External Legal Counsel as Transaction Cost Engineer and its Influence on Loan Contract Design and Performance

We investigate whether external legal counsels (ELCs) affect the design and performance of syndicated loan contracts. Using a dataset of ELCs representing both borrowers and lenders in the U.S. syndicated loan market and fixed effect models, we find that ELCs explain significant variation in loan contract characteristics, including loan spreads, covenants intensity, and covenants strictness. To understand one of the potential channels through which ELCs exert their influence, we explore the role of ELCs acting as transaction cost engineers. We find that connected ELCs, i.e., ELCs advising the lender (borrower) and with a recent working relationship with the borrower (lender), reduce information asymmetries between the two sides of the transaction, thus lowering interest spreads as well as the intensity and the strictness and of loan covenants. Furthermore, we document that ELCs affect future loan performance—loan contracts with connected ELCs are less likely to be downgraded or experience default.