Within‐syndicate conflicts, loan covenants, and syndicate formation

• Date: 01 June 2020
• Author: Nishant Dass,Vikram Nanda,Qinghai Wang
• Published date: 01 June 2020
• DOI: http://doi.org/10.1111/fima.12270

DOI: 10.1111/fima.12270

ORIGINAL ARTICLE

Within-syndicate conflicts, loan covenants,

and syndicate formation

Nishant Dass1Vikram Nanda2Qinghai Wang3

1Scheller College of Business, Georgia Institute

of Technology,Atlanta, Georgia

2Jindal School of Management, University of

Texasat Dallas, Richardson, Texas

3College of Business, University of Central

Florida, Orlando, Florida

Correspondence

NishantDass, Scheller College of Business, Geor-

giaInstitute of Technology,800 West Peachtree

StreetNW, Atlanta, GA 30308.

Email:Nishant.Dass@scheller.gatech.edu

Abstract

We study how conflicts within a lending syndicate affect loan con-

tract and syndicate formation. We argue that loan provisions serve

an important dual function: In addition to moderating borrower–

lender conflicts, they reduce within-syndicate conflicts. We show

that greater potential for within-syndicate conflicts is associated

with more and stricter covenants.Loans are less restrictive when the

interests of participants and the lead arrangers are better aligned,

for example, when participant–banks have stronger relationships

with the lead arranger or hold borrower’s equity (indirectly). Over-

all, our results show that covenant choice, syndicate formation, and

lead arranger’s loan allocation all play an important role in reducing

within-syndicate conflicts.

KEYWORDS

bank loans, conflicts of interest, covenants, lending syndicate,

monitoring

1INTRODUCTION

Many financial services are deliveredby financial intermediaries organized as syndicates. However, the intermediaries

ina syndicate may be asymmetrically informed and have divergent interests, creating the potential for within-syndicate

conflicts of interest. How does the presence of such conflicts of interest affect the financial contracts written by a syn-

dicate? Although there is ample research on the role of contracts in reducing potential problems between two con-

tracting parties (e.g., Bolton & Dewatripont, 2005; Harris & Raviv,1992; Jensen & Meckling, 1976), in this paper, we

study how the contract structure might be different when there are conflicts within one of the contracting parties. We

develop and test our hypothesesin the context of syndicated loans.

Although banks are seen as “delegated monitors” (Diamond, 1984), the role of a delegated monitor in syndicated

loans is typically played only by the lead arranger and not by the participants.1Although such an arrangement

saves the syndicate participants from expending resources on monitoring the borrower, it results in information

c

2019 Financial Management Association International

1Although occasionally bank loans can havemultiple lead arrangers, a single lead arranger is most typical, and as such, we refer to the “lead arranger” in the

singularthroughout the paper.

Financial Management. 2020;49:547–583. wileyonlinelibrary.com/journal/fima 547

548 DASS ET AL.

asymmetries and conflicts of interest that arise naturally within lending syndicates due to the divergent incentives

of the lead arranger and participant banks. Participating banks may haveconcerns about the lead’s screening prior to

loan initiation and its monitoring of the borrower overthe course of the loan. A reason is that screening and monitoring

is costly and, to the extent that the lead retains only a fraction of loan, it may be less willing to bear these costs. The

lead arranger might also be motivated to understate borrower risks if,for instance, it has an ongoing relationship with

the borrower that it wants to preserve or enhance in the hope of receiving future rents (Boot & Thakor, 2000; Dass

& Massa, 2011). Future disagreements within the syndicate may also arise if the borrower is under financial distress.

The lead arranger may be concerned about the potential adverse effects of borrower default on its reputation and its

ability to arrange future syndicates (Gopalan, Nanda, & Yerramilli,2011). Thus, it may be more willing to renegotiate

loan terms than other participating banks and may favor the survival of the borrower,even when it is suboptimal from

the participants’ perspective.2

In light of these divergent objectives, we argue that syndicates will seek arrangements,whether contractual or oth-

erwise, to control the conflicts of interest and the dissipative costs they entail. In particular, we propose two ways

in which syndicates could curtail the likelihood of such conflicts. The first is through their choice of a loan contract

structure that moderates lead–participant conflicts and the second is through the lead arranger’schoice of compatible

syndicate members. The literature suggests that increasing the lead arranger’s loan allocation can also help moderate

agency problems and within-syndicate conflicts (Sufi, 2007).

We start with the first contractual tool that helps address within-syndicate conflicts. Tothe extent that such con-

flicts are driven by the lead arranger’s informational advantage and/ormoral hazard, we would expect loan contracts

to be structured in ways that assuage participant banks’ concerns in this regard. This could be done, for instance, with

contracts that give participant banks more state-contingent control and/orcash-flow rights over the term of the loan,

therebylimiting participants’ exposure to the lead arranger’s (as well as borrower’s) informational advantage and moral

hazard.3

We thus hypothesize that, in terms of contract structure, syndicated loans are likely to havemore restrictive fea-

tures when there is a greater potential for within-syndicate conflicts stemming from information or incentive diver-

gence between the lead and participant banks. In our empirical tests, we focus on the most prominent type of loan

restrictions: accounting-based quantitative financial covenants. All loan contracts are expectedto include some boil-

erplate covenants; these are typically qualitative or positive in nature.4However, our argument is about including

accounting-based quantitative covenants, cashflow sweeps, dividend restriction, etc., that are specific to the loan (i.e.,

not boilerplate). These loan restrictions are usually determined after negotiations between the lenders and the bor-

rower,with considerable variation across loans.

