Does Corporate Governance Make Financial Reports Better, or Just Better for Equity Investors?
Tel Aviv University
INSEAD – Accounting & Control Area
Interdisciplinary Center (IDC) Herzliyah; Singapore Management University – School of Accountancy
Financial reports should provide useful information to both shareholders and creditors, according to U.S. accounting principles. However, directors of corporations have fiduciary duties only toward equity holders, and those fiduciary duties normally do not extend to the interests of creditors. We examine whether this slant in corporate governance biases financial reports in favor of equity investors, and in particular leads to a downward bias in reported debt that can hurt creditors. We focus on firms’ decision to issue structured debt securities that are classified as equity in financial reports and can circumvent debt covenants. We find that when the local legal regime requires directors to consider creditors’ interests, firms are less likely to use such structured transactions, particularly if the board of directors of the firm is independent. Our results suggest that when corporate governance is designed to protect only equity holders, firms’ financial reports serve equity holders’ interests at the expense of other stakeholders.
Corporate Governance: Introduction
Financial reports should provide useful information to both equity investors and creditors, and reflect accurately the assets and liabilities of the firm. Statement of Financial Accounting Concepts No. 1, Objectives of Financial Reporting by Business Enterprises (1978) states that:
“Financial reporting should provide information to help present and potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts from dividends or interest and the proceeds from the sale, redemption, or maturity of securities or loans.”
While financial reports should equally serve shareholders’ and creditors’ needs, corporate governance mechanisms usually protect only shareholders’ interests. In particular, U.S. managers (officers) and directors owe fiduciary duty primarily to shareholders, not creditors. Shareholders are the residual claimants to the firm’s assets. They are viewed as the weakest stakeholder, in need of directors’ protection. Other stakeholders such as debt holders and employees are able to protect themselves through contracts and other legal means (Jensen 2002; Tirole 2001). Fiduciary duties toward shareholders require managers, under the supervision of directors, to enhance shareholders’ value. This is true even when enhancing shareholder value will reduce value for creditors (Becker and Stromberg 2012). We examine whether this slant in corporate governance biases financial reports in favor of equity investors, and in particular leads to a downward bias in reported debt that can undermine creditors’ interests.
We test the effect of directors’ fiduciary duties on firms’ propensity to use structured debt transactions that lower reported debt. We show that firms are more likely to use such structured debt when directors owe fiduciary duties only to shareholders than when directors are legally required to also consider creditors’ interests.
We focus on issuances of mandatory redeemable preferred shares, preferred shares with a debt-like maturity feature that requires issuers to redeem the invested amount by a specific future date. Prior to 2003, these structured debt securities were reported as equity in financial reports, and were used by firms to lower their reported leverage and circumvent debt covenants put in place by creditors (e.g., Engel et al. 1999; Moser et al. 2011; Levi and Segal 2014). By lowering reported debt and circumventing debt covenants, managers effectively transfer wealth from creditors to shareholders. They prevent creditors from taking timely actions when the firm approaches insolvency, actions that can help creditors to reduce bankruptcy risk and avoid bankruptcy costs, or recover more from the borrowing firm. Equity investors, on the other hand, can be viewed as holding an out of the money option when the company approaches insolvency, and can benefit when the firm is allowed to continue and operate.
See full article in PDF here SSRN-id2439728