Private debt and the missing lever of corporate governance.

• Author: Baird, Douglas G.

Traditional approaches to corporate governance focus exclusively on shareholders and neglect the large and growing role of creditors. Today's creditors craft elaborate covenants that give them a large role in the affairs of the corporation. While they do not exercise their rights in sunny times when things are going well, these are not the times that matter most. When a business stumbles, creditors typically enjoy powers that public shareholders never have, such as the ability to replace the managers and install those more to their liking. Creditors exercise these powers even when the business is far from being insolvent and continues to pay its debts. Bankruptcy provides no sanctuary, as senior lenders ensure that their powers either go unchecked or are enhanced. The powers that modern lenders wield rival in importance the hostile takeover in disciplining poor or underperforming managers. This Essay explores these powers and begins the task of integrating this lever of corporate governance into the modern account of corporate law.

INTRODUCTION

In 2003, Krispy Kreme was the darling of Wall Street. Its stock had more than quadrupled since first going public only a few years before. Krispy Kreme's CEO also served as chairman of its board, and he had been with the company for more than twenty-five years. No one was more dedicated to the business. His wedding cake was made out of hundreds of Krispy Kreme doughnuts. His infectious enthusiasm and aggressive growth strategy were going to make the business another Starbucks. The cover story in Fortune concluded on a decidedly upbeat note:

Unless the fat police run riot across this land, Krispy Kreme is here to stay. It isn't some fly-by-night dot-com. There's 66 years of history here. It's a product that people not only love but understand. (Quick, what does InfoSpace do?) The world is always filled with unknowns, never more so than fight now. With all that's wrong out there, sometimes it's easy to lose focus on the big picture. So take a second and ask yourself." Is the American dream still alive? Is Krispy Kreme for real? Don't bet against it. (1) Krispy Kreme's fortunes, however, took a turn for the worse over the next few months. A low-carb craze was dampening growth. News accounts suggested that the company's accounting practices were too aggressive. The stock declined precipitously, and the predictable security class actions and SEC investigations followed shortly thereafter. The board met to take stock. It fired the CEO and replaced him with a complete stranger. This stranger was the CEO of a failed energy business--and not just any failed energy business. Krispy Kreme hired Enron's CEO and allowed him to remain at Enron while serving simultaneously as Krispy Kreme's CEO. (2)

Conventional accounts of corporate governance simply cannot explain how a board that had worked so long with a highly praised and firmly entrenched CEO would dump him within several months of the first signs of trouble and replace him with a part-timer from Enron. This is not to say that the decision was bad or counter to the interests of the shareholders. Indeed, the stock went up in reaction to the news. But boards hand-picked by a CEO are not supposed to lose faith so quickly. (3) Dispersed shareholders have no say over the choice of the CEO, and in any event, Krispy Kreme's shareholders held no meeting and did no voting between the time the bad news first hit and the time the CEO was fired. No hostile takeover loomed on the horizon and for good reason. The market for corporate control does little work in an environment in which the books of the business are untrustworthy. Something is missing from standard accounts of corporate governance. (4)

In our Essay, we explore this missing lever of corporate governance: the control that creditors exercise through elaborate loan covenants. Bondholders typically can do little until a corporation defaults on a loan payment. Even then, their remedies are limited. Not so with bank debt or debt issued by nonfinancial institutions. These loans--and their volume now exceeds half a trillion dollars per year--come with elaborate covenants covering everything from minimum cash receipts to timely delivery of audited financial statements. When a business trips one of the wires in a large loan, the lender is able to exercise de facto control fights--such as replacing the CEO of a company--that shareholders of a public company simply do not have. (5)

Corporate law, and in particular, rules of corporate governance, properly includes all the ways in which investors exercise control over the affairs of the corporation. Hence, one must take into account the rights that creditors acquire through contract. Loan covenants now are the principal mechanism for handling one of the most challenging problems in corporate governance, the one that arises when a once-effective manager needs replacing and the operations of the business must go through a fundamental overhaul. In the case of Krispy Kreme, the failure to deliver third-quarter financial statements violated various bank loan covenants. This was enough to give control to the banks. To maintain its ongoing operations, Krispy Kreme needed to secure waivers from the banks. The price the banks demanded for the waivers included firing the CEO and replacing him with a seasoned turnaround specialist. (6)

This Essay focuses on the ways in which loan covenants now play a central role in corporate governance. We make two central claims about the power of creditors in shaping corporate decision making. The first is a reconceptualization of the dynamics over control of the corporation. When a business enters financial distress, the major decisions-whether the CEO should go, whether the business should search for a suitor, whether the corporation should file for Chapter 11--require the blessing of the banks. (7) We first review in a general fashion the way in which rights of corporate governance are commonly shaped through contract. We then explore how loan covenants work in conjunction with the more familiar instruments of corporate governance, and follow with an examination of the way in which these contractual rights have reshaped the dynamics of Chapter 11. Our second claim is that, while there are potential risks associated with this lever of corporate governance, they are not the ones commonly attributed to senior lenders--that they will be biased towards liquidating the business and forego profitable projects. The fear that senior lenders will routinely destroy valuable businesses ignores the multiple options these lenders possess. Indeed, when one compares the role of private lenders to feasible alternatives, it is likely the case that private debt provides an important check on the agents of enterprise.

1. CORPORATE GOVERNANCE AND THE POWER OF CONTRACT

   On its face, corporate law vests authority to run a corporation in the board of directors. (8) Shareholders, in turn, elect the directors, approve charter amendments and bylaws, and pass on certain extraordinary actions. Corporate governance debates center on whether and how the law should alter this allocation. (9) Legal constraints are needed at times when exogenous events create a mismatch between the incentives of the individual investors who possess control rights and what is in the best interests of the investors as a whole. Shareholders, as residual claimants, serve as good proxies for all investors when the business is flush. They bear both the costs and benefits of the enterprise, but they do not actually control the day-to-day affairs of the business, ceding decision making over all but a handful of matters to directors and officers. Shareholders nominally have the right to elect directors, but given the dispersion of shares, the board is effectively self-perpetuating. (10)

   In such a world, we face the problem that Adolf Berle and Gardiner Means brought to the surface many decades ago: the separation of ownership and control. (11) The challenge of corporate law lies in ensuring that the interests of the shareholders remain foremost in the minds of those in charge of the business. (12) CEOs may place perks above profits. (13) We need well-designed compensation contracts to tie the wealth of the CEO to the well-being of the shareholders. (14) Managers can place their friends on the board. (15) These friends do not ask hard questions on a host of issues, ranging from the operation of the business to the compensation of the CEO and her team. (16) We need independent directors and greater shareholder input to check managers' incentives to pursue their self-interest to the detriment of the corporation as a whole. (17) Directors enjoy serving on boards. We need to provide incentives so they will sell the business when a buyer makes an offer that is in the shareholders' best interests. (18) While one finds vehement disagreement over how the law should allocate control between shareholders and directors, the law makes the allocation in the first instance. Any change occurs through the cumbersome process of amending the corporate charter.

   According to this conventional account, creditors receive no special fights against the corporation. The creditors' power is limited to suing the debtors when they fail to pay as promised. Creditors do not have their hands on the levers of power. When financial woes strike, the board's fiduciary duties do shift from the shareholders to the creditors. (19) This shift, however, is quite limited. (20) One searches in vain for directors ever being held liable for violating their duties to creditors. Creditors can protect themselves by setting out specific covenants in their loan agreements, but such protection is not a part of corporate governance in all but the most general sense. Under the prevailing view, debt performs a disciplining role only in the sense that the obligation to repay the loan forces the managers to focus...