The Lost Promise of Private Ordering

Abstract

The agency problem is corporate law’s most enduring challenge: when corporate managers spend investors’ money, how does the law protect investors from reckless management? Scholars of law, fnance, and accounting have suggested that in one corner of corporate law—corporate debt—a powerful tool exists to mitigate the agency problem. Specifcally, through loan covenants, lenders can force borrowers to comply with lenders’ preferences, thereby mitigating the agency problem in lending.

But loan covenants are disappearing. Over the last decade, loan covenants have become fewer and skinnier, and so called “covenant-lite” or “cov-lite” loans have become dominant. If loan covenants do such a good job of mitigating agency costs, why have lenders willingly parted with them?

This Article attempts to unravel the puzzle of disappearing covenants, and makes three contributions to literatures in law, fnance, and accounting. First, using an original, hand-collected, and hand-coded dataset of 7,638 loan agreements spanning the last decade, this Article shows for the frst time that fnancial covenants—the focus of most existing research—are not the only covenants disappearing. Rather, governance covenants, such as those that might give lenders the right to engage with the borrower’s board of directors, are also disappearing. This Article coins the term “gov-lite” to describe loans that have few governance covenants and shows, for the first time, how prevalent gov-lite loans have become, even in ways that sometimes diverge from the covlite trend. Second, this Article draws from original interviews with lawyers working in corporate lending to explain the source and importance of this trend. This qualitative empirical evidence shows that regulation, the structure of the loan industry, and the rise of shadow banking have all contributed to the cov-lite and gov-lite trends. Finally, this Article explores the important theoretical and practical implications of the covlite and gov-lite trends. It discusses how the disappearance of covenants exacerbates the agency problem for lenders and shareholders, and how can stakeholders use covenants to advance social interests.