We call the second grand compromise the seniority-control compromise. This compromise is based on a tradeoff between seniority of claims and explicit control rights. Securities with high seniority generally assign few explicit control rights to the lender, while securities lower down the seniority ladder assign more such rights. Money market debt is in effect a very senior claim because of its short maturity — it must be paid off when due or the firm could be forced into bankruptcy. Bank loans and bonds represent claims that are effectively junior to money-market claims, but may often include clauses that establish relatively higher seniority. In particular, many bank loans and bonds require future borrowings of the firm to be subordinated to them. In compensation for a lower seniority position, banks and bondholders demand some control rights over the firm. These are passive control rights, in the sense that they are simply rules and stipulations about the use of the firm’s assets and place restrictions on the actions of the borrowers. They are enforced by acceleration clauses that require repayment of the entire outstanding debt in case of any covenant violation. And as in the case of money market debt, bonds and bank loans have significant contingent control rights that can be exercised if the firm comes close to or enters into bankruptcy. Finally, common stock holders are the last in line as “residual claimants” on the firm’s assets and cash flows, but have explicit control rights over the election of the Board of Directors and hence over the firm’s managers.
From a lender’s perspective, the seniority-control compromise works as follows: seniority reduces default risk by increasing the chances of being paid in full, and/or by increasing the amount that the lender expects to recover in the case of default. Short maturity debt (especially bank loans) is the most senior. But lenders will accept control rights over the use of the firm’s assets as a substitute for seniority. Control also reduces default risk, but through a different mechanism. Explicit control rights enable lenders to force the borrower to take actions to decrease the probability of default. Seniority and control are imperfect substitutes for lowering the risk of losing money, and lenders take this into consideration when designing financial instruments. Another way to view such tradeoffs is that high-seniority and high-control securities represent different investment strategies that lenders can choose. Investors in high-seniority secrutiies earn high returns by lending to firms that promise payments that are large relative to the probability of default. Investors in high-control securities earn high returns by managing the firm’s operations more profitably.
From Ralph Chami, Sunil Sharma, Connel Fullenkamp, A Framework for Financial Market Development (IMF Working Paper 2009), pp.22-23.