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

Abstract

The traditional 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 governance function of debt, whose effectiveness is tied to the historical, 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, potentially resulting in lower cost alternatives - such as loan trading and credit derivatives - to the traditional reliance on covenants and monitoring. What has been the impact on corporate governance‘ In this Article, I argue that the governance function of debt has evolved in line with change in the credit market, reflecting greater liquidity in private credit instruments and the impact of new costs and benefits on capital structure and the institutions of corporate governance that extend from it. One outcome for debt governance may be a shift from the traditional dependence on covenants and monitoring to a greater reliance on liquid credit instruments. As new sources of risk capital enhance a firm's ability to opt in favor of private equity, I also raise the possibility of an alternative capital and corporate governance structure - based on a shift from public to private capital, in the case of equity; and private to increasingly public capital, in the case of debt - driven by costs and benefits beyond those within the traditional framing. Current turmoil in the credit market has potentially called into question the viability of a governance structure that relies, in part, on private credit. Greater liquidity has prompted an increase in agency costs and other market frictions that may overwhelm the associated benefits. New regulation may be necessary, and that regulation may affect growth in the credit market. I offer some preliminary lessons for private credit and debt governance.

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