Home > Corporate Governance Theory > Should Corporate Governance include bondholders?

Should Corporate Governance include bondholders?

In a recent post Prisker and Wang analyzed the benefits that deferred compensation or inside debt as a part of total Ceo pay would entail in favor of adequate risk-taking and value firm. (1)

In this post though, we will more broadly tackle the debt topic in connection with Corporate Governance, (CG). Are equity holders the only ones to be considered when CG is structured? This is what Steven L. Schwarcz studies in his recently published article, “Rethinking Corporate Governance for a Bondholder Financed, Systemically Risky World”. (2)

As he puts it, the Theory of CG understands managers engage the firm in risk taking activities so as to maximize shareholders` wealth or at least primarily benefit them. This engenders some externalities which are particularly relevant in the case of big and systemically relevant firms, whose failure could trigger a domino effect, (big banks and others). Although part of the legal recommendations after the recent crisis tackles this issue through convertible debt assets, that would convert into equity (thus penalizing equity holders) in case of failure, these tools increase the funding costs and have only an indirect efficacy, (through governance influencing stringent covenants, which are nonetheless not always present, as higher interest rates are traded in order to avoid them).

As a result, the author wonders whether altering shareholder primacy could more efficiently reduce inefficient risk-taking in big firms. And the proposal, although not perfect, includes bondholders.

  1. Should Corporate Governance include bondholders?

The distinction between equity and debt for CG. Equity holders are considered the only ones having a stake in the firm`s wealth, even in case of insolvency, as debt holders could protect themselves through covenant structures, so that equity holders rely on good management and deserve to receive some corporate governance rights.

Does this traditional distinction still hold?  As bondholders have become more prone to rotate their portfolios through secondary markets, they view themselves relying more on asset-pricing than on their priority of claim. Both equity and bond holders have thus a stake in performance.

CG should include bondholders. As a result of the above mentioned reality, their interests should be considered, but also because of the following:

  1. Bonds have become a principal source for corporate financing, exceeding equity issuances. As a result of its cheaper cost, (savings in transaction costs, interest payments tax-related savings, etc), this cannot be thought to be temporary, but a growing trend.
  2. Including them would reduce systemic risk. Their risk-averse attitude is linked to the credit ratings. Agencies assess the company`s creditworthiness, and if it fails, ratings are downgraded, and bond values fall, so that bondholders have an interest in avoiding the fall in creditworthiness. As this fall is not symmetric when creditworthiness goes up, bondholders are right to be more risk-averse than equity holders.
  1. How should CG include bondholders?

Steven L. Schwarcz suggests two approaches:

  1. A governance-sharing approach: in this case both constituencies would elect managers, something similar to the two-board system in Germany, or the preferred shareholder model. In the latter one, contingent voting rights are granted to elect directors if preferred shareowners` rate of return cannot be paid by the firm. In this sharing approach, even if bonholders´ representation is a minority, the decision-making process is enriched.  The disadvantages raised by opponents are the fact that minority representatives could end being mere consultants or generating inefficiencies in the decision-making process.  As for the first, bondholders should in fact have special rights in decisions directly affecting them, (supermajority requirements, or consent requirement, for instance).
  2. A dual-duty approach: this is the case of the “”insolvency model” and the “public governance model”:
    1. Insolvency model. According to this, bondholders become the senior residual claimants in insolvency cases, so that duties by managers and directors are due to them. In the vicinity of this situation, the dual approach could hold, as managers would need to balance the interests of both groups in this environment. Benefits and risk for shareholders and bondholders should be weighed and margins of safety would be required in order for a decision to be adopted, (protective of bondholders` interests).
    2. The Public governance model, (where directors pursue corporate but also other social goals) arises some questions: (i) how should it be imposed; (ii) what`s the role of the business judgment rule if managers pursue different or conflicting goals? These issues would also affect the author`s proposal for bondholders.

The author favors the sharing approach, as given the same or similar results, its execution would be simpler. In fact the dual-duty model seems difficult to implement as bondholders would not have direct representatives, as in the case of the governance sharing model.

1.- http://clsbluesky.law.columbia.edu/2016/03/25/ceos-inside-debt-and-dynamics-of-capital-structure/

2.- Schwarcz, Steven L., Rethinking Corporate Governance for a Bondholder Financed, Systemically Risky World (March 24, 2016). Duke Law School Public Law & Legal Theory Series. Available at SSRN:http://ssrn.com/abstract=2741794

  1. April 3, 2016 at 9:54 am

    See this case of a bondholder takeover, as a result of big losses:


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