How to Reduce Agency Conflicts Between Stockholders and Bondholders
Stockholders and bondholders both make money by putting money into businesses. Conflict between shareholders and bondholders happens because stockholders benefit from corporate gambles, while bondholders benefit from playing it safe. Because management is the shareholders' agent, corporations often do what the shareholders, not the bondholders, want.
Covenant bond agreements reduce conflicts between shareholders and bondholders. For example, corporations have an incentive to please shareholders by issuing big dividends, even if that risks their ability to pay off debt. A covenant limiting the size of dividends prevents that.
The relationship between stockholders and corporate management is one of principal to agent. The stockholders, as the owners of the company, are the principals. The corporation's management is the agent charged to act in the stockholders' interest.
Any principal/agent relationship has the potential for conflict. Is the agent making decisions to benefit themselves rather than the principal? Is the agent doing a bad job because they're incompetent?
In corporate governance, shareholders want good money management from their agent. They want to know where their money went, and they want a return on their investment either from dividends or from rising stock prices. If it doesn't happen, they want to know why their agent didn't deliver.
The appeal of bonds is that they're a safe, stable investment compared to stocks. On many bonds, the investor knows exactly what rate of return they're getting and when they'll be paid off. Other bonds offer fluctuating rates or higher risk for higher returns.
If a company takes a gamble and succeeds, shareholders may get larger dividends. Bondholders don't see more money. When a bond issuer takes on added risk, this has no upside to the bondholders' investment and may end up hurting them.
The hurt comes when a bond issuer goes bankrupt. The bondholders then have to compete with other creditors for a share of what they're owed. That gives them a different view of risk than shareholders have.
As the stockholders' agent, corporate management has a fiduciary duty to look out for the investors. The board and the CEO don't have the same obligation to put their creditors' interests first. That's the basic conflict between shareholders and bondholders.
A corporation could, for example, respond to shareholder demands by issuing huge dividends, even if this is bad for the company's long-term health. Taken to the extreme, this behavior puts bondholders and other creditors at financial risk. The company could wind up an empty shell that can't pay back its debts.
Some companies even issue added debt so that they can keep paying dividends. This avoids the wrath of shareholders who might be able to force a change in management. Taking on added debt doesn't benefit bondholders, but they don't have the same influence.
The conflict between shareholders and bondholders typically comes in one of four forms.
- Excessive dividend payments that reduce the company's financial health.
- Claim dilution, where the company takes on added debt to pay dividends. The more debt the company carries, the tougher it is for any one creditor to collect if the company collapses.
- Asset substitution. Suppose someone buys corporate bonds because they see the company's underlying assets are solid. Down the road, shareholders push the company to buy riskier assets with the promise of high return. That's potentially good for the investors, but if it puts the company at greater risk for bankruptcy, it's bad for bondholders.
- Underinvestment is the flip side of asset substitution. Companies put less money in safe investments because shareholders aren't satisfied with the rate of return.
Other conflicts arise when a company sells off its assets or merges with another company and uses the added funds for shareholders' benefit rather than creditors.
The full impact of conflict between shareholders and bondholders is hard to estimate. Corporate finance is complicated, and decisions often have multiple motives. It's difficult to identify which decisions can be seen as taking shareholders' side over the bondholders.
One research approach is to look at cases where stockholders are also major bondholders. When shareholders are also heavily invested in bonds, there's no conflict between the two parties. One 2016 research paper found that in those situations, payments decrease in size because the stockholders are keen on getting the bonds paid off as well.
The paper concluded that when bondholders and stockholders aren't the same people, corporations favor payouts to shareholders over paying their debts.
One way corporations can reduce agency conflicts is with bond covenants. These are agreements that obligate the corporation to follow policies that protect the bondholders. They can include both positive and negative covenants.
Negative covenants forbid the corporation from taking certain actions, even if the stockholders demand it:
- Restrictions on issuing further debt.
- Restrictions on securing new debts with corporate assets. Secured debt goes to the head of the line in bankruptcy, ahead of bondholders.
- Setting a limit on the amount of dividends the company pays out.
- Limiting other kinds of payments such as share repurchases.
- Restricting asset sales and mergers.
Positive covenants require the corporation to act, rather than refrain from doing something:
- Filing regular financial statements.
- Maintaining their property.
- Insuring their assets.
- Hedging against volatility in interest rates.
- Committing the corporation to use the bond money for a specific purpose.
- The company has to maintain certain financial ratios, such as net worth or debt to earnings.
- The company has to check its financial ratios if it takes certain steps, such as issuing added debt.
- The company will increase coupon payments on the bonds if its credit rating drops. This covenant is used primarily on high-yield, high-risk bonds.
- The bondholders can sell their bonds back to the company at a premium if ownership changes, the credit rating is downgraded, or other trigger events come to pass.
- The corporation will pay off the bond within 30 to 90 days if certain conditions happen. These could include bankruptcy or a large legal judgment against the company.
Covenants are a common solution to conflicts between shareholders and bondholders, but they aren't a perfect one. For example, the bond issuer may find the covenant terms restrict them so tightly they can't make necessary investment and financial decisions. Restrictions on issuing further debt may block the company from raising money when it needs to.
Financial ratio covenants are often a sub-optimal choice for minimizing conflicts with shareholders. It takes regular monitoring to confirm that companies are maintaining the required financial ratio. Banks are well equipped for that work, but most other bondholders aren't.
By the time a bondholder discovers the issuer has exceeded the financial ratios, the corporation may already be insolvent. Setting specific terms on the policies that the business should or should not follow is usually more effective for a company that doesn't want to monitor the ratios constantly.
One proposal for reducing conflicts in the future is to give bondholders a say in corporate governance. The need to keep shareholders happy may lead corporate heads to make decisions that don't benefit the business. Giving bondholders more influence could counteract that.
Shareholders benefit if corporations take risky gambles that pay off. Bondholders benefit if corporations play it safe. Bonds are widely traded after the initial issue. Bond buyers who want to sell need corporations to make decisions that keep the bonds' highly rated, promising a safe return on investment.
The bondholders' need for security could counterbalance the stockholders' interest in risk. If bondholders exercised more direct control, that might increase the health and productivity of the corporate sector for the long haul.