Even if many lenders skip it, taking the time to review the makeup and function of a borrower’s corporate board of directors can be an invaluable tool for managing credit risk.

By Howard Brod Brownstein

Dating back to the Enron scandal and even earlier, a company’s board of directors has been an increasingly valued part of its corporate existence. Strong corporate governance is widely respected as a tool to potentially reduce risk and enhance enterprise value. Recently, corporate governance has received progressively more attention, with the membership of the National Association of Corporate Directors (NACD) now at more than 23,000 people and directorship credentials awarded by the NACD and others becoming increasingly sought-after.1

The fiduciary duty of corporate board members to provide effective oversight is a central part of all state corporation laws, and these duties are increasingly being taken quite seriously, even for closely-held companies. It is therefore puzzling that lenders pay scant attention to a borrower’s corporate governance.

The Missing Piece

During the loan underwriting process, a lender is typically permitted to review and analyze all aspects of a borrower’s business, including the makeup of its management team. Yet lenders rarely look at the composition of a borrower’s board to determine if it includes independent directors and what combination of skills and experience its members have, no do lenders commonly review minutes, etc.

“As a board member, I support management’s efforts by holding them to account, asking tough questions, identifying when an outside resource might be helpful and helping to create a management mentality that regularly considers risk as a key element in decision-making.”

And on the “back end” of a loan, lenders typically set forth terms for an extension, waiver The reason for the omissions on the back end is likely not that it is a “blind spot,” but that lenders feel like including such measures is overinvolvement in the borrower’s business, which might lead to lender liability or equitable subordination. This attitude of avoidance has likely affected the “front end” as well, leading lenders to avoid inquiring into areas that they may feel are “out of bounds.”

However, these attitudes are quite unnecessary as long as the lender does not propose serving on a borrower’s board itself or specify who should. Therefore, by not reviewing a borrower’s corporate governance, lenders miss an opportunity to review an important part of a company that can be very useful in managing and reducing risk for the borrower while helping the lender better understand and reduce its own credit risk.

Consider the following example: A lender is looking at two identical borrowers, both family- owned and successful, but one has a board that includes truly independent directors and board minutes that the lender can read as part of its underwriting and periodic credit evaluations. Meanwhile, the other company has a board with directors tightly connected to the business owners and without easily accessible minutes. It seems obvious that the company with a proper and independent board would be a more attractive borrower.

Managing Risk

An important part of a corporate board’s activities is the oversight of a company’s risk management. Typically, this involves helping to ensure that the company identifies risks to which it is subject and monitoring regularly for changes in those risks as well as any new risks arising, especially when the company’s activities change. In addition, the corporate board should monitor whether the company is reducing risk whenever economically feasible, whether through insurance, risk mitigation or something else. To accomplish these tasks, it is valuable for a lender to receive copies of the board minutes and any risk reports from a borrower so that it can gauge how the borrower is managing risk and, thereby, better understand its own credit risk.

In back-end situations in which a lender is specifying remedial actions a borrower must take to enable an extension, waiver or forbearance agreement, the lender could easily include a requirement for the borrower to add one or more independent board members if it doesn’t have any. Again, the lender would not propose to have its own representatives on the board, nor specify whom the new independent directors should be; instead, it could just require that the directors be truly independent, e.g., meeting the SEC definition of independence even if the company is privately-held.2 Such a requirement would not be “over the line” for a lender, as it would not put the lender in “control” and put it at risk of lender liability and equitable subordination.

In my “day job” as a turnaround and restructuring professional, I see companies across all industries in varying degrees of distress. I have often observed instances in which troubled company situations might have been prevented or ameliorated by more effective governance. Plus, as someone who regularly serves as an independent board member, I am directly involved in the oversight of many companies’ risk management activities. As a board member, I support management’s efforts by holding them to account, asking tough questions, identifying when an outside resource might be helpful and helping to create a management mentality that regularly considers risk as a key element in decision-making.

It is perhaps ironic that lenders overlook this opportunity to understand and potentially reduce their credit risk, since banks with more than $50 billion in assets are required to have a separate risk committee on their own board of directors,3 meaning oversight of risk management is not assigned by default to the bank’s audit committee as it is with many non-lender boards. Many banks with total assets well below the $50 billion threshold and non-regulated lenders similarly have a separate risk committee even though they may not be required to do so. I have chaired such a risk committee for a non-bank lender and can attest to the enhancement in governance focus on risk that such a committee provides to a board.

What to Ask

So, if lenders overcome their current reticence to consider a borrower’s corporate governance and even suggest or require strengthening it as part of the lending process, they could also ask a borrower to create a separate board risk committee as they themselves likely have.

In the event a lender would like to consider including a borrower’s corporate governance as an element of the information that it collects for its loan underwriting and portfolio management processes, here is a potential list of information requests that it might present to the borrower:

• A copy of the borrower’s corporate bylaws
• A list of members of the borrower’s board of directors, including their bios, whether they are considered independent and for how long they have served
• A list of the borrower’s board committees, copies of the committee charters and a list of which directors serve on each committee
• Copies of board and committee minutes
• Copies of documents provided to the board and committees
• In the case of publicly-held companies, copies of reports that the audit committee receives from the company’s internal auditors or outside advisors about the company’s systems and controls, as required under the Sarbanes-Oxley Act

By overlooking a borrower’s corporate governance and its potential to reduce a borrower’s risk and increase its enterprise value, lenders miss out on a valuable opportunity to manage their own credit risk. Lenders can easily add this element to their underwriting and portfolio management processes without putting themselves in danger of violating any rules or incurring legal liability. •