Lenders in Charge

Largely overlooked, creditors exert more control over companies than previously thought.

When 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 goes bankrupt.

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.

Breaking Promises

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 other expenses.

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 violation.

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.

Making Changes

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 was violated.

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 goes bankrupt.

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," says Sufi.

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.