The Evolution of Debt: Covenants, the Credit Market, and Corporate Governance

Boston University Public Law & Legal Theory, No. 08-26

Charles K. Whitehead

Abstract

The standard agency cost framing of the firm is premised on the low-cost ability of banks to monitor borrowers and enforce loan covenants in order to mitigate credit risk. Covenants and monitoring constitute a principal corporate governance function of debt, whose effectiveness is tied to the traditional, close relationship between lenders and borrowers.

But, clearly, change is afoot. Lenders are now better able to buy and sell loans and other credit instruments, resulting in lower cost alternatives - such as loan trading and credit derivatives - to the traditional reliance on covenants and monitoring. The lender-borrower relationship has transformed as well. What has been the impact on corporate governance?

In this Article, I use the evolution of debt to illustrate the role that new costs and benefits, beyond those within the traditional framing, may play in determining capital structure and effecting change in the institutions of corporate governance that extend from it. We can, as a result, expect corporate governance to evolve in line with changes in the credit market.

For debt, an increasingly liquid credit market may begin to provide a new governance function tied to changes in the price at which credit instruments trade and, in turn, a borrower's cost of capital, providing a real time check against actions that increase riskiness. Over time, private debt may move from its traditional dependence on covenants and monitoring to a greater reliance on liquid credit instruments. A similar relationship - between change in the capital market and corporate governance - exists for equity. New sources of risk capital have enhanced the ability of firms to opt in favor of private equity and its related form of corporate governance. Taken together, I raise the possibility that an alternative capital and corporate governance structure - based on the shift from public to private capital, in the case of equity; and private to increasingly public capital, in the case of debt - may become possible, driven by costs and benefits beyond those within the traditional framing. I also offer some preliminary lessons, for debt governance, from the current credit crisis.

Keywords: corporate governance, credit derivatives, credit market, loans, agency cost, credit crisis, covenants, private equity

JEL Classifications: G21, G32, K22

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