Scholar warns that weak lending contracts can leave lenders and investors with fewer warning signs.
Companies do not follow only the rules that regulators write. Some of the strongest limits on companies come from lending agreements—contracts that companies sign with lenders to borrow money. In a recent trend, however, these agreements have imposed fewer and weaker limits on company behavior, according to legal experts Cathy Hwang, Yaron Nili, and Jeremy McClane.
They argue in a recent article that lending agreements that grow lighter on contractual limits or covenants leave lenders with fewer warning signs when a borrower’s problems become severe. They encourage lenders to enhance what they call “governance” covenants in their lending agreements.
When a company borrows money, its lending agreement contains more than just terms spelling out how much it must pay back and when. It often includes extra promises that a company borrowing the money must keep while it still owes the money. These promises—called covenants—protect lenders by limiting behaviors that could make a company less likely to repay their debt.
Hwang, Nili, and McClane observe that some covenants set financial guardrails—such as limits on how much more money a company can borrow or requirements to keep earning enough money to stay on track to pay the lender back.
Other covenants, they note, set governance guardrails—rules about how the company must run itself while it owes the money, such as requiring regular reporting to lenders or restricting business decisions that are too risky.
Hwang, Nili, and McClane observe that most existing research focuses more on lending agreements that have weak financial guardrails. But they argue that lending agreements with weak governance covenants—what they call “gov-lite” loan agreements—matter just as much.
Drawing on an analysis of a hand-collected dataset of more than 7,000 lending agreements, Hwang, Nili, and McClane find that governance covenants in lending agreements have thinned out over time, alongside the better-known decline of financial covenants. They warn that “gov-lite” lending agreements could leave lenders with fewer tools to monitor and respond to company misconduct.
Hwang, Nili, and McClane contend that governance covenants in lending agreements give lenders a way to keep borrowing companies accountable. In some cases, they argue, these covenants can provide one of the few practical checks on these companies beyond regulators and courts.
They note, for example, that lender oversight can matter most when a company has many scattered small investors, because those investors may struggle to coordinate and monitor company managers. Lenders, by contrast, can monitor by enforcing the covenants they negotiated in the lending agreement.
Hwang, Nili, and McClane argue that lenders are not accepting weaker covenants because covenants have stopped being useful. Instead, they argue that changes in how companies borrow money have made it harder for lenders to demand and enforce strong covenants in lending agreements.
They contend that one change has arisen in how competitive it is to lend money: more lenders want to lend than companies want to borrow. Hwang, Nili, and McClane argue that when lenders chase the same companies that need to borrow money, companies can demand fewer covenants in lending agreements, lest they lose out to competitors who are willing to lend money with fewer strings attached.
Another change stems from how companies now borrow from many different lenders at once, with each lender providing only a small share of the money. Hwang, Nili, and McClane argue that spreading the borrowing this way can weaken lenders’ incentives to demand strong covenants, because fewer lenders have a large enough stake to insist on strict terms—or to spend time and money on enforcing them later.
Hwang, Nili, and McClane explain that companies today also borrow increasingly from non-bank lenders instead of traditional banks. They note that, because banks face heavier regulation and often move more slowly, some borrowers shop for lenders who can supply the money quicker with less paperwork. One natural way to supply the money fast is to negotiate fewer covenants up front, which non-bank lenders frequently do, according to Hwang, Nili, and McClane.
They argue that the upshot is that “gov-lite” lending agreements do not just change the relationship between lenders and the borrowing company—they also affect investors. Without robust governance covenants, investors can be worse off because lenders may no longer play the watchdog role that helps catch problems early and push company managers to change course.
Hwang, Nili, and McClane urge courts not to presume that lenders can protect themselves through lending agreements, because many agreements have become “gov-lite.” In their view, if that assumption no longer holds, courts should reconsider whether existing corporate law gives lenders enough protection—suggesting, in the end, that needed fixes might have to come from changes to corporate regulation rather than lending agreements.
