Louis Noirault[1]
I. Introduction
This Article builds upon existing literature on controlling shareholders, financial intermediation and creditor governance (Part II) to analyze the mirroring setup between controlling and noncontrolling shareholders on the equity side, and private and public lenders on the debt side (Part III). It studies the dynamic interaction of these characteristics across jurisdictions where different combinations of debt and equity exist (Part IV). Finally, it concludes that this framework can sometimes explain cross- and intra-jurisdictional variations in governance outcomes (Part V).
II. Literature Review
The traditional account of ownership concentration revolves around the distinction between controlling (“CS”) and noncontrolling shareholder (“NCS”) firms and jurisdictions.[2] On the one hand, it is costlier for NCSs to supervise companies and coordinate their actions to influence corporate decisions.[3] NCSs also have a limited incentive to incur these costs given their relatively small stake in a given company.[4] On the other hand, CSs are better able to align managerial behavior with their preferences because they do not need to overcome the hurdle of coordination costs, and the large stakes that they hold make monitoring companies worth the costs.[5]
The public-private debt dichotomy mirrors the NCS-CS framework in many respects. Like CSs, private debt creditors generally have large individual stakes, incentivizing them to monitor their debtors. Furthermore, private debt creditors and CSs face different collective action problems than scattered public debt creditors and NCSs. This mirror image is also reflected in the illiquidity of private debt[6] and large equity stakes on secondary markets, which contrasts with the relative ease in selling public debt and the small number of shares held by NCSs. It is helpful to study shareholder-creditor agency theory to elucidate the implications of this mirroring setup.
Creditors will typically fear shareholder behaviors that would reduce the value of their debt claims, such as raising additional senior or pari passu debt.[7] While they are deemed able to protect themselves via covenant clauses covering a wide array of corporate actions,[8] these contractual levers are mostly relevant to private debt creditors. Indeed, the cost of negotiating, monitoring, and enforcing covenants is often prohibitively high for public debt creditors, who tend to obtain laxer and less extensive protection.[9]
This distinction is fundamental because it undergirds a new strand of literature that questions the conventional wisdom that creditors only play a passive role in corporate governance.[10] Rather, according to these authors, creditors are actually able to influence corporate decisions when debtors violate covenants, giving creditors the right to declare an event of default.[11] This observation reflects how creditors actually hold significant negotiating leverage, as they can validly threaten to call the loan. Since debtors routinely breach their covenants, the interference of creditors in governance occurs much prior to acute financial distress.[12]
III. Research Design
A. The Problem
Like there are NCS and CS jurisdictions, there are jurisdictions in which corporate lending relies more heavily on private debt than public debt, and vice-versa. Therefore, to each jurisdiction corresponds a pairing which depends on where it stands on both the NCS-CS and the public debt-private debt axes (Table 1). Combining the insights from the three strands of literature mentioned above can help better understand the interaction of these two factors. In a (NCS; Private Debt) jurisdiction like the UK, one may hypothesize that the free space left out in corporate governance by scattered shareholders is filled by creditors rather than managerial slack. A (NCS; Public Debt) configuration like the US seems to be the most favorable to opportunist managers seeking to extract value from the firm, as both shareholders and creditors lack strong incentives and means to monitor them. France fits the (CS; Private Debt) category, which would seem prone to a balance of power between “strong owners” and “strong creditors”. The (CS; Public Debt) configuration would theoretically give the CS more latitude to control the company and extract value at the expense of the minority and creditors. However, no existing jurisdiction seems to fit this intersection.
Table 1: The Financial Intermediation-Ownership Concentration Matrix.
| Noncontrolling Shareholders | Controlling Shareholders | |
| Public Debt | United States | [none] |
| Private Debt | United Kingdom | France |
B. The Method
This Article assesses how this mirroring setup dynamically functions across these three jurisdictions by looking at appointment and dismissal rights, one of the levers of alignment presented in The Anatomy.[13] This lever involves dynamics that crystalize the interaction between ownership concentration and financial intermediation. By focusing on appointment and dismissal rights, this Article seeks to understand whether creditors or shareholders have more control over what these methods seek to achieve (e.g., control of the functions of the board of directors).
