A new governance structure for corporate bonds.

• Author: Amihud, Yakov

This article proposes a new governance structure for publicly issued corporate bonds. Ownership of public bonds is both fluid and dispersed. Fluidity and dispersion generate benefits: They increase the liquidity of public bonds and make their risk more easily diversifiable. By the same token, however, fluidity generates a bonding problem and dispersion generates a collective action problem. In the context of public bonds, these problems increase the agency cost of debt and thus lower the overall value of the company. Private debt, the ownership of which is neither fluid nor dispersed, lacks easy diversification and liquidity, but also entails lower agency cost of debt. The new governance structure Professors Yakov Amihud, Kenneth Garbade, and Marcel Kahan propose is designed to overcome the collective action and bonding problems while retaining the easy diversifiability and liquidity associated with public bonds. The centerpiece of this structure is a new type of bondholder representative, the supertrustee. In contrast to the conventional indenture trustee, the supertrustee will be given the authority and the incentives to monitor the company actively, as well as to enforce and, where appropriate, to renegotiate a bond's covenants on behalf of public bondholders. Because the supertrustee is a single entity, and because the company will have some power over who is appointed as supertrustee, this structure resolves the collective action and bonding problems presently associated with dispersed and fluid ownership of public debt. At the same time, because public bond indentures will contain covenants similar to those presently contained in private debt, agency costs are reduced.

INTRODUCTION

Over the last two decades, "corporate governance" has become an important focus of academics and policymakers. Newspapers editorialize on corporate governance;(1) executives, investors, and judges deliver speeches on corporate governance;(2) international conferences are devoted to corporate governance;(3) the American Law Institute drafted "Principles of Corporate Governance;(4) and countless articles analyze, compare, and criticize the corporate governance system(5)--in short, a "corporate governance movement"(6) has been sweeping through boardrooms, the halls of academia, and the popular press.

The term "corporate governance" conventionally refers to the legal and economic structures that mediate the relationship between a firm's shareholders and its managers. Companies, however, raise substantially more capital from selling debt than from issuing stock,(7) and the interests of creditors and stockholders often conflict. There is, therefore, a second dimension to corporate governance: the legal rules and economic arrangements that mediate the relationship between the firm and its creditors. This raises the question, largely ignored in the present debate,(8) of how one should design the governance structure of debt.

In discussing corporate debt, one needs to distinguish between publicly issued corporate bonds on the one hand and "private" debt--bank loans and privately placed bonds--on the other. Ownership of public corporate bonds is both dispersed, in that many different investors hold bonds of a single issue, and fluid, in that ownership of bonds changes over time and the company has little control over the changing identities of its creditors. This dispersion and fluidity in ownership creates both advantages and disadvantages. On the plus side, dispersion and fluidity make it easier for investors to diversify their holdings and increase the liquidity of their securities. On the minus side, dispersion results in a collective action problem (familiar from the shareholder context)(9) and fluidity results in a "bonding" problem (which has no shareholder analog).(10) Both of these problems raise the agency costs of debt. Private debt, which is neither dispersed nor fluid, lacks easy diversifiability and liquidity, but also entails lower agency costs.

This article proposes a substantial reform--in fact, an innovation--in the governance structure of public corporate bonds which overcomes the collective action problem and the bonding problem, but which retains the easy diversifiability and liquidity of public corporate bonds. We argue that this new structure is, for many companies, more attractive than either of the two existing schemes and that those companies can increase their aggregate market value by adopting the proposed governance scheme.

The proposed structure includes the following features:(11)

* A strengthening of the substantive rights of public bondholders by the inclusion of more and tighter covenants, thereby reducing agency costs.

* The appointment of a newly structured entity--the "supertrustee"--with the duty and power to actively monitor, renegotiate, and enforce bond covenants, and with access to confidential company information, thereby overcoming the collective action problem.

* A weakening of the procedural rights of bondholders by vesting in the supertrustee the exclusive authority to renegotiate and enforce covenants, stripping bondholders of the power to give directions to the supertrustee, and curtailing their power to replace the supertrustee, thereby overcoming the bonding problem.

* An incentive-based compensation scheme for the supertrustee, coupled with business-judgment-rule type protection for renegotiation and enforcement decisions and with capped liability for failure to monitor compliance with covenants, thereby addressing agency problems created by the supertrusteeship.

We also explain why having bondholders monitor a supertrustee, which in turn monitors the company on behalf of the bondholders, is superior to having bondholders monitor the company directly.

Two recent developments may have greatly increased the benefits of supertrustee bonds. First, the market for publicly issued "junk" bonds--bonds issued by companies with high credit risk--has grown substantially. Junk bonds entail much larger agency costs than investment-grade bonds. Nevertheless, the same governance structure for investment-grade bonds, which is not well designed to control agency costs, has been haphazardly applied to junk bonds.(12) The supertrustee governance structure, which is designed to reduce agency costs, would be especially beneficial for such junk bonds. Second, the growing emphasis on encouraging managers to maximize shareholder wealth, although on the whole beneficial, has aggravated the agency cost of debt problem.(13) In the past, creditors were to some degree protected by managers' self-interested risk aversion and their desire to reinvest (rather than distribute) cash. As this protection has eroded, reducing agency costs directly, as our proposal does, has become increasingly important.

We stress that the supertrustee proposal is market oriented rather than regulation oriented. We do not advocate a change in the laws to force companies to adopt our proposed governance scheme. While our scheme would benefit many companies, there are doubtless other companies that would prefer one of the existing schemes. Ultimately, the choice of governance structure should be made by the market participants whose money is at stake--by companies and bondholders--rather than by academics and legislators. We do, however, advocate removing regulatory barriers created by the Trust Indenture Act that impede the implementation of the supertrustee proposal.

Part I of the article examines the existing governance structures for private debt and for publicly issued corporate bonds and assesses the advantages and disadvantages of each structure. Part II provides the details of our proposed new governance scheme, explains their rationale, and analyzes how the supertrustee differs from the indenture trustee, which presently serves, in some limited respects, as a bondholder representative. Part III discusses issues related to the implementation of our proposal.

1. PRIVATE DEBT AND PUBLIC BONDS

   This Part examines the existing governance structures for corporate debt. The first section describes why debt generally introduces economic inefficiencies into the management of a corporation and explains how corporations and their creditors mutually benefit from loan agreements and bond indentures designed to mitigate such inefficiencies. The second section analyzes and contrasts the institutional characteristics, covenant structures, and behavior of creditors in private and public debt markets. In the third section, we argue that the differences between private and public debt give rise to two separate governance schemes, each with its own advantages and disadvantages. The proposal presented in Part II seeks to establish a new governance structure for public debt that grafts the advantages which we associate with private debt onto the governance structure for public bonds.

   1. Agency Costs of Debt and Debt Covenants

      Credit constitutes a large fraction of the capital companies use to finance their operations. About $3 trillion in corporate debt was outstanding in 1996. That debt constituted 31% of the capital structure of U.S. companies.(14)

      But once a company has taken on debt, conflicts of interest commonly arise between the creditors and the company's shareholders and managers.(15) Managers serve the interests of shareholders by acting to maximize the value of the company's common stock. But some actions that enhance the value of equity reduce the value of the company's debt. Such actions include cash distributions to shareholders (through dividend payments(16) or stock repurchases), spin-offs to shareholders of the common stock of lightly leveraged subsidiaries owning valuable corporate assets,(17) dealings between shareholders and the company on terms preferential to shareholders, investments in projects with greater risk than originally anticipated by creditors, and financing new projects with debt rather than equity.(18)...