CEO contractual protection and debt contracting

Chief Executive Officer (CEO) contractual protection, in the forms of CEO employment agreements and CEO severance pay agreements, is prevalent among S&P 1500 firms. While prior research has examined the impact of these agreements on corporate decisions from shareholders’ perspective, there is little research on the impact from debt holders’ perspective. We find that, compared with other loans, loans issued by firms with CEO contractual protection on average contain more performance covenants and performance-pricing provisions. This effect increases with CEOs’ risk-taking incentives and opportunities, but it decreases with CEOs’ preference for and opportunity of enjoying a quiet life. Furthermore, for loans issued by firms with CEO contractual protection, debt holders include stricter covenants, charge a higher interest rate and use a more diffuse syndicate structure. Collectively, these results shed light on the impact of CEO contractual protection on debt contracting.     

The Costs of Issuing Preferred Stock

U.S. firms commonly use preferred stocks to raise external capital. Yet this hybrid security's issuance costs and offer yields have not been previously examined in a systematic manner. We analyze a sample of 3,042 U.S. preferred stocks issued between 1980 and 1999. We find that convertible issues, which are riskier than straight issues, entail higher gross spreads and other direct expenses. Scale, credit rating, and industry effects influence gross spreads and issuance costs. We also compare preferred stocks yields with various bellwether bond yields. Our results support the tax‐based argument that suggests that yields on preferred stocks should be lower than comparable risky bonds.     

How do agency problems affect firm value? – Evidence from China

Using newly available data, we examine the effects of the agency conflicts between ultimate controlling shareholders and minority shareholders in China's publicly listed firms between 2004 and 2009. We measure the severity of these agency problems by the excess control rights of the ultimate controlling shareholders. We show that higher excess control rights are associated with significantly lower firm value. We identify two channels through which the excess control rights affect firm value: (1) related-party loan guarantees, and (2) legal violations. We find that higher excess control rights are associated with significantly larger amounts of related-party loan guarantees (scaled by assets) for non-state and private firms, but not for state-owned firms. We find that, for non-state and private firms, the excess controls rights are associated with (1) significantly higher probability that the firm will issue value-destroying related-party loan guarantees and (2) significantly worse stock market reactions to the announcements of related-party loan guarantees. However, these results do not hold for state-owned firms. We also find that higher excess control rights are associated with significantly higher probability, frequency and severity of legal violations for non-state and private firms, but not for state-owned firms.     

Bank incentives and suboptimal lending decisions: Evidence from the valuation effect of bank loan announcements in Japan

Using a sample of bank loan announcements in Japan, we examine whether or not banks have incentives to engage in suboptimal lending that results in wealth transfer from the banks to the borrowing firms. We find that abnormal returns for borrowing firms are significantly positive, but those for lending banks are sometimes significantly negative. Furthermore, the announcement returns for borrowing firms are negatively related to those for lending banks, especially when poorly performing firms borrow from financially healthy (low-risk) banks. Our results suggest that the positive valuation effect of bank loan announcements for borrowing firms is mainly due to a wealth transfer from lending banks.     

Earnings Management Surrounding New Debt Issues

We examine whether firms manage earnings before issuing bonds to achieve a lower cost of borrowing. We find significant income‐increasing earnings management prior to bond offerings. We also find that firms that manage earnings upward issue debt at a lower cost, after controlling for various bond issuer and issue characteristics. Our results are consistent with studies that report earnings management around equity issuance. The results indicate that, like equity holders, bondholders fail to see through the inflated earnings numbers in pricing new debt.     

OPERATING LEVERAGE AND UNDERINVESTMENT

Using a contingent claims model, we examine the impacts of both operating leverage and financial leverage on a firm's investment decisions in the context of capacity expansion. Our model shows that quasi‐fixed operating costs could significantly mitigate the underinvestment problem for debt‐financed firms. The existing debt induces equity holders to delay equity‐financed expansion because the expanded earnings base will also benefit the debt holders by lowering the bankruptcy risk. The operating costs decrease this type of wealth transfer from equity holders to debt holders by magnifying the bankruptcy risk of the existing debt upon investment. By applying the Cox proportional hazard model on a large sample of publicly traded U.S. firms over 1966–2016, we offer empirical support for the theoretical predictions. The results are robust to various measures of operating leverage.     

Emerging from Bankruptcy with When‐Issued Trading

We examine the set of firms that emerged from Chapter 11 bankruptcy and traded on a when‐issued basis before their official return to the regular way in NASDAQ, Amex, or NYSE. We find that this when‐issued market is liquid and price efficient. The when‐issued closing price is a good indicator of the first closing price in the regular way market. Emerging firms that have when‐issued trading experience lower regular way volatility and smaller relative spreads than those without when‐issued trading. Our probit regressions show that firm size is an important determinant of the adoption of when‐issued trading.     

Is Chapter 11 costly?

