Stockholder-bondholder Conflict Research Articles

The Effect of Managerial Share Pledges on the Cost of Debt

We examines whether share pledges by controlling shareholders influence a firm’s cost of debt. We also investigate whether the relationship between share pledges and the cost of debt stems from the managerial risk-taking incentives or pursuing the private benefits of controlling shareholders. We make three major findings. First, we find the cost of debt is higher in firms with share pledges than in firms without share pledges. Furthermore, we identify a positive relationship between the cost of debt and the level of share pledges. Second, we find that there is no increased corporate financial leverage or investment activities in firms with share pledges. Finally, our empirical evidence demonstrates that the positive relationship between share pledges and cost of debt is more pronounced for lower foreign institutional investor stakes or higher controlling shareholders ownership. Overall, the results indicate that share pledges by controlling shareholders negatively affect the cost of debt. However, the effect of share pledges on the cost of debt is differently influenced by a firm’s ownership structure. Our findings suggest that share pledges induce stockholder-bondholder conflict, and the bondholder requires more risk premium due to the decrease of firm value.

Catering to investors through capital expenditures: Testing assets substitution problem around financing

We test the catering theory, which describes how investor preferences might influence individual firms' investment financing decisions. To the best of our knowledge, our study may well be the first that directly connects catering with asset substitution to contrast the magnitude of catering by bondholders and shareholders. And indeed, it is interesting to find that although catering behavior is found to exist among both corporate bond and seasoned equity offering (SEO) managers, the coexistence of both appears to offset the abnormal investment phenomena of either underinvestment or overinvestment. The study results further reveal that firms engage in overinvestment when catering to conversion holders of existing convertible bonds. Taken together, we find that support for the asset substitution and abnormal investment argument is strong from a stockholder–bondholder conflict.

Co-opted boards and capital structure dynamics

This study examines the effects of co-opted directors and further tests the monitoring effectiveness of non-co-opted independent directors and co-opted independent directors on capital structure decisions. Employing a large sample of 2548 US firms over the 1996–2015 period, we find strong evidence that co-opted boards exert a positive and significant influence on firms' financial leverage. We also find that, whereas co-opted independent directors are positively associated with financial leverage, non-co-opted independent directors have a negative influence on a firm's leverage ratio, suggesting that co-option weakens the effective monitoring, thereby increasing the firm's leverage ratio. Further analysis indicates that co-opted boards adjust towards target leverage levels at a faster speed, with a half-life within a year for book and market leverage. Lastly, our results show that the agency costs of managerial discretion and stockholder-bondholder conflicts arising from board co-option are important drivers of financial leverage relative to tax incentives. Our results are robust to alternative measures of board co-option, financial leverage, and endogeneity concerns.

Cláusulas Restrictivas (covenants) en los contratos de bonos: evidencia empírica en Chile

Within financial literature aimed at analyzing agency issues, a particularly interesting aspect of it corresponds to the conflict that arises between stockholders and bondholders. There is a fair amount of literature that dissects the different manifestations or outcomes that such a conflict might generate, as well as the possible ways of solving these, one of which is the use of covenants in debt contracts. This paper presents a discussion in the main features of the stockholder-bondholder conflict, a description of the regulatory framework of bond issuance in Chile and a clinical assessment of the characteristics of the covenants used in Chile, from 1987 to 2000, specially emphasizing of certain specific clauses in the Chilean debt market. This paper shows that the covenants most widely used in the Chilean Market, are those related to the claim dilution problem (83% of the contracts restrict the either financial policy or the capital structure).

Investment timing and optimal capital structure under liquidity risk

ABSTRACTDeterioration in debt market liquidity reduces debt values and affects firms' decisions. Considering such risk, we develop an investment timing model and obtain analytic solutions. We carry out a comprehensive analysis in optimal financing, default, and investment strategies, and stockholder–bondholder conflicts. Our model explains stylized facts and replicates empirical findings in credit spreads. We obtain six new insights for decision makers. We propose a ‘new trade-off theory’ for optimal capital structure, a new tax effect, and new explanations of ‘debt conservatism puzzle’ and ‘zero-leverage puzzle’. Failure in recognizing liquidity risk results in substantially over-leveraging, early bankruptcy or investment, overpriced options, and undervalued coupons and credit spreads. In addition, agency costs are surprisingly small for a high liquidity risk or a low project risk. Interestingly, the risk shifting incentive and debt overhang problem decrease with liquidity risk under moderate tax rates while they increase under high tax rates.

Joint Determination of Leverage and Managerial Incentive Compensation: Theory and Evidence

This paper investigates how capital structure and managerial compensation are jointly determined within a contingent claims model where the two interact through manager-stockholder and stockholder-bondholder conflicts. In the presence of frictions, agency conflicts affect investment decisions and, hence, firm value. Rational stockholders set financial policies and managerial compensation simultaneously, to minimize the distortion caused by these conflicts. This joint optimization creates a tradeoff between leverage and managerial incentive compensation: equity holders would avoid setting both high. The model predicts that due to the tradeoff between the two, key firm characteristics should move the two in opposite directions. This article also reports empirical evidence strongly supporting the model by estimating simultaneous equations of market leverage and pay-performance sensitivity. The negative correlation between the two dependent variables is captured in the opposite effects from key firm characteristics. After controlling for the tradeoff, market leverage and pay-performance sensitivity have a positive relation.

