Controlling Tunnelling Through Lending Arrangements

‘If you owe the bank $100, that is your problem. If you owe the bank $100 million, that is the bank’s problem’, J. Paul Getty reportedly said. This is largely true for banks’ relationship with their debtor companies. In their lending arrangements, banks—still a dominant financing source both in developed and developing countries—regulate their relationships with debtor companies with all sorts of provisions in an attempt to mitigate and hedge against various risks.

In a recent article, forthcoming in the European Business Law Review, I examine how the common provisions in the lending arrangements (drawing from the LMA and LSTA modal agreements) handle the problem of value diversion in the debtor companies. Tunnelling, which indicates the various practices of corporate insiders to expropriate company value, has been largely considered a problem mainly for (minority) shareholders as the residual claimants. Creditors have fixed claims and would not be concerned with value diversion unless the debtor approaches insolvency. While this is true to a certain extent, my analysis shows that the lending arrangements, including security interests, undertakings, (non-)financial covenants and restrictions, have great potential to monitor, deter and restrain value diversion via self-dealing in the debtor companies, even if this is not their main aim. Based on Atanasov et al.’s taxonomy of asset, cash and equity tunnelling, I demonstrate how different provisions may affect tunnelling (even if the debtor is not in financial distress).

First, financial covenants and other provisions which require the debtor companies to comply with some financial requirements and restrictions effectively constrain tunnelling that would otherwise affect the financial metrics used in these provisions and as a result make companies violate them. Secondly, the provisions on disposal of assets, mergers & acquisitions and distribution to shareholders either proscribe such activities or require lenders’ consent (while sometimes excluding transactions at fair value). These provisions catch, by definition, related party transactions (RPTs) (especially practices within the category of asset tunnelling), thus directly prohibiting them or requiring the lenders’ consent or requiring such transactions to be at fair value. Most importantly, there can be a provision directly on RPTs, as clearly seen in the LSTA’s modal agreement. Closely resembling the RPT rules in corporate law, this provision prohibits any transaction with related parties (defined as ‘affiliate’ in the LSTA agreement) while allowing transactions in the ordinary course of business at prices and on terms and conditions not less favourable to the debtor company than could be obtained on an arm’s-length basis from unrelated third parties. It also permits transactions between the debtor company and the wholly owned subsidiary.

My analysis also shows that thanks to various factors, lenders have tremendous access to information on the debtor company (better than shareholders) and sufficient expertise to monitor value diversion by corporate insiders. Overall, the lending relationship provides an arguably strong disciplining mechanism against tunnelling in the debtor companies.

Nevertheless, there are certain limits to potential disciplining effects, especially the self-interest of lenders and opportunities for risk transfer and developments in the market for lending. Reputational constraints and conflicts of interests may mean that banks overlook some self-dealing practices. More importantly, recent but well-established ways for lenders to diversify away or transfer the credit risk (such as syndication, loan sales in the secondary market, securitisation, and derivatives) can cause the decoupling of economic interest and control, limiting lenders’ reliance on contractual provisions and monitoring. Yet, there are still reasons which suggest that we may still expect a certain degree of restriction on tunnelling in the debtor companies. This will be so when the seller bank still carries an economic risk and when reputational issues and relational reasons still incentivise monitoring and self-compliance. Furthermore, with the growing liquidity in the private credit market, the credit quality of the borrower increasingly affects the pricing of credit instruments (loan sales, derivatives etc), which in turn impacts the price and non-price terms of the loans to the borrower. By affecting the borrower’s credit quality, tunnelling can increase the cost of capital for the borrower, therefore its profitability and share price, which should discipline corporate insiders.

These limits show that a lending arrangement as a tool against tunnelling is imperfect. Yet, it is important to note the limitations of other tools mostly employed in RPT regulations as well (such as disinterested shareholder vote or independent directors review). Empirical evidence also suggests that banks’ impact on the debtor companies may be beneficial.

One should further note that in some cases, lending can also be used as an instrument for value diversion (to acquire more resources to tunnel), rather than forming a disciplining mechanism. This scenario arises where there is no arm’s length lending relationship (the bank is associated with the borrower) and/or corporate insiders have too little economic stake in the company (as is the case of controller with little cash flow rights).

Lastly, the potential disciplining effects of the lending arrangements on value diversion have some implications. A recurring question in law & finance circles has been why, in weak/ineffective (minority) shareholder protection regimes, companies raise finance from the equity market (despite the supposedly high discounts to share prices) and public investors subscribe to those shares (despite no protection from expropriation). In addition, there arises the question of why in such regimes controlling shareholders do not expropriate more than they actually do although there are no effective barriers in corporate law (also known as Gilson’s riddle). I argue that the role of the lending arrangements in curbing tunnelling may provide a part of the explanation. Under the pecking order theory of corporate finance, the high cost of capital in the stock market would make companies turn to the banks. But bank finance comes with its own restrictions, which should also constrain tunnelling. This would in turn enable the companies to turn to the equity market with less discounts applied to their share price by public investors who would now discern that the self-dealing risk is ameliorated through lending arrangements. In terms of forward-looking implications, I discuss how developments in other fields such as financial regulation & supervision and tax can or should affect lenders’ role in corporate governance.

All in all, my article aims to join the line of scholarship that has reflected on the likely (and beneficial) creditor influence in corporate governance. My overall conclusion is that lending arrangements with banks constitute a complementary tool to avert value diversion in the debtor companies (rather than a full-fledged mechanism to prevent tunnelling).

Alperen Afşin Gözlügöl is an Assistant Professor in the Law & Finance cluster of the Leibniz Institute for Financial Research SAFE.