Creditor Control Rights and Board Independence

• Author: BEATRIZ MARIANO,DANIEL FERREIRA,MIGUEL A. FERREIRA
• Published date: 01 October 2018
• Date: 01 October 2018
• DOI: http://doi.org/10.1111/jofi.12692

THE JOURNAL OF FINANCE •VOL. LXXIII, NO. 5 •OCTOBER 2018

Creditor Control Rights and Board Independence

DANIEL FERREIRA, MIGUEL A. FERREIRA, and BEATRIZ MARIANO∗

ABSTRACT

We find that the number of independent directors on corporate boards increases by

approximately 24% following financial covenant violations in credit agreements. Most

of these new directors have links to creditors. Firms that appoint new directors after

violations are more likely to issue new equity,and to decrease payout, operational risk,

and CEO cash compensation, than firms without such appointments. Weconclude that

a firm’s board composition, governance, and policies are shaped by current and past

credit agreements.

AFTER A LOAN COVENANT VIOLATION, creditors can use the threat of accelerating

loan payments and/or terminating credit agreements to extract concessions

from borrowers in exchange for contract renegotiation. In practice, creditors

rarely need to carry out such threats; most covenant violations lead to con-

tract renegotiation (Roberts (2015)). Covenant violations enhance creditors’

bargaining position in renegotiations, as shown by the empirical literature on

the impact of violations on firm policies (e.g., Chava and Roberts (2008), Roberts

and Sufi (2009), Nini, Smith, and Sufi (2009,2012), Falato and Liang (2016)).

This literature describes such an improvement in creditors’ bargaining power

as an increase in “creditor control rights.”1

∗Daniel Ferreira is at the London School of Economics, CEPR, and ECGI. Miguel A. Ferreira is

at the Nova School of Business and Economics, CEPR, and ECGI. Beatriz Mariano is at the Cass

Business School, City,University of London. We thank Michael Roberts (the Editor), the Associate

Editor, two anonymous referees, Andres Almazan, Per Axelson, Ilona Babenko, Laurent Bach,

Tom Bates, Bruno Biais, Daniel Carvalho, Geraldo Cerqueiro, Jonathan Cohn, Andrew Ellul, Ce-

sare Fracassi, Diego Garcia, Jarrad Harford, Jay Hartzell, Thomas Hellmann, Leonid Kogan, Yrjo

Koskinen, Kai Li, Chen Lin, Laura Lindsey, Daniel Metzger, Walter Novaes, Daniel Paravisini,

Enrico Perotti, Alessio Saretto, Clemens Sialm, Stephan Siegel, Laura Starks, and Margarita

Tsoutsoura; participants at the European Finance Association Annual Meeting and University of

British Columbia Winter Finance Conference; and seminar participants at Arizona State Univer-

sity, EIEF, ESCP, IE Business School, Hong Kong University of Science and Technology, London

School of Economics, Nanyang Technological University, National University of Singapore, PUC-

Rio, Queen Mary University, Singapore Management University, University of British Columbia,

University of Cambridge, University of New South Wales, Universitat Pompeu Fabra, University

of Technology–Sidney, University of Texas–Austin,and University of Sydney for helpful comments.

Miguel Ferreira acknowledges financial support from the European Research Council. We have

read the Journal of Finance’s disclosure policy and have no conflicts of interest to disclose.

1The term control rights is used informally; a creditor has no legal rights to control the borrower

following a covenant violation.

DOI: 10.1111/jofi.12692

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2386 The Journal of Finance R

In this paper, we show that covenant violations trigger changes that have

profound effects on a firm’s governance. Such governance changes, in turn,

magnify the effect of loan covenants on firm policies, particularly those policies

that require the board to behave proactively.By changing governance, covenant

violations can thus affect firm policies many years after the event, implying

that current and past credit agreements have a long-lasting impact on a firm’s

governance.

Our main finding is that firms tend to appoint new independent directors to

their boards following covenant violations. The new directors typically do not

replace outgoing directors, which implies that board size increases as new di-

rectors are appointed. We call a covenant breach an implied covenant violation

because a registered violation may not occur if a firm obtains a covenant waiver

through renegotiation. We examine implied rather than registered covenant vi-

olations because renegotiation is one of the mechanisms through which loan

covenants can affect firm choices. The effect of implied covenant violations on

the number of independent directors is sizable: in our baseline specification,

a violation leads to a 24% increase in the number of independent directors.

