Debt Contracting on Management

• Date: 01 August 2020
• Author: DAVID DE ANGELIS,BRIAN AKINS,MACLEAN GAULIN
• DOI: http://doi.org/10.1111/jofi.12893
• Published date: 01 August 2020

THE JOURNAL OF FINANCE •VOL. LXXV, NO. 4 •AUGUST 2020

Debt Contracting on Management

BRIAN AKINS, DAVID DE ANGELIS, and MACLEAN GAULIN∗

ABSTRACT

Change of management restrictions (CMRs) in loan contracts give lenders explicit

ex ante control rights over managerial retention and selection. This paper shows

that lenders use CMRs to mitigate risks arising from CEO turnover, especially those

related to the loss of human capital and replacement uncertainty, thereby provid-

ing evidence that human capital risk affects debt contracting. With a CMR in place,

the likelihood of CEO turnover decreases by more than half, and future firm perfor-

mance improves when retention frictions are important, suggesting that lenders can

influence managerial turnover, even outside of default states, and help the borrower

retain talent.

The occurrence of any one or more of the following events shall constitute

an “Event of Default” by Borrower hereunder: [ ...]

(n) Change of Management.

If James Bazet shall cease to be the Chief Executive Officer of Borrower at

any time.

Debt contract with Cobra Electronics Corporation (2002)

∗Brian Akins is at Rice University. David De Angelis is at Rice University. Maclean Gaulin is

at the University of Utah. We thank Amit Seru (the Editor); an anonymous associate editor; two

anonymous referees; Kerry Back; Anne Beatty; Jonathan Bitting; Alex Butler; Alan Crane; Kevin

Crotty; Peter Demerjian; Dave Denis (discussant); Dick Dietrich; Jefferson Duarte; Aytekin Ertan;

Janet Gao; Yaniv Grinstein; Gustavo Grullon; Matthew Gustafson (discussant); Yael Hochberg;

Victoria Ivashina; S´

ebastien Michenaud; Yihui Pan (discussant); Andrea Pawliczek (discussant);

Mitchell Petersen; Paul Povel; K. Ramesh; Michael Roberts; Daniel Saavedra; Doug Skinner;

Ioannis Spyridopoulos; Joe Weber; James Weston; Regina Wittenberg-Moerman; Tzachi Zack;

Feng Zhang (discussant); and seminar participants at London Business School, The Ohio State

University, Rice University, University of Houston, the 2016 Academic Conference on Corporate

Governance at Drexel University, the 2016 Annual Meeting of the Financial Management Associ-

ation, the 2016 Annual Meeting of the Northern Finance Association, the 2016 Colorado Summer

Accounting Research Conference, the 2016 Lone Star Accounting Conference, and the 2017 SFS

Cavalcade North America Conference for helpful comments. We also thank Ryan Israelsen, Amir

Sufi, and Ekaterina Volkova for sharing their data. We are grateful for the excellent research

assistance provided by Wendy Chong, Asiya Kazi, Richie Ledo, Sophia Shao, and Richard Swartz.

All remaining errors are our own. We have read The Journal of Finance disclosure policy and have

no conflicts of interest to disclose.

Correspondence: David De Angelis, Jones Graduate School of Business, Rice University, 6100

Main Street, MS 531 Houston, TX 77005; e-mail: deangelis@rice.edu

DOI: 10.1111/jofi.12893

C2020 the American Finance Association

2095

2096 The Journal of Finance R

LENDERS CAN INCLUDE CHANGE OF management restrictions (CMRs) in loan

contracts. These restrictions give lenders explicit ex ante control rights over

retention and/or selection decisions. The presence of these covenants directly

speaks first to the possibility of lenders addressing the human capital risk

associated with a manager and second to lenders having an active role in

corporate governance. In their seminal paper, Hart and Moore (1994) develop

a theory of debt based on firms’ inability to transfer human capital from the

individual to the firm, but little is known about how debtholders address this

risk. There is also little empirical evidence of debtholders’ influence on an

important aspect of a borrower’s governance, namely, managerial turnover,

outside of default events (Shleifer and Vishny (1997), Roberts and Sufi (2009)).1

In this paper, we fill these two gaps in the literature by documenting the

presence of CMRs in loan contracts and addressing the following questions: (i)

Why do lenders use CMRs? and (ii) What are the implications of CMR inclusion

for CEO turnover and future firm performance? Our sample consists of 15,501

private loan contracts for 4,411 borrowing firms for which we identify whether

a loan includes a CMR and, if so, the way it is implemented. We find that

CMRs generally concern firms’ CEOs, and that 8.5% (17.2%) of (small) firms

in our sample have a CMR in at least one loan. Although CMRs are relatively

uncommon, they appear to be important in certain loans, such as those for

small and risky firms.

