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How to increase the efficiency of bond covenants: a proposal for the Italian corporate market

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Abstract

Covenants are particular clauses in the debt contracts of firms that restrict business policy, giving creditors the possibility of putting precise actions into force (normally early repayment) when the covenants are violated. The main purpose of covenants given in the literature is to resolve the conflicts of interest between shareholders and bondholders. Lack of coordination between bondholders may, however, reduce the efficiency of these instruments. We propose an application of the Italian law allowing the insertion of a mandatory representation into the new financial hybrid contracts to give an investment firm the right to act with full power on behalf of the bondholders. We show the impact of this proposal using a formalised example for the issuance of a bond with a covenant for a firm.

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Notes

  1. Until the first years of the present decade, Italian companies recurred to the “Euro bond market” to finance their activities. Normally, the securities were emitted by a Dutch or a Luxembourger company, and the bondholders were represented by an English trustee (Onado 2003; Di Staso 2004; Fimmanò 2004; Fortunato 2004; Pardolesi and Portolano 2004; Inzitari 2005). The use of this foreign legal scheme and the consequent bondholders’ deficiency of perceiving the worsened financial position of the lenders can be considered one of the main reasons for the Parmalat and Cirio cases (Abriani 2004; Nigro 2005).

  2. The sufficient conditions for an internal solution for the maximisation problem are qualitatively similar, with respect to the discussion on the coordination level, to the necessary conditions.

  3. Although this task could be assigned to a single person, a financial service company or a trust company are also considered eligible.

  4. However, the use of the trust model is still exceptional in Italy: in obedience to the Civil Law tradition, the Italian lawmaker does not generally support a legal distinction between legal ownership and equitable ownership. On the contrary, the regulation concerning financial services traditionally contains provisions about a securities indenture in favour of a beneficiary: Law. no. 1966 of 1939 provided for the “società fiduciaria” (trust company) to supply real assets or securities portfolio fiduciary managements. Nevertheless, after the Investment Services Directive of 1993 was acknowledged by legislative decree no. 415 of 1996, the “società fiduciarie” may continue to exercise single-portfolio management as trust companies, but they cannot more directly operate other financial services on behalf of their clients in respect of the rule of separation of assets (art. 60, actually applicable by legislative decree no. 58 of 1998, art. 199; Costi 2008).

  5. The costs in the case of a covenant violation normally increase with the complexity of the covenant’s structure. At a low level of complexity, they could assigned to the bondholders, but with increased complexity, they become greater for the bondholders than for the firm (or for the investment firm), mainly because of the different levels of information and the disparity of financial knowledge. Thus, in this case, to reduce the costs, costs should be assigned to the firm.

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Acknowledgments

We would like to thank Paola De Vincentiis, Yunbi An, an anonymous referee, and seminar participants at the second annual conference of Italian Association of Scholars of Economics and Management of Financial Institutions and Markets (ADEIMF), Capri (Italy), June 13–14, 2008, and at the European Financial Management Association Annual Meeting (EFMA), Milan (Italy), June 24–27, 2009, for comments that were helpful in developing this work. All errors are the authors’ alone.

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  1. Faculty of Economics, University of Trento, Trento, Italy

    Flavio Bazzana

  2. Faculty of Law, University of Bologna, Bologna, Italy

    Marco Palmieri

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  1. Flavio Bazzana
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Correspondence to Flavio Bazzana.

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Sections 2.1 and 3 are attributable to Flavio Bazzana and Sects. 2.2 and 4, to Marco Palmieri. Sections 1, 5, and 6 were written jointly.

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Bazzana, F., Palmieri, M. How to increase the efficiency of bond covenants: a proposal for the Italian corporate market. Eur J Law Econ 34, 327–346 (2012). https://doi.org/10.1007/s10657-010-9210-y

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