THE ROLE OF DEBT IN INTERACTIVE CORPORATE GOVERNANCE

Most of the corporate governance literature rests on a premise that th e interests of various stakeholder groups conflict and that managerial loyalty is more likely to be captured by shareholders than any other constituency. Yet, stakeholder interests do converge in the objective of controlling managerial slack and nonequity constituents have substa ntial influence over firm decisions. Although the study of governance has taken early steps to abandon its preoccupation with equity-centere d solutions and identify interdependencies existing among a broader ra nge of stakeholders, governance scholars have missed an important elem ent of interactivity. A stakeholder reacts to the actions of others an d thereby contributes to the collective interest in controlling slack. Each stakeholder has a window on the firm through which it can acquir e some type of information at lower cost than other stakeholders. When a stakeholder detects an unsatisfactory state of affairs, it reacts b y choosing to exit or exercise voice. The exercise of either the voice or exit option may pressure management to correct the unsatisfactory state of slack. More to the point, however, a stakeholder's exit bears important information for other stakeholders, at least some of whom m ay be better placed to take action that corrects the slack. This Artic le describes an interactive system of corporate governance and provide s a stylized theory of the role offenders within this system. The dive rgence in the interests of these lenders and other stakeholders does n ot preclude interactive governance, but it does threaten to reduce the net benefits from the process. Therefore, the authors identify a numb er of legal and institutional mechanisms that help to channel the effo rts of the fender toward the common goal of containing and correcting managerial slack. The interactive perspective thus permits new explana tions for phenomena such as debt covenants, bankruptcy preference rule s and lender liability laws. For example, the definition of debt coven ants and events of default in lending agreements raise the likelihood that the lender exit is prompted by slack rather than lender opportuni sm and thereby enhances the informational value of the exit. Bankruptc y preference rules encourage early exit before the firm becomes insolv ent, thereby enabling remaining stakeholders to take action before the firm's condition becomes irreparable. Thus, debt covenants and prefer ence rules provide a window that increases the value of lender exit in prompting the correction of managerial slack.