Shareholders and debtholders of a firm often have conflicting objectives. The root of shareholder-debtholder conflict is the different nature of cash-flow claims they are each entitled to. The actual power possessed by shareholders depends upon the specific rules of corporate governance. For example, when governance discipline reserves more power for shareholders, the firm’s owners can more easily replace the board of directors, who in turn hire and fire top management. As agents of shareholders, management nowadays is motivated by equity-based compensation and concerned about the possibility of voting shareholders firing them. In this case, firm management is more aligned withshareholders and they are more likely to undertake risky investment strategies. In addition, a firm with strong shareholder rights can be targeted for a leveraged buyout much more easily; such a buyout will lead to an increase in leverage due to recapitalization.
These risk-seeking behaviors are aligned with the goals of shareholders while expropriating the wealth from creditors and exacerbating the shareholder-creditor conflicts. Creditors are concerned about firms’ risk-taking activities that are associated with strong shareholder rights (and shareholder-friendly management). Ultimately, the risk of expropriation due to strong shareholder rights should be reflected in borrowing costs or a debt contract design.
In my recent working paper, I study whether shareholder rights affect the design of loan contract terms. I focus on three important non-price loan contract terms: collateral requirements, loan maturity, and loan size. These loan contract terms provide ex-ante protection to creditors and ensure they won’t be exploited by excessive firm risk-taking due to strong shareholder rights. I mainly use the firm-level Governance Index (G Index) as the key measurement of shareholder rights. The higher value of the G-Index means a greater number of anti-takeover provisions documented in the corporate charter, corresponding to more restrictions on voting for accepting a takeover offer and increases in managerial entrenchment, namely weaker shareholder rights. In the empirical analysis, I find that strong shareholder rights increase the possibility of collateral requirements, shorten the loan maturity by 13%, and reduce the loan size by 8%. One interpretation of these results is that creditors are concerned about the risk-shifting incentives associated with strong shareholder rights and therefore impose more stringent non-price loan contract terms to protect their wealth.
The possibility of having collateral
Borrowers can credibly commit to lower risk-shifting by providing collateral. Thus, collateral is a contractual mechanism that can protect lenders from the borrower’s moral hazard incentives. If firms with strong shareholder rightsusually have high risk-shifting incentives, lenders are expected to impose collateral requirements on those firms. I find that the probability of having collateral requirement in a loan contract is higher when the borrower has stronger shareholder rights.
Banking literature predicts that low-quality borrowers require intense monitoring. What follows is that lenderstend to provide them with short-term loans. In addition, the probability of being taken over increases when the borrower has strong shareholder rights. This may increase the default risk of borrowers by increasing the financial leverage of target firms. Another concern that arises in connection with shareholder rights is that the probability of the borrower’s risk-shifting behavior increases with the increase in the life of loans. Since strong shareholder rights are associated with higher risk, the relationship between shareholder rights and loan maturity is expected to be negative. Note that collateral status and debt maturity can be treated as substitute or complement mechanisms for controlling borrowers’ risk-seeking incentives. Thus, I estimate the relationship between loan maturity and shareholder rights by employing an instrumental variable approach to control for the simultaneous relationship between the two terms and find that the stronger (weaker)shareholder rights are associated with the higher (lower) likelihood of collateral requirements.
Previous banking literature suggests that the borrower’s credit may be rationed if lenders fail to eliminate theinvestment distortions from shareholder-creditor conflicts through monitoring. When the borrower’s shareholder rights are robust, the risk-taking incentives are high, and hence lenders of the same firm may try to tighten the credit availability and provide smaller loan amounts. I find that stronger shareholder rights are associated with lower loan amounts. Strikingly, adding one more takeover defense provision into corporate governance rules would result in a 1.5% increase in the loan amount. I also find that compared with borrowers who are associated with medium or high takeover risks, borrowers in low takeover risk groups are associated with significantly larger amounts of loans. For example, a change from the lowest quintile of shareholder rights group to the highest quintile of shareholder rights group shortens loanmaturity by around 13.1% (or 6 months on average in my sample) and decreases loan amount by 8.4% (or $36 million on average in my sample).
Takeover defense and terms of the loan contract
Using an alternative measure of takeover defense (The entrenchment index) that is based on provisions such as staggered boards, limits to shareholder bylaw amendments, poison pills, golden parachutes, and supermajority requirements for mergers and charter amendments, I find that loan lenders are concerned about the risks associated with strong shareholder rights of borrowers and tend to protect themselves against those risks by imposing more stringent loan contract terms.
This study provides the first evidence that the company’s governance structure has significant impact on the non-price terms of loan contracts, and it complements the existing research on borrowers’ shareholder rights and loan price. Overall, stronger shareholder rights can lead to a more stringent loan contract design. Thus, this study advances our understanding of the optimal power-sharing relationship between shareholders and creditors within a company.
Yunhui Han is a PhD Candidate at the University of Utah, David Eccles School of Business
This post is adapted from her paper, “Shareholder Rights and Non-Price Loan Contract Terms” available on SSRN.