The syndication process normally functions as follows: Although the preliminary term sheet of the loan includes

many contractualfeatures (such as pricing, structure, and collateral), the quantitative covenants and other restrictions

are only finalized after the lead arranger has obtained feedback from potential participants.5This sequence is con-

sistent with the hypothesis that these restrictions are not solely determined by the borrower’s and lead arranger’s

attributes: participants’ input and concerns are also factored in. Further,syndicated loans typically require unanimity

2Thisis exemplified in the controversy that surrounded a syndicated loan made to Enron just before its bankruptcy filing. In this case, the participants accused

the lead arranger(J.P. Morgan Chase & Co.) of deliberately concealing Enron’s perilous financial condition and of using part of the loan proceeds to lower its

own exposuret oEnron. For details, see “Enron Ties May Haunt J.P. Morgan Anew – Finance Firm Could Face Action by Banks That Joined in Loanto Failed

HoustonEnergy Trader” in The Wall Street Journal, 21 February2003.

3In principle, the syndicate members could write additional contractsamong themselves to mitigate lead arranger’s moral hazard. However, these contracts

wouldbe prohibitively costly and difficult to enforce. Therefore, the syndicate converges on a single contract with which to mitigate the conflicts both between

andwithin the contracting parties.

4Forexample, these boilerplate covenants are intended to ensure that a company maintains its operations in a responsible manner,and obtains an unqualified

auditreport, etc.

5SeeTaylor and Sansone (2006) and Standard & Poor’s (2011) loan guide. Forinstance, the Standard & Poor’s (2011, p. 9) loan guide describes the syndication

processas follows: “The list of terms and conditions will be a preliminary term sheet describing the pricing, structure, collateral, covenants, and other terms of

thecredit (covenants are usually negotiated in detail after the arranger receives investor feedback)” (emphasis added).

DASS ET AL.549

among the lenders for loan modification, giving considerable voice to each participating bank (see, e.g., Coyle, 2002,

p. 47). Therefore, these state-contingent provisions give the participant banks the ability to intervene and limit risk

shifting by the borrower.For example, a covenant violation can allow the participant banks to call the loan even when

the lead bank might prefer to renegotiate instead.

A second way to moderate within-syndicate conflicts can be through the selection of compatible syndicate mem-

bers. We hypothesize that, for each loan, the lead arranger seeks out participant banks with whom the potential for

future conflicts is lower.For instance, the lead arranger could strive for participants that are relatively better informed

about the borrower and, hence, have fewer concerns about information asymmetry.Banks that either have an equity

stakein the borrower (indirectly through investment affiliates or in a fiduciary capacity) or have had a past lending rela-

tionship with the borrower would therefore be attractive as potential syndicate participants. An indirect equity stake,

in addition to indicating greater familiarity with the borrower,may also better align the incentives of participant banks

with those of the lead: an equity position will induce banks to be more flexibleand forbearing in response to borrower’s

financial problems. This would align them with a lead arranger that also has the incentive to support the borrower,say

due to accumulated relationship capital. Further,we expect that banks that have developeda working relationship with

the lead bank through their past participation in joint syndicates would also be favored by the lead bank for inclusion

in the syndicate.

A third solution to within-syndicate conflicts—increasing the lead arranger’s loan allocation—has received signifi-

cant attention in the literature. In our analysis, we examine the relationship between lead arranger’s loan allocation

and the use of restrictive covenants. We argue that the lead arranger may favor loan covenantsas a substitute for

retaining a greater fraction of the loan as this helps in diversifying the loan portfolio.

We formalize these arguments in a theoretical setup of a lending syndicate with asymmetric information and con-

flictsof interest between the lead arranger and participant lenders. We test the empirical predictions from this theoret-

ical framework(presented in Supporting Information Appendix B) using a sample of bank loans. We begin by examining

the effects of within-syndicate conflicts on the terms of the loan and on the protection accorded to participant banks

using features in the loan contract, such as covenants, sweeps, and other restrictions.

We test our hypotheses based on a 2009 extract of the Thomson Reuters’ Dealscan database. Next, we test our

predictions with the hand-collected data used in Nini, Smith, and Sufi (2009)—henceforth “NSS.”6In both samples, we

excludethose loan observations from our analysis where the information on covenants is missing (i.e., we do not assume

that these loans have zero covenants). Finally,we also test our predictions using data on other restrictive features in

the loan, such as cashflow sweeps, dividend restriction, etc. Consistent with our predictions, we find that the structure

of loan contracts and selection of syndicate participants are determined to a significant degree by the need to reduce

within-syndicate conflicts.

Specifically, we show that covenants are more likely to be present when there is greater potential for within-

syndicate conflicts, for example,either when the number of lenders in the syndicate is higher or when the lead arranger

has a past lending relationship with the borrower while none of the participants do. These findings on the use of

covenants are not easily explained by differences in borrower quality.We further test whether potential conflicts of

interest can be mitigated if the participating lenders either have an equity stake in the borrower (through affiliated

institutional investors or held in a fiduciary capacity) or have a past relationship with the lead arranger.As discussed,

greater equity in the borrower maybe associated with participants having fewer information concerns as well as incen-

tives that are better aligned with those of the lead arranger and borrower (Jiang, Li, & Shao, 2010; Santos & Wilson,

2008). As a result, such participants would be more inclined to renegotiate the loan and avoid the adverse impact of a

default on equity value. Consistent with this conjecture, we find that the odds of including a quantitative covenant or

sweep are between 15% and 30% lower when the participant banks havea “large” equity stake in the borrower.

6NSS collected their data directly from the firms’ SEC filings; the “NSS data” are generously made available by Amir Sufi on his website, http://

faculty.chicagobooth.edu/amir.sufi/data.html.