Rethinking Corporate Governance For A Bondholder Financed, Systemically Risky World

Steven L. Schwarcz

Duke University School of Law

March 24, 2016

Duke Law School Public Law & Legal Theory Series


This article rethinks the shareholder-primacy model of corporate governance, arguing that bondholders, who are more risk averse than shareholders, should be included in the governance of systemically important firms. The inclusion of bondholders not only could help to reduce systemic risk but also is merited by two crucial changes in the bond markets. In contrast to the past century, bond issuances have dwarfed equity issuances as the source of corporate financing for more than a decade. Bondholders therefore often have more invested in firms than shareholders. Moreover, bondholders — like shareholders — now typically trade their securities instead of holding them to maturity. That ties bond prices to the firm’s performance. Therefore bondholders, like shareholders, also have a vested interest in that performance.

It therefore is logical to include bondholders in corporate governance if that could be done without impairing legitimate corporate profit-making. The article examines two ways to accomplish that: by enabling bondholders and shareholders to directly share governance, with shareholder representatives having voting control except as needed to protect bondholders from significant harm; and by requiring a firm’s managers to balance a dual duty to both bondholders and shareholders. Of these approaches, the former (sharing governance) would be simpler, involving less managerial discretion. Both of these approaches, however, should not only have lower costs but also more effectively reduce systemic risk than post-crisis regulatory experiments to try to harness bondholder risk-aversion through the forced issuance of contingent capital.

Rethinking Corporate Governance For A Bondholder Financed, Systemically Risky World – Introduction

Based on several critical but heretofore uncorrelated developments in financial markets, this article calls for a fundamental change in the governance of systemically important firms. Traditional corporate governance views a firm’s managers as acting primarily on behalf of the firm’s shareholders. Only in very limited circumstances do managers have a duty to others, such as creditors. Shareholder primacy effectively obliges managers to engage the firm in risk-taking in order to make profits.

Although that risk-taking can cause externalities, they are usually minor. This changes, however, when the risk-taking causes “systemic” externalities—such as the failure of a systemically important firm which triggers a domino-like collapse of other firms or markets, harming the real economy. That threat is real, as the Federal Reserve recently observed, because shareholder primacy lacks sufficient “incentives [for systemically important firms] to take precautions against their own failures.”

In response to the financial crisis of 2008-09 (the “financial crisis”), regulators have been experimenting with contingent capital regulation to attempt to harness risk-averse creditors as a check on corporate risk-taking. Such regulation would require certain debt claims against systemically important firms to convert to equity upon specified (deteriorating) financial conditions. To reduce the chance those conditions will occur, holders of the convertible debt claims are expected to impose strict loan covenants on their debtor-firms’ ability to take risks.

Contingent capital regulation can be costly, however, and its efficacy is uncertain. It is costly because debt issued as contingent capital is riskier, and thus may be more expensive, than non-convertible debt. Its efficacy is uncertain because it operates indirectly–incentivizing holders of debt issued as contingent capital to influence corporate governance through strict covenants. Strict covenants may not always be imposed, however. Firms customarily offer creditors higher interest rates as a quid pro quo to allow looser covenants, especially if the debt is sold to the public which makes it difficult to later obtain covenant waivers. Experience shows that creditors usually “go for the gold,” choosing the higher rates over strict covenants.

Choosing higher rates over strict covenants not only reduces the efficacy of contingent capital regulation; it also has the unintended effect of making debt issued as contingent capital even more expensive. And contingent capital regulation can have other unintended consequences. For example, capitalizing a systemically important firm with contingent capital in order to make the firm less likely to fail might motivate the firm’s managers to take even greater corporate risks. Furthermore, because covenants are relatively inflexible–any change requires a formal waiver–they can “impair[] the managers’ ability to pursue value-maximizing projects [which would] reduce the likelihood of increases in cash-flow production and enhance the risk of debtor payment defaults.”

This article argues that law could more effectively temper the risk-taking of systemically important firms by directly engaging shareholder primacy. One way to do that, the article contends, would be to require the corporate governance of those firms to include bondholders–i.e., the holders of long-term corporate debt securities (“corporate bonds” or simply “bonds”)–in addition to shareholders, thereby harnessing the more risk-averse bondholders as a check on corporate risk-taking. This would not be a perfect solution to the problem of systemic risk because bondholder interests are not fully aligned with the interests of the public. Only something like a “public governance” duty of managers–not to engage firms in excessive risk-taking that could lead to systemic externalities–could fully align those interests. Nonetheless, including bondholders in the corporate governance of systemically important firms should reduce systemic risk by reducing risk-taking: the less such a firm engages in risk-taking, the less likely would that firm be to fail, with potentially systemic consequences.

Rethinking Corporate Governance For A Bondholder Financed, Systemically Risky World

See full PDF below.