The Lost Promise of Private Ordering

61 Pages Posted: 5 Feb 2024 Last revised: 5 Feb 2024

See all articles by Cathy Hwang

Cathy Hwang

University of Virginia School of Law

Yaron Nili

Duke University School of Law; European Corporate Governance Institute (ECGI)

Jeremy McClane

University of Illinois College of Law

Date Written: February 2, 2024

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.

Suggested Citation

Hwang, Cathy and Nili, Yaron and McClane, Jeremy, The Lost Promise of Private Ordering (February 2, 2024). Cornell Law Review, Vol. 108, No. 7, 2024, Virginia Public Law and Legal Theory Research Paper No. 2024-12, Virginia Law and Economics Research Paper No. 2024-06, Univ. of Wisconsin Legal Studies Research Paper No. 1793, Available at SSRN: https://ssrn.com/abstract=4714983

Cathy Hwang (Contact Author)

University of Virginia School of Law ( email )

580 Massie Road
Charlottesville, VA 22903
United States

Yaron Nili

Duke University School of Law ( email )

210 Science Drive
Box 90362
Durham, NC 27708
United States

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Jeremy McClane

University of Illinois College of Law ( email )

504 East Pennsylvania Avenue
Champaign, IL IL 61820
United States
2173003756 (Phone)
61820-6909 (Fax)

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