We examine a sample of 459 firms filing for Chapter 11 during the period 1991–1998 and find that our sample firms experience significant improvements in their operating performance during Chapter 11. Our evidence is consistent with the hypothesis that Chapter 11, if anything, provides net benefits to bankrupt firms. In the cross section, firms with higher debt ratios experience greater improvements in operating performance, and the complexity of the renegotiation process negatively affects the improvement. We find no relationship between Chapter 11 outcome and changes in risk-adjusted firm value in Chapter 11.     

Government contracts and US bond yield spreads: A study on costs and benefits of materialized political connections

In a 1991–2013 sample of bonds issued by US public firms, we find that the cost of debt (yield spread relative to comparable Treasuries) of suppliers to government agencies is contingent on the strategic importance of the supplier's industry. The yield spreads for strategically unimportant government suppliers are higher than for firms that are not government suppliers. If government contracts serve as tangible evidence of political connections, these higher yield spreads indicate that weaker corporate governance as a cost of political connections outweighs the benefits of said connections. For the subsample of government suppliers from strategically important industries, where the benefits of implicit bailout guarantees and revenue stability outweigh the corporate governance problems, the cost of debt is lower than for firms that are not government suppliers. The higher (lower) cost of debt for strategically unimportant (strategically important) suppliers is confined to contracting with the federal government. Our findings are robust to alternative variable and sample specifications, and to endogeneity concerns.     

Banks and bubbles: How good are bankers at spotting winners?

This paper examines the bank lending relations of a large sample of technology and nontechnology firms that went public during the 1996–2000 period. We use a unique hand-collected data set to examine the characteristics of firms that establish pre- Initial Public Offering (IPO) bank lending relations and whether post-IPO performance is related to the existence and size of pre-IPO banking relations. We find that the majority of IPO firms have banking relations before they go public. Firms with banking relations are older, more profitable or, in the case of tech firms, have lower losses, and are more likely to have funding from venture capitalists than firms without banking relations. We also find that banks lent aggressively to technology firms in the sense that current earnings and cash flows were significantly less important in determining banking relations for technology firms than for nontechnology firms. Consistent with the importance of so-called soft information in lending decisions, we find that, controlling for ex ante observable risk measures, there is a positive and significant relation between improvements in post-IPO operating performance and the existence and size of pre-IPO banking relations. Overall, our results indicate that firms with the best current and future prospects establish banking relations. Our findings provide an explanation as to why investors could interpret lending relations as a positive signal of firm quality.     

Investor protection and convertible debt design

An important issue that firms consider when designing convertible debt is to specify security features such as conversion ratio, maturity date and call period. Following Lewis et al. [Lewis, M., Rogalski, R., Seward, J., 2003. Industry conditions, growth opportunities and market reactions to convertible debt financing decisions. Journal of Banking and Finance 27, 153–181], we employ a single measure that simultaneously considers all of these features: the expected probability (measured at issue date) that the convertible will be converted to equity at maturity. We find that firms in countries with stronger shareholder rights issue convertible debt with a higher expected probability of converting to equity. The positive association between the expected probability of conversion and shareholder rights is less pronounced in firms for which ownership structures create potentially high managerial agency costs. Specifically, in countries with stronger shareholder rights, firms with higher separation of control rights and cash flow rights tend to issue convertibles with lower probability of conversion. Furthermore, we find that large non-management block ownership strengthens the likelihood of issuing convertible debt with higher probability of conversion in countries with stronger shareholder rights. In contrast, firms in countries with stronger creditor rights issue convertibles with lower probability of conversion. We also document that the negative association between creditor rights and probability of conversion is more pronounced in firms with higher separation of control rights and cash flow rights.     

The Debt Trap: Wealth Transfers and Debt‐Equity Choices of Junk‐Grade Firms

If outstanding debt is risky, issuing equity transfers wealth from equity holders to debt holders. If existing leverage is high and bankruptcy costs are small, this wealth transfer effect outweighs the gains to stockholders from optimizing firm value. Empirically, we find that for investment‐grade firms, higher leverage implies a greater likelihood of issuing equity, as expected in a standard tradeoff model. However, consistent with the impact of wealth transfer effects, for junk‐grade firms, higher leverage implies a greater likelihood of issuing debt. The analysis implies an additional route through which historical shocks determine firms’ financing choices.     

Corporate derivatives use and the cost of equity

We investigate the relation between derivatives use and corporations’ cost of equity capital. Using a large sample of non-financial firms, we compute and analyze (i) the relative cost of equity of firms that use derivatives and those that do not; and (ii) the change in cost of equity experienced by firms initiating derivatives programs. We find that the cost of equity of derivatives users is lower than non-users by 24-78 basis points. Our results are robust to specifications that account for potential endogeneity related to a firm’s derivatives use and capital structure decisions. We further find that the reduction in the cost of equity is attributable to both lower market beta and SMB beta, suggesting that firms use derivatives to reduce their financial distress risk and that this distress risk has a systematic component that is priced in the market. Finally, the observed reductions in the cost of equity tend to be largest for smaller firms and for firms utilizing currency and interest rate derivatives.     

