Rethinking Corporate Governance for a Bondholder Financed, Systemically Risky World

ABSTRACT This Article makes two arguments that, combined, demonstrate an important synergy: first, including bondholders in corporate governance could help to reduce systemic risk because bondholders are more risk averse than shareholders; second, corporate governance should include bondholders because bonds now dwarf equity as a source of corporate financing and bond prices are increasingly tied to firm performance. TABLE OF CONTENTS INTRODUCTION I. SHOULD CORPORATE GOVERNANCE INCLUDE BONDHOLDERS? A. The Traditional Corporate Governance Distinction Between Debt and Equity B. Modern Financial Markets Have Minimized that Distinction for Bondholders C. Corporate Governance Should Include Bondholders 1. Bonds Have Become the Principal Source of Corporate Financing 2. Including Bondholders in Corporate Governance Would Help to Reduce Systemic Risk II. HOW COULD CORPORATE GOVERNANCE INCLUDE BONDHOLDERS? A. The Sharing-Governance Approach 1. The Preferred Shareholder Model 2. The German Co-Determination Model 3. Assessment of the Models for Sharing Governance B. The Dual-Duty Approach 1. The Insolvency Model 2. The "Public Governance" Dual Duty C. Comparing the Approaches CONCLUSION INTRODUCTION Based on several critical but heretofore uncorrelated developments in financial markets, this Article calls for a fundamental change in the governance of systemically important firms. (1) Traditional corporate governance views a firm's managers as acting primarily on behalf of the firm's shareholders. (2) Only in very limited circumstances do managers have a duty to others, such as creditors. (3) Shareholder primacy effectively obliges managers to engage the firm in risk-taking in order to make profits. (4) Although that risk-taking can cause externalities, they are usually minor. (5) This changes, however, when the risk-taking causes "systemic" externalities--such as the failure of a systemically important firm, (6) which triggers a domino-like collapse of other firms or markets, harming the real economy. (7) That threat is real, as the Federal Reserve recently observed, because shareholder primacy "lack[s] sufficient incentives [for systemically important firms] to take precautions against their own failures." (8) In response to the financial crisis of 2007-08 (the "financial crisis"), regulators have been experimenting with contingent capital regulation to attempt to harness risk-averse creditors as a check on corporate risk-taking. (9) Such regulation would require certain debt claims against systemically important firms to convert to equity upon specified (deteriorating) financial conditions. (10) To reduce the chance those conditions will occur, holders of the convertible debt claims are expected to impose strict loan covenants on their debtorfirms' ability to take risks. (11) Contingent capital regulation can be costly, however, and its efficacy is uncertain. It is costly because debt issued as contingent capital is riskier, and thus may be more expensive, than nonconvertible debt. (12) Its efficacy is uncertain because it operates indirectly, incentivizing holders of debt issued as contingent capital to influence corporate governance through strict covenants. (13) Strict covenants may not always be imposed, however. Firms customarily offer creditors higher interest rates as a quid pro quo to allow looser covenants, (14) especially if the debt is sold to the public, which makes it difficult to later obtain covenant waivers. (15) Experience shows that creditors usually "go for the gold," choosing the higher rates over strict covenants. (16) Choosing higher rates over strict covenants not only reduces the efficacy of contingent capital regulation; it also has the unintended effect of making debt issued as contingent capital even more expensive. And contingent capital regulation can have other unintended consequences. …