Controlling Tunneling Through Lending Arrangements

In a recent article, I examine how common provisions in lending arrangements (drawing from the LMA and LSTA modal agreements) handle the problem of value diversion in debtor companies. “Tunneling,” which is the expropriation of company value by corporate insiders (Johnson et al. 2000), has been largely considered a problem mainly for (minority) shareholders, as residual claimants. With fixed claims, creditors are typically not concerned with value diversion unless the debtor approaches insolvency. Yet my analysis shows that lending arrangements – including security interests, undertakings, (non-)financial covenants and other restrictions – can nonetheless be effective in monitoring, deterring, and restraining value diversion in debtor companies, even if that is not their main purpose. Based on Atanasov et al.’s taxonomy of asset, cash, and equity tunneling, I demonstrate how different provisions may affect tunneling (even if the debtor is not in financial distress).

First, financial covenants and similar provisions requiring debtor compliance effectively constrain tunneling, which would otherwise affect the financial metrics used in those provisions and as a result put companies in violation of them. Second, the provisions on disposal of assets, mergers and acquisitions, and distributions 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 tunneling), thus directly prohibiting them or requiring the lenders’ consent if not done for fair value. Most important, a provision can directly address 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), except transactions in the ordinary course of business at prices and on terms not less favorable to the debtor than could be obtained on an arm’s-length basis from unrelated third parties. It also permits transactions between the debtor company and its wholly owned subsidiary.

My analysis also shows that lenders have broad access to information on the debtor and sufficient expertise to monitor value diversion by corporate insiders. Overall, the lending relationship can provide a strong check against tunneling.

Nevertheless, this check can be weakened by the self-interest of lenders and opportunities for off-loading risk or the loans themselves. A desire to maintain a reputation as a non-aggressive lender or conflicts of interests can lead banks to overlook some self-dealing practices. More important, lenders often diversify away from, or transfer, credit risk (such as through syndication, loan sales in the secondary market, securitization, and the creation of derivatives), which can decouple economic interests from control and thereby limit lenders’ reliance on contractual provisions and monitoring.

Yet, there are still reasons to expect limits on tunneling in debtor companies – if the seller bank continues to be at economic risk or wants to maintain its reputation and certain relationships by continuing to monitor the debtor’s compliance. Furthermore, with growing liquidity in the private credit market, the credit quality of a borrower increasingly affects the pricing of credit instruments (loan sales, derivatives etc), which in turn affects the price and non-price terms of loans to the borrower. By affecting the borrower’s credit quality, tunneling can increase the cost of capital for the borrower and therefore decrease its profitability and share price, which should discipline corporate insiders.

All this demonstrates that loan agreements are imperfect tools for preventing tunneling. Yet, it is important to note that other tools, such as RPT regulations and required approvals by disinterested shareholders or independent directors, are also far from perfect. Empirical evidence also suggests that banks may have a beneficial impact on debtor companies via contractual terms that restrict corporate agents’ otherwise value-decreasing behavior  (see, eg, Shepherd et al. 2008; Nini et al. 2009; Harvey et al. 2004).

It’s worth noting, though, that, lending can itself sometimes be an instrument for value diversion by, for example providing more resources to tunnel. This scenario arises where there is no arm’s length lending relationship (the bank is associated with the borrower) or corporate insiders have too small an economic stake in the company (as is the case of a controller with few cash flow rights).

Finally, the potential disciplining effects of lending arrangements on value diversion have other implications. Why, for example, where shareholder protections are weak, do companies raise funds through the equity markets and public investors subscribe to those shares? In addition, why in such circumstances do controlling shareholders not expropriate more company resources than they actually do, given that there are no effective barriers to such behavior in corporate law (also known as Gilson’s riddle)? I argue that the role of lending arrangements in curbing tunneling may provide 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 banks. But bank financing comes with its own restrictions, which should also constrain tunneling. This would in turn enable the companies to turn to the equity market, where they could offer their shares at less of a discount because public investors could see that lending arrangements had reduced the risk of self-dealing.

My article is among the scholarship that has reflected on the likely (and beneficial) influence of creditors on corporate governance. My conclusion is that lending arrangements with banks are a complementary tool to avert value diversion in debtor companies.

This post comes to us from Alperen Afşin Gözlügöl, an assistant professor in the Law & Finance cluster of the Leibniz Institute for Financial Research SAFE, Frankfurt am Main. It is based on his recent article, “Controlling Tunnelling Through Lending Arrangements: The Disciplining Effect of Lending Arrangements on Value-Diversion, Its Limits and Implications,” available here. A version of this post appeared on the Oxford Business Law Blog.