The Overlooked Role of Debtholders in Investor Stewardship
One remarkable aspect of the ongoing discussions of the stewardship role of institutional investors, including on environmental, social, and governance (ESG) matters, is the usual focus on equity investors. Investors in debt instruments tend to be overlooked in this discourse. Yet, corporate debt is the dominant external source of funding business activities, and it is through their role as the providers of debt financing that investors can have real leverage on corporate behaviour.
In a forthcoming paper, I aim to clarify the stewardship and corporate governance role of debtholders by identifying the mechanisms of debtholder influence, assessing their effectiveness in modern capital markets, and outlining the implications of this analysis for investor stewardship and regulatory efforts to support it.
My paper identifies two channels through which debtholders could act as active stewards. First, just like equity investors, debtholders could exercise their rights and rely on private engagement to influence borrowers. But my paper shows that there are major problems with the use of this tool by debtholders for stewardship purposes. In public debt markets, the limits of the tool are associated with the limited reach of the contractual rights of bondholders and the intermediated relationships between bondholders and bond issuers; by contrast, private lenders have stronger rights and direct relationships with the borrowers, but their incentives to engage on matters not directly linked to credit risk are unclear. Thus, debtholders can rely on ‘voice’ in financially healthy firms in more limited circumstances than shareholders.
Second, debtholders can integrate their stewardship preferences in investment decisions on public debt markets or in loan underwriting criteria on private markets. This tool, which my paper calls ‘stewardship integration’, is where the real leverage of debtholders lies. Debtholder influence is limited during the maturity term of the debt, but their voice can be loud when extending new debt or refinancing existing debts.
The value of stewardship integration by debtholders is not obvious when we look through the prism of traditional shareholder stewardship where divestment works effectively in liquid markets. Corporate debt markets are often illiquid, yet, the limited maturity terms of debt instruments, after which borrowers need to repay their debt, mean that companies need to return to the debt market regularly to draw new funds. This provides debt investors with an opportunity to screen borrowers on primary markets on a periodic basis. Companies that do not meet the stewardship preferences of debt investors, including on ESG criteria, are expected to have limited and costlier financing options.
My paper thus concludes that the only effective tool of creditor influence in financially healthy firms is stewardship integration. This also means that debtholders do not face the dilemma ‘to engage or divest’ in pursuit of impact. Unlike shareholders, debtholders can safely exit without causing negative side effects for voting and engagement because debtholders have limited scope for using voice during normal times anyway.
Last, my paper highlights some implications for regulatory efforts to advance investor stewardship, especially in the light of the recent extension of the concept of investor stewardship beyond listed shares in the UK Stewardship Code 2020. Two are worth highlighting. First, the extension of investor stewardship to debtholders is an important step in the direction of bringing more firms within the reach of investor stewards. Many non-listed firms issuing bonds, including fully state-owned enterprises, can no longer escape investor oversight. But debtholder stewardship will have limited impact and is likely to distort business financing unless it becomes a norm at a broader scale. This can be achieved by extending debtholder stewardship to private lenders.
Second, although the Stewardship Code 2020 adds investors in debt securities to the list of investor stewards, the code offers very little detail on reporting expectations of non-equity investors. Without more explicit guidelines accompanying abstract and generalist debtholder stewardship principles, significant changes in current practices are unlikely. Investors are likely to concentrate their efforts on stewardship efforts where more reporting is expected. As such, debtholder stewardship will be confined to the margins of mostly shareholder engagement-focused stewardship reports.
Both aspects deserve special attention during the planned review of the stewardship code in the United Kingdom, as well as in countries that are closely watching investor stewardship developments in Britain as a source of ideas for revising or designing their own stewardship codes.
Suren Gomtsian is an Associate Professor in Business Law, University of Leeds, School of Law.
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