The protection of corporate bondholders in the United Kingdom and Germany : an integrated governance approach

公司債券持有者之保護 : 綜合管治方式之英國與德國觀點

Student thesis: Doctoral Thesis

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  • Fung Peng Abril CHOY

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Awarding Institution
Award date15 Jul 2014


Globalization and the changing role of finance have transformed capitalism. The global financial capitalism brings a new landscape to the business world. It provides a fertile area for public-listed companies to consider the expansion of the fund raising activities from the domestic capital market to the international capital market. It has increased both the opportunities and threats of running international business in a global economy. Since the collapse of Lehman Brothers in the global financial crisis of 2008-2009, the debt investors become more cautious and careful. External financing in the international capital market is competitive and more exposed to a political-economic environment. It is argued that this global financial crisis was largely caused by opportunistic behavior of directors tolerated by poor regulation, weak corporate governance, and inadequate risk management. As one of the debt capital suppliers, the interests of corporate bondholders are deserved much attention from the regulators, legislators, company directors and professionals. In corporate finance, debt capital in form of corporate bond is a part of the capital structure of a company. Corporate bond is a very traditional debt security in the business world. Most corporate bonds issues are often unsecured. The characteristics of a debt security are negotiable, transferable, and marketable. Corporate bondholders are given a contractual relationship to a public-listed company. In the pre-contractual stage, the investment decision of a debt investor is made on the basis of material information available in the prospectus and annual financial statements of a company issuer as well as the financial commentaries by financial analysts. Debt investor subsequently becomes a corporate bondholder of a public-listed company after the bond subscription in the post-contractual stage. As the result, a corporate bondholder becomes one of the unsecured creditors of a public-listed company after the bond subscription. Debt investors make the informed decisions on the debt investment based of the doctrine of caveat emptor ("Let's the Buyer Beware"). Material information is treasured to the corporate bondholders. Debt investors are expecting the provision of the reliable and representative information from the investee company for the long-term investment in the international capital market. Not every debt investors could derive and evaluate the necessary company information from annual financial statements in order to make informed decisions. On the other hand, financial expert advices including financial analysts or even financial press is taken close observation on providing unbiased information for each debt investors. This unbiased information for debt investors is supposed to free from material conflicts of interest that might compromise the integrity of their analysis or advice. A public-listed company is engaged at the very heart of the fund raising activities in the international capital market. Acting as an agent of a company issuer, an investment bank takes a leading role to issue, market, and distribute the bond. The bond issuance must be offered at the right time in the right place. However, the standard terms and conditions of the corporate bond indenture are drafted by these international financial intermediaries. Numerous corporate bondholders have not taken part in the negotiation process of contract drafting. The freedom of contract prevails. A unilateral financial covenant is drafted by this financial agent from a financial institution for binding two parties between a company issuer and corporate bondholders worldwide. Serving as an administrator and custodian, an English trustee or a German bondholder's representative is appointed by a company issuer to take care of the bond issue for numerous corporate bondholders worldwide. In the perspective of the debt investors, the motto of "high risk, high return" or low risk, low return" prevails. In technical sense, corporate bond is classified as the low-risk investment vehicle. In fact, corporate bond bears not only the credit default risk but also financial risk and insolvency risk of a company issuer. All corporate bonds are exposed to credit risk. Any bond investment carries with the uncertainty whether a company issuer will make timely payment of interest and principal as prescribed by the bond indenture. Debt financing puts an obligation on a company. If the company is failed to honor the interest payments or the repayment of principal sum when due, it constitutes legal default in accordance with the terms and conditions of the bond indenture. Court proceedings can be introduced to enforce this financial contract. However, a "no-action" clause is imposed on a financial covenant. Corporate bondholders are prevented from taking independent action by a "no-action clause. The clause states that no corporate bondholder is to be entitled to enforce unless a trustee fails to do so within a reasonable time. This failure action is continuing to retain the rights of the corporate bondholders to take sole action being suspended. Court rules may allow a corporate bondholder to bring a class action and or a representative action on behalf of himself and all other members of the class. The essence of the class action by a representative is used for numerous claimants on common issues. All members of the class are bound by a judgment or court-approved settlement. The court must certify the class to ensure fairness among corporate bondholders. Class actions may encourage litigation and floodgates. Company assets are typically claimable under a hierarchy on insolvency in the following orders: debt, hybrids and shares. Debt is ranked senior on insolvency. As the result, corporate bondholders as the unsecured creditors have a prior legal claim over preferred and original shareholders. This legal priority does not insulate the corporate bondholders from financial loss where they may not be able to get the full value of the assets. In fact, corporate bondholders fully rely on a company's ability to generate sufficient cash flow to pay its obligations when due. For the protective reason, the growing numbers of the debt