IV. The Comparison
A. The Vicinity of Insolvency
When a firm nears insolvency, conventional expectations are that shareholders control the appointment and dismissal of directors. Since public debt indentures contain a restricted and looser set of covenants, US creditors can hardly influence such decisions. Dispersed shareholders will also have a limited reaction to the firm’s financial difficulties, as their monitoring is limited and intervening would be costly. However, when private creditors are faced with dispersed NCSs like in the UK, they are able to leverage their power to grant a waiver of default for “tripped” covenants. Although found in a US context, the case of Krispy Kreme exemplifies this setup. In 2005, bankers were able to obtain the dismissal of the CEO and chairman of the board after the firm failed to deliver financial statements under one of its covenants.[14]However, in France, controlling shareholders are better able to resist the pressure of private creditors. This can once again be illustrated through a discrete US case. In 1976, the clothing company Farah was teetering on the edge of bankruptcy when it was granted an additional loan by its bank creditor. This new loan included a covenant meant to keep out the former CEO, thereby demonstrating the bank’s significant influence on the way the firm is run. Nevertheless, the family in control of the company eventually reinstated him despite the threat of an event of default. This example reflects how a private creditor can be partially tamed by a controlling family that possesses the capacity and incentive to control the board.
B. Insolvency
Once a firm has filed for bankruptcy, the default rule in the US is that the debtor stays in possession of the firm, and existing management can remain in charge.[15] Should dispersed shareholders and public bondholders seek a change in management, they would have to actively seek its ousting, implying coordination costs. Despite a relatively lax statutory standard,[16] the appointment by the court of a trustee upon the creditors’ request is largely seen as an exceptional remedy.[17] This is consistent with the expectation that dispersed bondholders would not have the economic incentive to make use of their formal right to oust incumbents. In contrast, in the UK, the default legal rule is that debtors must relinquish control of their companies when they enter the insolvency regime.[18] In administration, the court-appointed administrator thereby acts for creditors as a whole.[19] While this provides protection from the shareholder abuses found in the US context, it leaves concentrated creditors with an opportunity to exert significant influence.[20] In contrast, the administrator in a French “redressement judiciaire” does not owe a duty of care to creditors. As the mission of the court-appointed judicial administrator is limited to “assistance,” CSs still preserve significant leeway over the firm leadership.[21] Creditors, on the other hand, are hamstrung by the French legal framework since the judicial representative representing their interests has a limited role. This prevents them from leveraging their strength to appoint directors on their own. This (Private Debt; Controlling Shareholder) configuration, can be exemplified by the case of the Hunter family in the US.[22] In line with the model’s prediction, the controlling family profited from the default rule that left them in control to undertake risky projects from which they would reap the benefits as shareholders. In case of failure, the bank creditors would have borne the losses on their claims. However, the fact that these private creditors did not move for the appointment of a trustee, even though they had both the means and an economic incentive to do so, left bankruptcy experts surprised.[23]
V. Conclusion
This mirroring setup thus explains how and why private creditors may exert significant influence over a firm out of formal bankruptcy proceedings, depending on the organizational capacity of the shareholders it faces. Conversely, it also sheds light on the extent to which CSs confronting private creditors may retain influence even after a bankruptcy filing. Moreover, it is easy to underestimate the central role played by the statutory framework of each jurisdiction as it may mitigate or magnify power imbalances between these constituencies. However, little scholarly attention has been so far dedicated to this interaction between debt and equity investors, which helps surpass monolithic views of corporate governance omitting the crucial role of creditors.[24]
[1] Student at Sciences Po Law School (Joint Master’s Degree in Law and Finance, Class of 2024); exchange student at Harvard Law School (Fall 2022).
[2] See Ronald J. Gilson, Controlling Shareholders and Corporate Governance: Complicating the Comparative Taxonomy, 113 Harv. L. Rev. 1642 (2006); see also John C. Coffee, Dispersed Ownership: the Theories, the Evidence, and the Enduring Tension Between ‘Lumpers’ and Splitters (European Corporate Governance Institute (ECGI), Working Article No. 144/2010), available at https://ssrn.com/abstract=1532922 (referring to this dichotomy as the “single most noticeable fact about corporate governance”).
[3] Lucian A. Bebchuk & Assaf Hamdani, The Elusive Quest for Global Governance Standards, 157 U. Pa. L. Rev. 1263, 1282–83, 1290–91 (2008).
[4] Id. at 1281; Mariana Pargendler, The Corporate Governance Obsession, 42 J. Corp. L. 359, 371 (2016).
