Reconsidering Creditor Governance In A Time Of Financial Alchemy

Abstract

For many years corporate lenders have been a crucial force in the boardroom, providing a check on management and con- tributing to firm governance. However, as this Article docu- ments, lenders’ influence has receded in recent years for a large and important class of corporate borrowers. The culprit is a familiar one in a less familiar guise: the sale of loans by origi- nating banks for securitization—like that which gained noto- riety with pre-financial crisis mortgage-backed securities, but now are deployed in the market for corporate loans. As this Ar- ticle points out, the shift from relationship lending to arms- length securitization has the potential to intensify moral haz- ard, leading banks to provide less monitoring for their highly securitized clients. Recent data supports this narrative of debt governance dereliction with potentially enormous conse- quences: it heralds the disappearance of an important source of fiscal discipline and governance at a moment when U.S. cor- porations carry more debt than at any time in history (totaling half of U.S. gross domestic product), and an economic crisis threatens to expose companies whose debt has been poorly managed.

This Article presents a theoretical and empirical examina- tion of the dramatic change in creditor corporate governance and its implications. It shows how the diminishment of lend- ers’ role in governance is a predictable result of a confluence of forces in the financial markets, in particular, the use of struc- tured finance to securitize loans, which in turn has driven a lending market with diminishing checks on borrower profli- gacy. It also shows how this new market is weakening govern- ance norms in ways that are harmful to borrowing companies, lenders, and society as a whole.

The Article makes two contributions to the literature. First, it empirically documents the decline of lenders’ corporate gov- ernance interventions, cataloging original data on all borrower loan covenant violations—a primary mechanism by which lenders intervene in governance—from 2008 through 2018. Second, although many scholars have written about lenders’ role in corporate governance and securitization separately, this Article brings the two together. It thereby adds a missing com- ponent to an important literature by showing how corporate governance and the financial system affect each other, and pro- posing solutions to bolster both.