Tunneling,propping, and expropriation: evidence from connected party transactions in Hong Kong

We examine a sample of connected transactions between Hong Kong listed companies and their controlling shareholders. We address three questions: What types of connected transactions lead to expropriation of minority shareholders? Which firms are more likely to expropriate? Does the market anticipate the expropriation by firms? On average, firms announcing connected transactions earn significant negative excess returns, significantly lower than firms announcing similar arm's length transactions. We find limited evidence that firms undertaking connected transactions trade at discounted valuations prior to the expropriation, suggesting that investors cannot predict expropriation and revalue firms only when expropriation does occur.     

Does the currency regime shape unhedged currency exposure?

This paper examines how unhedged currency exposure of firms varies with changes in currency flexibility. A sequence of four time periods with alternating high and low currency volatility in India provides a natural experiment in which changes in currency exposure of a panel of firms is measured, and the moral hazard versus incomplete markets hypotheses tested. We find that firms carried higher currency exposure in periods when the currency was less flexible. Our results support the moral hazard hypothesis: that low currency flexibility encourages firms to hold unhedged exposure in response to implicit government guarantees.     

Does religiosity enhance the quality of management earnings forecasts?

This study investigates whether firms located in areas with higher levels of religiosity disclose higher-quality management earnings forecasts than do other firms. Using a US sample of 4,655 firm-year observations over the period 2001 to 2014, we find that firms headquartered in counties with higher proportions of religious adherents issue earnings forecasts that are less optimistically biased and that the effect of religiosity is concentrated in firms with weak monitoring mechanisms. We also find that religiosity mitigates pessimistic bias in management earnings forecasts, but only for those issued by firms operating in low litigation industries. This result suggests that when the litigation risk is high, both ethicality and risk aversion are at work and their competing effects likely offset each other. Additionally, we document that forecasts issued by firms in more religious areas trigger stronger stock price reactions than those issued by other firms and that the effect is limited to forecasts containing optimistic bias. Overall, our results show that religiosity enhances the quality of management earnings forecasts, but the effect varies based on different conditions.     

The effect of state antitakeover laws on the firm's bondholders

We examine how state antitakeover laws affect bondholders and the cost of debt, and report four findings. First, bonds issued by firms incorporated in takeover-friendly states have significantly higher at-issue yield spreads than bonds issued by firms in states with restrictive antitakeover laws. Second, firms in takeover friendly states have significantly higher leverage than their counterparts in restrictive law states. Third, bond issues are associated with negative average stock price reactions among firms in takeover-friendly states, but positive stock price reactions among firms in restrictive law states. Fourth, existing bond values increase, on average, upon the introduction of Business Combination antitakeover law. These results indicate that state antitakeover laws tend to decrease bond yields and increase bond values, which is the opposite of their effect on equity values. This, in turn, implies that state laws help mitigate the agency cost of debt by shielding bondholders from expropriation in takeovers. Overall, the empirical evidence suggests that the effect of antitakeover provisions on firm value must take into account the impacts of both bondholders and stockholders.     

Cross-listing and pricing efficiency: The informational and anchoring role played by the reference price

When a firm cross-lists its shares in segmented markets, the price of the first issued share, as a reference, plays both an informational and anchoring role in pricing the second issued share. We develop a model illustrating the dual-role. Empirically, we examine a group of Chinese firms that first issue foreign shares and then domestic A-shares, for which the anchoring effect adds to the A-share underpricing. Consistent with the model predictions, we find that the A-share underpricing is positively related to the difference in costs of capital in the two segmented markets, and that this positive association is weaker when participants are less likely to resort to the anchoring heuristic and when the A-share valuation involves less uncertainty.     

The effect of credit guarantees on credit availability and delinquency rates

We use new data to examine whether credit guarantees affect economic incentives and whether they affect the credit available to small- and medium-size enterprises (SMEs). We find that firms that have both guaranteed and non-guaranteed loans are 1.67% more likely to miss payments on their guaranteed loans, but are not more likely to default on these loans. These findings suggest that guarantees affect firms’ incentives to repay loans but not their long-term performance. We also find that firms selected into the guarantee programs are 1.17% more likely to default on their loans compared with similar firms that borrow without guarantees. Since we find evidence that long-term performance is not affected by guarantees, the higher default rates among firms selected into the guarantee programs must be the consequence of adverse selection. We also find that credit guarantees increase the aggregated amount of credit; in particular, one additional dollar of guarantees increases the total credit for SMEs by US$ 0.65.     

Executive option exercises and financial misreporting

Several recent papers document that the magnitude of potential gains from stock-based compensation is positively related to the likelihood of misreporting. In a sample of firms that announce restatements of their financial statements from 1997 to 2002, we examine whether managers realize these potential gains occurring from their accounting choices. After controlling for diversification needs and stock price impact, we find no significant evidence of higher option exercises by executives in the misreported years. However, for firms that are more likely to have made deliberate aggressive accounting choices, we find significant evidence of higher option exercises. For these firms, option exercises are higher by 20–60% in comparison to industry and size matched nonrestating firms. Options exercises by executives are also increasing in the magnitude of the restatement as captured by the effect of the restatement on net income. These higher option exercises tend to be more pervasive and are not just confined to the CEO and CFO of the firm.