investors are looking for subscribing the listed debt securities over the public stock exchanges in the international capital market. Self-protection for the corporate bondholders is deemed necessary. In response to Anglo-Saxon model of free trade economy, the arm's-length finance in the UK implies dispersed ownership of debt and equity, and therefore, promotes liquid markets. Investors in the arm's-length financial systems are flat to portfolio orientation. The market for corporate control operating over the public stock exchanges is an important mechanism for correction of managerial failure. The terms of the bonds are drafted by the investment bankers acting on behalf of the owners by the instruction of company management. Debt investors are not involved in the negotiation process of drafting their own contract. Followed by German model of social market economy, the control-oriented finance in Germany dominates more concentrated ownership structures in private entity and develops a less liquid market. Control-oriented financial systems breed control-oriented investors. The opportunities for diversification are less and the costs of trading tend to be high. The mechanism for corporate control operates in form of large block trades outside the public stock exchanges. The terms of the bonds are negotiated between the controlling owners and the debt investors. If the mechanism of corporate control is altered, it may be unfavourable arrangement in the eyes of serving management. With a nation's specific economic conditions, history, heritage and tradition, the opportunity and challenged are realized by the United Kingdom and Germany to use a various combination of legal and regulatory instruments as hard law on one hand, and voluntary codes as soft law on the other hand to implement their governance models. These English arm's-length finance and German control-oriented finance place different demands on the general legal environment and enforcing institutions. Both systems rely on property rights, but the role of courts is likely to differ. The English arm's-length finance places greater demands on courts by requiring detailed enforcement of specific rights to assets and cash flows, whereas German control-oriented finance merely requires the protection of voting rights. These two forms of financial systems may potentially influence the evolution of the legal system. They determine the nature of conflicts between a company and its investors, as well as between shareholders and corporate bondholders. In the era of global interdependence, the common set of ground rules are established in the accordance with international standard to facilitate the mutual understanding in interpreting the principles, and eliminates the unnecessary transaction costs between the parties in the international business. The English and German systems have closely observed the internationally recognized standards and universal norms for enhancing the national systems. The structural regulations are designed through the established corporate governance framework complemented by an efficient insolvency framework and effective enforcement of creditor rights. There are various insolvency methods of handling the financial distressed companies before and during the liquidation: corporate rehabilitation, informal corporate workouts, restructuring and formal liquidation. The hierarchy of debt claims on insolvency for corporate bondholders is prioritized and governed by the national insolvency statutes. The World Bank Principles and UNCITRAL Legislative Guide provide a reference guideline for the national legislators to develop an internationally recognized standard for its own national insolvency statute. There are national differences on the insolvency proceedings between the United Kingdom and Germany. The traditional protective measures for corporate bondholders are used which are centered on an internal measure through a contractual agreement between a company issuer and the debt investors. It is supplemented by the external measures from the assistance of institutional guardian through English trustee or German bondholder's representative and accompanied by the company evaluation through the professional gatekeepers from certified accountants and commercial insurers as well. This traditional mode of protective mechanism is implemented by the combination of statutory and self-regulations in the private enterprise under these English-typed and German-typed market economies to provide its basic protection for the corporate bondholders in the domestic market. The contractual relationship between a company issuer and the corporate bondholders acts as a focal point of the protective measures in industrial capitalism. However, improved corporate bondholders' protection is required especially in financial capitalism. Good board governance and director professionalism are operating at the heart of the governance instrument in the era of financial globalization. It directly and indirectly strengthens the position of corporate bondholders. In financial capitalism, it goes beyond the importance of financial intermediation in the modern capitalist economy. It also encompasses the significant influence of the capital holders on the political process and the goals of economic policies. In contrast with industrial capitalism, financial capitalism is characterized by a predominance of the pursuit of profit from the purchase and sale of financial products. The 21st century predominance of financial capital has led to a preference for speculation over investment for entrepreneurial growth in the global economy. The traditional protections of corporate bondholders are required to be reviewed and further enhanced to suit a new political-economic environment. Good governance model has an economic and social effect. It enriches the society governance by allowing corporate bondholders to obtain the material information and empower them to protect their capital contribution toward a public-listed company. An effective corporate governance framework requires an effective legal, statutory and self-regulations, and institutional foundation that all market participants including company issuers can rely upon when they enter into different types of contractual relations. The regulatory cost is the extensive concern for the national regulators. In view of a new and imperative political-economic environment under financial capitalism, a multi-layered integrated governance approach is developed for strengthening the interests of corporate