Lenders as a Force of Corporate Governance -- Theory and Evidence

Abstract

Corporate governance is seen as the network of arrangements and rules aimed at maximizing total market value of the firm. Given risky debt, lenders are threatened by value decreasing post-contractual strategic action of owners. We ask how lenders should structure their control approach if they aim at effective protection. It is suggested that a static approach based on complete contracts is intrusive and costly. The more realistic dynamic approach relies on covenants which gradually increase active lender involvement in corporate governance as loans become more risky; in contrast, control rights are fully allocated to owners if debt is safe. Unfortunately, appropriate lender control in certain jurisdictions is impeded by regulations such as lender liability and bankruptcy law. An analysis of U.S., French and German bankruptcy law reveals a strong owner orientation in France, a less marked owner orientation in the U.S. and a creditor orientation in Germany. Owner oriented bankruptcy regimes provide incentives for owners to renegotiate contracts within bankruptcy proceedings. In contrast, a creditor oriented regime assures post-petition lender control and the enforcement of priority and collateral agreements. In countries which impede lender monitoring, we expect to find lower debt-equity ratios and well developed equity and venture capital markets. We hypothesize that risk premia on loans to more risky firms are an artifact of the legal environment.

JEL Classification: G21, G32, G34