An Institutional Innovation to Reduce the Agency Costs of Public Corporate Bonds

Debt financing gives rise to conflicts of interest between creditors and stockholders that are better controlled with private loans than publicly traded bonds. However, public debt has greater liquidity and diversifiability. We propose an institutional innovation ? a "supertrustee" - that incorporates the desirable characteristics of private debt into public debt. In particular, the supertrustee will be responsible for active monitoring of the borrower and for renegotiation and enforcement of the bond contract. Corporate managers, acting on behalf of shareholders, sometimes have incentives to undertake initiatives that would reduce the value of a firm's bonds. Creditors protect themselves with loan covenants that restrict the actions of the firm or that specify minimum operating characteristics whose breach triggers acceleration of a loan's maturity. However, covenants may prevent the firm from undertaking value-increasing projects, or the firm may inadvertently breach a covenant and trigger financial distress. The joint interests of creditors and shareholders may be better served with numerous, tight covenants that can be waived or renegotiated as the occasion demands. Encumbering public bond indentures with many and tight covenants, with the intention of renegotiating them should the need arise at a later date, has two problems: renegotiation is costly when bondholdings are fluid and bondholders are dispersed (covenant changes require a time-consuming and expensive vote by the bondholders and individual bondholders have little incentive to acquire information and to negotiate with the issuer) and a firm may be apprehensive of bondholders acting opportunistically. For example, bondholders may demand compensation for agreeing to an amendment that far exceeds the uncompensated cost of the amendment. For these reasons, public corporate bonds typically have few and loose covenants. Agency costs of debt are controlled more effectively with bank and privately placed loans, where ownership is neither fluid nor dispersed and where lenders negotiate non-opportunistically in order to promote a reputation that will enhance the flow of new business. (Bondholders do not care about their reputations because issuers cannot control the identity of their public creditors.) On the other hand, private loans are inferior to public bonds in their liquidity and diversifiability. We propose that a publicly registered corporate bond provide for a "supertrustee" to act on behalf of bondholders. The supertrustee will be charged with responsibility to monitor compliance with covenants and will be given exclusive authority to negotiate amendments and to decide what action to take in the event of a breach. By ameliorating the problems associated with the dispersion and fluidity of ownership, our proposal will allow public bonds to more closely resemble private loans, with more and tighter covenants, active monitoring and relatively inexpensive renegotiation. This will more effectively control agency costs while allowing an issuer to undertake projects that enhance the aggregate value of the firm. At the same time, because it is publicly traded, the debt will retain the benefits of liquidity and diversifiability. The supertrustee is intended to emulate the behavior of a solitary private creditor in monitoring compliance, in renegotiating covenants and in deciding what action to take. following breach. This behavior can be elicited with incentives regarding liability, compensation, and appointment power. The liability regime for the supertrustee should take account of the benefits to bondholders which flow from the supertrustee's reputation for non-opportunistic behavior, i.e., enhancing the confidence of the issuer that tight covenants will not be enforced opportunistically. We recommend that the supertrustee's decisions be evaluated under a standard analogous to the "business judgment rule. " This will allow the supertrustee the latitude needed to take account of the effect of its decisions on its own reputation. The compensation of a supertrustee should be greater for bonds issued by companies with more complicated operating characteristics and for bonds with more complex covenants and bearing more credit risk, for which more intense monitoring is appropriate and more renegotiation is likely. Given the latitude in decision making available to the supertrustee, its compensation may also include incentives similar to executive stock options. The supertrustee will be appointed initially by the borrower - thereby emulating the situation in the private credit markets where a borrower chooses its creditors. This will increase the sensitivity of the supertrustee to the cost of acquiring a reputation for opportunistic behavior. The bond indenture may further provide for the bondholders to elect a replacement supertrustee - just as stockholders choose a board of directors. This will enhance the responsiveness of the supertrustee to creditor concerns. We believe the proposed structure will be more desirable for debt issued by firms with greater inherent credit risk and in more volatile industries with significant intangible assets. The scheme will be more attractive for larger issues and for issuers with more public indebtedness because most of the costs of a supertrustee do not vary with the size of an issue or the number of issues. The scheme will also be more attractive for longer term bonds because there are temporal economies of scale in monitoring a company through time and because covenant protection and the ability to renegotiate covenants are both more valuable on longer term debt.