Corporate Governance for a Bondholder Financed, Systemically Risky World

In Rethinking Corporate Governance for a Bondholder Financed, Systemically Risky World, available here, I  argue that including bondholders in the governance of systemically important firms not only could help to reduce systemic risk but also is merited by crucial changes in the bond markets. I identify two bond-market changes. First, bondholders now typically trade their securities instead of holding them to maturity. Because trading ties bond prices to the firm’s performance, bondholders, like shareholders, have a vested interest in that performance. Second, bond issuances now dwarf equity issuances as the source of corporate financing.

Including bondholders in the governance of systemically important firms can also reduce systemic risk because bondholders are more risk averse than shareholders. The traditional reason for bondholder risk aversion—that investors holding bonds to maturity are only entitled to principal and interest and don’t benefit from the firm’s profitability—does not apply to bond trading. In a world of bond trading, however, there’s another reason for bondholder risk aversion: because credit ratings on bonds are more likely to be downgraded if the firm performs poorly than to be increased if the firm performs well, bond traders bear less of the upside of success than the downside of failure.

Bondholders therefore should be included in the governance of systemically important firms if that could be done without impairing legitimate corporate profit-making. The article examines and compares two possible governance approaches: one in which bondholders and shareholders share governance, the other in which a firm’s managers have a duty to both bondholders and shareholders. For each approach, the article analyzes how interests could be balanced to maximize shareholder profitability while protecting bondholders from significant harm.

Because bondholder interests are not fully aligned with the interests of the public, the article acknowledges that these governance approaches represent second best solutions to the problem of systemic risk. Only something like a “public governance” duty of managers not to engage systemically important firms in excessive risk-taking — which I analyze in Misalignment: Corporate Risk-Taking and Public Duty, 92 Notre Dame L. Rev. 1 (forthcoming Nov. 2016, and available here) — could fully align those interests.

Professor Steven L. Schwarcz is Stanley A. Star Professor of Law & Business at Duke University School of Law.