bondholders in the international capital market. This proposed interlocking and scaffolding check-and-balance mechanisms are further intensified on the basis of the traditional model of the protective mechanism so as to provide a wide-ranging preventive and protective measure with earlier warning signals to a company and its investors. The concept of risk management is emphasized. New paradigm is shifted to the effective shareholder engagement and the vision of sustainable companies. It avoids a company operating under negative gearing. The interests of corporate bondholders are in jeopardy in the long run. A considerable proportion of governance instruments are called for stronger safety measures. Good corporate governance is instigated with more enhancing transparency by the engaged shareholders that make a regulatory framework more user-friendly for protecting the interests of corporate bondholders. It does not create unnecessary burdens for companies but strengthen them to increase their competitiveness in order to promote long term success of companies so as to further enhance the total value of the companies. It ultimately benefits companies, shareholders, bondholders and an economy at large in a dynamic changing investment environment in the international capital market. Through the multi-layered integrated governance approach, a regulatory framework of unifying the strategic cooperation is designed among different functions of players from the board and its company directors. It is assisted by a team of professional gatekeepers so as to strengthen the protective mechanisms of the corporate bondholders. The philosophy of this new governance approach is applicable to all companies regardless their company size. The management philosophy is the universal applicable particularly in the public-listed companies which are allowed to go public for fund raising and listed their debt securities on public stock exchange domestically and internationally. The rationale behind this governance approach is to adopt an internal corporate monitoring by an effective board and the competent directors complemented by external monitoring from a team of responsible professionals and capital market players to safeguard the interests of corporate bondholders. The company board should play a central role in an enhanced corporate governance model in financial capitalism. In a global economy, effective shareholder engagement with the vision of a sustainable company is one of the cornerstones of a public-listed company. Its corporate governance model relies on checks and balance among different organs and different stakeholders. Stewardship is advocated to be a benchmark of prudential governance with ethical-driven decision making in dealing with the company affairs. The quality of company management is the critical success factor of a company. Acting as the agent of the company itself, directors should maintain the balance of the interests of shareholders and corporate bondholders when a company has debt obligations. Where a company is solvent, a company's interests are represented by the interests of its shareholders. When a company's solvency is in doubt, there is gradual shift in whose interests represent that of the distressed company away from the interests of shareholders in favour of the interests of company's creditors where the corporate bondholders are one of the kinds. In the vicinity of insolvency, a responsible and competent director must act in a way that he considers, in good faith, would be mostly to make business viability for the benefit of the corporate bondholders. The greater risk of insolvency involved, the greater attention must be given to the interests of corporate bondholders. Directors should act in the utmost good faith for a company. By improving a quality of the supervision, good corporate culture and sound mind work well in developing a high standard company. Acting as the crisis manager, the responsible directors of a distressed company in approaching insolvent must decide at which point the interests of corporate bondholders override the interests of shareholders. The timing of this decision is critical. Directors must be able to identify when there is a risk of insolvency happening. When considering a company's insolvency position, the cash flow or balance sheet tests can both be employed to determine a financial position of a company's ability to pay debts when due. In the vicinity of insolvency, it has not been set a time when a distressed company may be considered technically insolvent on cash flow or balance sheet basis. During this twilight period, a distressed company entering into transactions is still exposed to condemn and may give rise to personal liability on the part of the directors and company wrongdoings. The interests of corporate bondholders are in jeopardy resulted from the directors' misconduct. Essentially, the multi-layered integrated governance approach is advocated for strengthening the protection of corporate bondholders through different stages of the procedural protective measures by improving transparency and disclosure in the financial reporting and insolvency regimes; by more active shareholder engagement at board level; by reducing insolvency risks through stewardship program; by more directors' accountability in the vicinity of insolvency; and by the company evaluation through a team of professionals. Effective creditors' empowerment for corporate bondholders minimizes reliance on the law and regulation. Prudential corporate governance and effective shareholder engagement in the age of financial capitalism goes far beyond the interests of corporate bondholders of a public-listed company. It is also a public policy concern and economic stability. Although both English and German insolvency laws take references to evaluate a company's ability to meet its debt obligation, it is more important to see that a company issuer has ability to honor its commitment involved in the financial contracts. If a company fails to observe to certain obligations, in particular to the interest payments and principal repayment to the corporate bondholders when it dues on time, a company's sustainability is at risk. Liquidation of a company will adversely affect the interests of corporate bondholders and society at large. The cost and benefit trade-off are particularly important to the multinational corporations and international investment in a global economy.

    Research areas

  • Germany, Law and legislation, Corporate bonds, Great Britain