[5] John Armour, Luca Enriques, Henry Hansmann & Reinier Kraakman, The Basic Governance Structure: The Interests of Shareholders as a Class, in anatomy of corporate law: a comparative and functional approach 128 (Reinier Kraakman, John Armour, Paul Davies, Luca Enriques, Henry Hansmann, Gerard Hertig, Klaus Hopt, Hidekki Kanda, Mariana Pargendler, Wolf-Georg Ringe & Edward Rock, 3rd ed., 2017) (henceforth “The Anatomy”).
[6] Douglas W. Diamond & Raghuram G. Rajan, Banks and Liquidity, 91(2) Am. Econ. Rev. 422, 422 (2001); Daniel K. Tarullo, Nomura Professor of International Financial Regulatory Practice, Harvard Law School, Lecture at Harvard Law School on the Regulation of Financial Institutions (2022); see also George A. Akerlof, The Market for “Lemons”: Quality Uncertainty and the Market Mechanism, 84 Q. J. Econ. 488 (1970).
[7] See, Michael C. Jensen & William H. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3 J. Fin. Econ. 305(1976); Mark J. Roe, David Berg Professor of Law, Harvard Law School, Lecture at Harvard Law School on Bankruptcy (2022).
[8] See David Christoph Ehmke, Bond Debt Governance: A Comparative Analysis Of Different Solutions To Financial Distress Of Corporate Bond Directors 151–57 (2018).
[9] Yakov Amihud et al., A New Governance Structure for Corporate Bonds, 51 Stan. L. Rev. 447, 458 (1999); Douglas W. Diamond, Financial Intermediation and Delegated Monitoring, Rev. Econ. Stud. 393, 410 (1984) (“If there are m outside security holders in a firm and it costs K>0 to monitor, the total cost of direct monitoring is m.K. This will either imply a very large expenditure on monitoring or a free rider problem where no securityholder monitors because his share of the benefit is small”).
[10] See Frederick Tung, Leverage in the Board Room: The Unsung Influence of Private Lenders in Corporate Governance, 57 UCLA L. Rev. 115 (2009); see also Douglas G. Baird & Robert K. Rasmussen, Private Debt and the Missing Lever of Corporate Governance, 154 U. Pa. L. Rev. 1209 (2006); see also Greg Nini et al., Creditor Control Rights, Corporate Governance, and Firm Value, 25 Rev. Fin. Stud. 1713 (2012).
[11] See in general, Frederick Tung, supra note 10.
[12] Id. at 115.
[13] See, John Armour et al., Agency Problems and Legal Strategies, in Anatomy Of Corporate Law, supra note 5, at 32; on the functional approach, see David Christoph Ehmke, supra note 8, at 32 (“The question has to be whether the same, a similar or an apparently different rule performs the same function within the particular legal and extra-legal environment similarly effective”); see also, Konrad Zweigert & Heinz Kötz, Einführung in die Rechtsvergleichung, (3rd ed., 1996).
[14] Douglas G. Baird & Robert K. Rasmussen, supra note 10, at 1211–12.
[15] Bankruptcy Code §1107 (the statute uses the term of art “Debtor-In-Possession” (or “DIP”)); see John Armour et al., Corporate Ownership Structure and the Evolution of Bankruptcy Law: Lessons from the United Kingdom, 55 Vand. L. Rev. 1745 (2002) (arguing that the rationale is the incumbent’s detailed knowledge of the firm).
[16] US Bankruptcy Code §1104.
[17] Mark J. Roe, David Berg Professor of Law, Harvard Law School, Lecture at Harvard Law School on Bankruptcy (2022).
[18] Vanessa Finch, Corporate insolvency law: perspectives and principles 280-281 (2nd ed., 2009).
[19] Insolvency Act 1986 Schedule B1 s. 3(1).
[20] Finch, supra note 18, at 440-441.
[21] French Commercial Code art. L631-12.
[22] Mark J. Roe & Frederick Tung, Bankruptcy and Corporate Reorganization, Legal and Financial Material 253 (4th ed. 2016).
[23] Id. at 294-305.
[24] In 2002, an article analyzed the US and UK bankruptcy regimes through this lens. Both statutes and the legal scholarship have since then evolved in significant ways but there has been no comparable work in the last two decades; See, John Armour et al., supra note 15.