compared with lenders who do not require earnings-based covenants.

The results give weight to concerns that institutional lenders trade illegally in the equity market, using information that is revealed to them long before the same information is announced to the public. In contrast, the authors find no evidence that Chinese walls and other procedures implemented by banks to prevent leaks between the public and private sides of the information wall are ineffective.

"Price Discovery and Dissemination of Private Information by Loan Syndicate Participants." Robert Bushman, Abbie J. Smith, and Regina Wittenberg-Moerman. Journal of Accounting Research, December 2010.