March 16, 2007
Creditors and Corporate Governance
Posted by Fred Tung

A handful of us corporate scholars  have been beating the drum on the role of creditors in corporate governance (see, e.g.).  We view creditors as an underappreciated influence for the monitoring of management and agency cost reduction.  Now a trio of finance scholars has come out with an empirical paper detailing the important influence of bank creditors on firm investment policy.  Their paper focuses on the use of capital expenditure covenants in bank loan agreements to affect investment policy of solvent public firms.  From a conventional corporate governance perspective, investment policy would seem to be one of those areas especially within the expertise and discretion of firm management, and correspondingly immune to shareholder challenge.  And yet, wouldn't it be nice if a properly incentivized monitor could curb managerial excess in this regard?  This is exactly what Greg Nini, David C. Smith, and Amir Sufi find in Creditor Control Rights and Firm Investment Policy.  Of special interest for corporate governance, they find  evidence that bank-imposed capex restrictions may result in efficient levels of investment.  In their sample, firms with a capex restriction showed large and statistically significant increases in firm value (as measured by market-to-book) and operating performance (as measured by return on assets) in the year after imposition of the restriction. 

Here's the abstract:

We provide novel empirical evidence of a direct contracting channel through which firm financial policy affects firm investment policy. We examine a large sample of private credit agreements between banks and public firms and find that 32% of the agreements contain an explicit restriction on the firm's capital expenditures. Creditors are more likely to impose a restriction following negative borrower performance. Moreover, the effect of credit downgrades and financial covenant violations on the incidence of capital expenditure restrictions in new contracts is larger than the effect on interest spreads. We also find that restrictions cause a reduction in firm investment and that firms obtaining contracts with a new restriction experience subsequent increases in market valuation and operating performance. The evidence suggests that capital expenditure restrictions reduce inefficient excess investment by managers.

Corporate Governance, Empirical Legal Studies, Finance | Bookmark

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