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. |
