Rethinking corporate governance for a bondholder financed, systemically risky world.

• Author: Schwarcz, Steven L.

ABSTRACT

This Article makes two arguments that, combined, demonstrate an important synergy: first, including bondholders in corporate governance could help to reduce systemic risk because bondholders are more risk averse than shareholders; second, corporate governance should include bondholders because bonds now dwarf equity as a source of corporate financing and bond prices are increasingly tied to firm performance.

TABLE OF CONTENTS INTRODUCTION I. SHOULD CORPORATE GOVERNANCE INCLUDE BONDHOLDERS? A. The Traditional Corporate Governance Distinction Between Debt and Equity B. Modern Financial Markets Have Minimized that Distinction for Bondholders C. Corporate Governance Should Include Bondholders 1. Bonds Have Become the Principal Source of Corporate Financing 2. Including Bondholders in Corporate Governance Would Help to Reduce Systemic Risk II. HOW COULD CORPORATE GOVERNANCE INCLUDE BONDHOLDERS? A. The Sharing-Governance Approach 1. The Preferred Shareholder Model 2. The German Co-Determination Model 3. Assessment of the Models for Sharing Governance B. The Dual-Duty Approach 1. The Insolvency Model 2. The "Public Governance" Dual Duty C. Comparing the Approaches CONCLUSION 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. (1) Traditional corporate governance views a firm's managers as acting primarily on behalf of the firm's shareholders. (2) Only in very limited circumstances do managers have a duty to others, such as creditors. (3) Shareholder primacy effectively obliges managers to engage the firm in risk-taking in order to make profits. (4)

Although that risk-taking can cause externalities, they are usually minor. (5) This changes, however, when the risk-taking causes "systemic" externalities--such as the failure of a systemically important firm, (6) which triggers a domino-like collapse of other firms or markets, harming the real economy. (7) That threat is real, as the Federal Reserve recently observed, because shareholder primacy "lack[s] sufficient incentives [for systemically important firms] to take precautions against their own failures." (8)

In response to the financial crisis of 2007-08 (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. (9) Such regulation would require certain debt claims against systemically important firms to convert to equity upon specified (deteriorating) financial conditions. (10) To reduce the chance those conditions will occur, holders of the convertible debt claims are expected to impose strict loan covenants on their debtorfirms' ability to take risks. (11)

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 nonconvertible debt. (12) Its efficacy is uncertain because it operates indirectly, incentivizing holders of debt issued as contingent capital to influence corporate governance through strict covenants. (13) Strict covenants may not always be imposed, however. Firms customarily offer creditors higher interest rates as a quid pro quo to allow looser covenants, (14) especially if the debt is sold to the public, which makes it difficult to later obtain covenant waivers. (15) Experience shows that creditors usually "go for the gold," choosing the higher rates over strict covenants. (16)

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. (17) 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." (18)

This Article argues that the law could more effectively temper the risk-taking of systemically important firms by directly engaging shareholder primacy. One way to do that, this Article contends, would be to require the corporate governance of those firms to include bondholders--that is, the holders of long-term corporate debt securities ("corporate bonds" or simply "bonds" (19))--in addition to shareholders, thereby harnessing the more risk-averse bondholders as a check on corporate risk-taking. (20) 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. (21) Only something like a "public governance" duty of managers--not to engage firms in excessive risk-taking that could lead to systemic externalities (22)--could fully align those interests. (23) Nonetheless, including bondholders in the corporate governance of systemically important firms should reduce systemic risk by reducing risktaking: the less such a firm engages in risk-taking, the less likely that firm would be to fail, with potentially systemic consequences.

The rationale for proposing this fundamental change in corporate governance is not merely its potential to reduce systemic risk. This Article identifies two critical but heretofore uncorrelated market changes that themselves should justify the change in governance. First, modern financial markets have minimized the traditional rationale for differentiating bondholders and shareholders for corporate governance purposes. Like shareholders, bondholders often realize their investment value not by holding onto the securities, but by selling them to other market investors. (24) They therefore view their investment decisions from a market pricing standpoint, rather than from a priority-of-claim standpoint. (25) Because that market pricing depends on the financial condition and operations of the firm issuing the bonds, which is determined largely through managerial decision-making, bondholders, like shareholders, now rely heavily on management. Second, bonds increasingly exceed equity shares as the source of corporate financing. (26)

This Article proceeds as follows. Part I.A describes the traditional corporate governance distinction between creditors and shareholders. Part I.B explains why modern financial markets have minimized that distinction for bondholders. Part I.C then shows why including bondholders in the corporate governance of systemically important firms would not only be logical from a governance perspective, but also would help to reduce systemic risk. Thereafter, Part II examines how corporate governance could include bondholders. To that end, Part II.A analyzes whether bondholders and shareholders should share governance, Part II.B analyzes whether managers should have a dual duty to both bondholders and shareholders, and Part II.C compares these approaches.

1. SHOULD CORPORATE GOVERNANCE INCLUDE BONDHOLDERS?

   1. The Traditional Corporate Governance Distinction Between Debt and Equity

      Traditionally, the corporate governance distinction between debt and equity turns on the supposition that only shareholders have a direct stake in their firm's future performance. (27) According to that distinction, creditors have much less of a stake because, as senior claimants of the firm, they should be paid in full their fixed investment plus an agreed rate of interest (28) unless the firm becomes insolvent. (29) Creditors can contractually protect against the firm's insolvency by negotiating covenants in their loan agreements. (30) The traditional view also assumes that creditors do not trade their claims. (31) For bond markets, that assumption has historical support: most corporate bonds used to be held by investors to maturity, (32) with investors expecting to receive their value through the periodic receipt of principal and interest payments. (33)

      In contrast, shareholders are residual claimants of the firm, holding equity interests. (34) As such, they are not entitled to a fixed return. Instead, they may look for income streams in the form of dividends, payable from a portion of the firm's profits. (35) Shareholders also place significant value on increasing the stock price, which enables them to sell their shares at a profit. (36) Because covenants "can never restrict or determine all the operating and investment decisions necessary to run the firm efficiently," (37) shareholders must rely on the firm's management. (38)

      As a result, the law traditionally assigns corporate governance rights to shareholders, not creditors. This assignment is sometimes referred to as the shareholder-primacy model, (39) in which a corporation is "organized and carried on primarily for the profit of the stockholders." (40) Under that model, managers have a fiduciary obligation to shareholders to try to achieve and maximize profitability, which in turn can enhance welfare by generating jobs and purchasing power. (41)

      I next show that the traditional corporate governance distinction between debt and equity investing has greatly diminished because bondholders now invest with the intention of selling their bonds before maturity.

   2. Modern Financial Markets Have Minimized that Distinction for Bondholders

      In today's financial markets, bondholders often sell their bonds prior to maturity and therefore, like investors in equity securities, view their investment decisions more from a market-pricing standpoint than from a priority-of-claim standpoint. (42) In 2014, for example, the average daily trading volume of...