Given the extensive evidence on other loan covenants, what unique role does

a CMR play? Like other covenants, CMRs provide a mechanism for creditors

to influence the borrower’s governance. Unlike other covenants, CMRs do not

restrict managerial actions or require that financial thresholds be met; rather,

they restrict managerial selection. By restricting a decision that is traditionally

seen as the responsibility of the board of directors, CMRs intrude into corporate

affairs, which can be risky for lenders. In particular, by contracting directly on

management, lenders can be considered insiders under the bankruptcy code,

and thus can be exposed to litigation from other stakeholders (Leichtling and

Wong ( 1997)). This risk of litigation could explain the relatively low use of

CMRs. Moreover, while violations of financial covenants tend to lead to CEO

removal (Nini, Smith, and Sufi (2012)), CMRs are specific to retaining a partic-

ular CEO.

Why do lenders use CMRs? The first hypothesis is that lenders include CMRs

to mitigate risks arising from CEO turnover (henceforth, the risk hypothesis).

A change in CEO is, in general, risky due to uncertainty about the poten-

tial change in operations (Berkovitch and Israel (1996), Grinstein (2006)). As

creditors are likely to favor less risky corporate policies (Jensen and Meckling

(1976)), they can use a CMR to reduce the likelihood of CEO turnover. CEO

1Previous results suggest that lenders can force executive replacement in the case of bankruptcy

(Gilson (1989)) or covenant violations (Nini, Smith, and Sufi (2012)). However, this evidence re-

lates only to ex post renegotiation events that arise when the firm has been performing poorly

and is in payment or technical default. Little is known about creditor influence on turnover out-

side of these default events, or whether lenders are directly involved in managerial retention or

selection decisions.

Debt Contracting on Management 2097

turnovers are also risky because the human capital associated with the cur-

rent CEO is lost, and the board’s ability to find an appropriate replacement is

uncertain (Becker (1964)). Certainly, human capital risk also matters to share-

holders, who should try to retain valuable CEOs. However, it may be difficult

for shareholders to ensure CEO retention, especially when they face contract-

ing frictions. In such cases, a CMR helps protect banks by giving them control

rights during a turnover. Additionally, a CMR could increase the likelihood of

CEO retention because lenders can threaten to recall the loan due to a CMR

violation if the CEO quits. Recalling a loan will negatively impact the firm’s

share price, making it costly for a CEO holding shares of the firm to leave. The

second hypothesis concerns the possibility of lenders and the CEO colluding

to protect the CEO’s tenure via the use of a CMR (henceforth, the collusion

hypothesis). Under this hypothesis, lenders include a CMR in exchange for

securing the lending relationship or for a higher interest rate.

We start by investigating the risk hypothesis. Our initial evidence that CMRs

are used more frequently for small and risky borrowers supports the view that

a CMR can help lenders manage the operating risk related to CEO turnover.

For these firms, a negative shock associated with the departure of the CEO

is more likely to cause financial distress or even bankruptcy than it is for

larger and less risky firms. Also consistent with the borrower being more risky,

CMRs tend to be used when the tangibility of borrowers’ assets is lower. For

these borrowers, a CMR may act as a substitute “pledge” for hard assets if

human capital represents a larger portion of firm value relative to the firm’s

hard assets.

To examine human capital explanations more directly, we study the extent to

which CMR inclusion relates to risks arising from the loss of human capital and

the difficulty and/or uncertainty involved in finding an appropriate replacement

for the current CEO. We find that CMRs tend to be included when the borrower’s

CEO is also the company founder (45% of CMR loans compared to 20% of non-

CMR loans), suggesting that lenders may view the cash flow success of the

company as dependent on the founder’s human capital.2Founder CEOs are

likely to have firm-specific skills that make them difficult to replace, which

increases the human capital risk for lenders. Lenders also tend to use CMRs

when the borrower operates in industries in which CEOs tend to be recruited

from within (rather than outside of) the firm. In these industries, managerial

skill tends to be more firm-specific, which is more difficult to transfer to other

firms (Cremers and Grinstein (2014)), and again makes it more difficult to find a

replacement for the CEO. Also consistent with lenders considering replacement

uncertainty, CMRs tend to be present when borrowers have no heir apparent

for the current CEO.

2This evidence provides an interesting contrast regarding the preferred choice of CEO between

lenders and shareholders. Although Kaplan, Sensoy, and Str¨

omberg (2009) show that venture

capitalists tend to favor replacing the founder CEO, we find and study cases in which banks

demand that the founder remain the CEO.