Our results support the hypothesis that covenant violations lead to changes in

board composition.

Our work is related to a number of studies that focus on the impact of credi-

tors and credit agreements on corporate governance. Gilson (1990) is the first

to investigate the influence of creditors on board composition. He finds evidence

that, in negotiated restructurings, banks influence the appointment of directors

both directly and through share ownership. Kaplan and Minton (1994) find that

poor financial performance triggers the appointment of former bank directors

to the boards of Japanese firms, which indicates that banks actively influence

corporate governance. Anderson, Mansi, and Reeb (2004) find a negative as-

sociation between board independence and the cost of debt, as the presence

of independent directors improves the quality of financial accounting reports.

Kroszner and Strahan (2001) and Guner, Malmendier, and Tate (2008) study

the costs and benefits of the presence of bankers on boards and find evidence of

conflicts of interest between creditors and shareholders. In this paper, we show

that credit agreements affect board appointments outside bankruptcy, and we

provide a causal estimate of the effect of implied covenant violations on board

composition.

Nini, Smith, and Sufi (2012) show that CEO turnover increases after

covenant violations. Our evidence complements theirs, as we show that the

turnover of independent directors is also a governance mechanism available to

creditors. However, our evidence is of a different nature, as we show that the

effect of covenant violations on board composition is stronger for the subset of

firms that do not replace their CEOs after a covenant violation. Becker and

Stromberg (2012) show that a 1991 change in the law that requires boards to

consider the interests of creditors in financially distressed firms led to an in-

crease in leverage among affected firms and a reduction in the use of covenants.

Their evidence suggests that, as boards become more likely to consider the

Creditor Control Rights and Board Independence 2387

creditors’ interests, covenants become less important. Our findings are broadly

consistent with this hypothesis.

The finding that loan covenant violations lead to the appointment of new

directors to the board raises a number of questions: who are these direc-

tors?, are they related to creditors?, and if so, how are they related? We

show that postviolation directors are similar to ordinary directors in all but

one respect. Specifically, directors appointed following covenant violations are

much more likely to hold positions in other firms that borrow from the same

banks.

What do these new directors do? We find that firms that appoint new

directors after covenant violations are more likely to change firm policies

that require board initiative. Such firms are more likely to raise new equity

through seasoned equity offerings (SEOs) and to invest than firms that vio-

late covenants but do not change their boards, which suggests that reformed

boards are in a better position to address debt overhang problems. In addi-

tion, reformed boards appear to take actions that decrease payout and oper-

ational risk, which alleviates concerns about risk-shifting problems. We also

find that the structure of CEO compensation changes after violations. After

violations, in firms that do not change the board, CEOs experience an in-

crease in cash bonuses that roughly compensates them for the reduction in

the value of their equity-based compensation. This trend is reversed, how-

ever, in firms that appoint new independent directors after violations: cash

bonuses fall and equity-based pay increases more than in firms without such

appointments.

To summarize, we find that new directors are more likely to have links to

creditors and that reformed boards are more likely to adopt creditor-friendly

policies. We also show that firms with stronger lending relationships with their

creditors appoint more directors in response to violations than firms with-

out such relationships. However, this evidence does not settle the question of

whether creditors explicitly intervene in corporate governance issues. It is true

that creditors trigger the process that leads to board changes by declaring a

covenant in breach. But the process that follows could be largely in the hands

of management or large shareholders who push for changes in board composi-

tion. For example, it could be the case that, to improve its negotiation stance,

a firm chooses to hire a director who has experience dealing with a particular

bank.

The reasons for creditors to care about board composition are not obvious.

Even if creditors can influence board appointments, directors still have a fidu-

ciary obligation to shareholders.2In addition, explicit intervention by creditors

may force them to have a fiduciary obligation to shareholders or, in the case

of bankruptcy, make them subject to equitable subordination (i.e., courts may

2However, depending on the company’s charter and state corporate law, a director may also

have fiduciary obligations to other stakeholders, such as creditors, employees, customers, and the

community. For example, in Delaware, directors also have fiduciary obligations to creditors in the

vicinity of insolvency (see Becker and Stromberg (2012)).