Corporate cash holdings and CEO compensation incentives

We examine the effect of chief executive officer (CEO) compensation incentives on corporate cash holdings and the value of cash to better understand how compensation incentives designed to enhance the alignment of manager and shareholder interests could influence stockholder-bondholder conflicts. We find a positive relation between CEO risk-taking (vega) incentives and cash holdings, and we find a negative relation between vega and the value of cash to shareholders. The negative effect of vega on the value of cash is robust after controlling for corporate governance, is stronger in firms with high leverage, is reversed for unlevered firms, and is not present in financially constrained firms. We also find that the likelihood of liquidity covenants in new bank loans is increasing in CEO vega incentives. Our evidence primarily supports the costly contracting hypothesis, which asserts that bondholders anticipate greater risk-taking in high vega firms and, therefore, require greater liquidity.

Corporate Cash Holdings and CEO Compensation Incentives

We examine the effect of CEO compensation incentives on corporate cash holdings and the value of cash to better understand how compensation incentives designed to enhance the alignment of manager and shareholder interests may influence stockholder-bondholder conflicts. We find a positive relation between CEO risk-taking (vega) incentives and cash holdings, and we find a negative relation between vega and the value of cash to shareholders. The negative effect of vega on the value of cash is robust after controlling for corporate governance, is stronger in firms with high leverage, is reversed for unlevered firms, and is not present in financially constrained firms. We also find that the likelihood of liquidity covenants in new bank loans is increasing in CEO vega incentives. Our evidence primarily supports the costly contracting hypothesis, which asserts that bondholders anticipate greater risk-taking in high vega firms and therefore require greater liquidity.

The Role and Structure of Debt Covenants

Through this paper, I discuss the existing research on the topic of debt and covenants and I intend to answer the following questions: i) Why is debt considered a governance mechanism?; ii) Are debt covenants supporting debt as an incentive mechanism?; iii) How and in what conditions can debt covenants mitigate the stockholder-bondholder conflict? and iv) How are debt covenants structured? The answers to the questions will encapsulate the role and structure of debt covenants in the context of debt governance.

Interactions of corporate financing and investment decisions: The effects of agency conflicts

We examine interactions between flexible financing and investment decisions in a model with stockholder–bondholder conflicts over investment policy. We find that financial flexibility encourages the choice of short-term debt thereby dramatically reducing the agency costs of under- and overinvestment. However, the reduction in agency costs may not encourage the firm to increase leverage, since the firm's initial debt level choice depends on the type of growth options in its investment opportunity set. The model has a number of testable predictions for the joint choice of leverage and maturity, and how these choices interact with a firm's growth opportunities.

An Empirical Analysis of the Stockholder-Bondholder Conflict in Corporate Spin-Offs

Spin-off announcements affect bondholders in two possible ways. Bondholders may profit from the increase in the total firm value that is caused by a spin-off. On the other hand, they may also suffer from a wealth transfer from bondholders to shareholders, because they loose part of the coinsurance effect that occurs in diversified firms. This problem is studied by analyzing daily stock and bond abnormal returns around spin-off announcements. Over a three-day event window, we find statistically significant abnormal returns of 3.07% for shareholders and 0.11% for bondholders. The latter result contrasts a finding by Maxwell and Rao (2003) who use monthly bond returns. Both stock and bond abnormal returns are higher for firms with higher pre-spin-off leverage and lower interest and dividend payouts. Focus-increasing spin-offs are associated with higher abnormal returns for shareholders, but not for bondholders. Overall, we find that the firm value increase compensates for the wealth transfer effect and that bondholders' wealth is not reduced as a result of spin-off.

Does Capital Structure Matter in Setting CEO Pay?

I examine how CEO compensation packages and pay-performance sensitivities are related to firms' capital structures. The results are fully consistent with shareholders designing compensation contracts not only to align incentives with managers, but also to mitigate stockholder-bondholder conflicts regarding risk-taking. The evidence is also weakly consistent with higher debt reducing manager-shareholder conflicts. Specifically, I find that CEOs in more levered firms have lower pay-performance sensitivities estimated by the empirical relation between changes in a CEO's firm-related wealth and changes in shareholder wealth. Closer examination reveals that pay-performance sensitivity decreases in straight-debt leverage, but is higher in firms with convertible debt. In addition, stock option policy is the component of CEO pay that is most sensitive to cross-sectional differences in capital structure.

What is a Dollar Worth? The Market Value of Cash Holdings

A curious fact of financial markets is that some firms have cash holdings in excess of their market value. To highlight this point, the Wall Street Journal reported that several firms had negative enterprise values (the market value of a company plus its debt and preferred stock minus its cash). This phenomena raises the obvious question: What value do investors place on the cash holdings of a firm? This study addresses this phenomena by investigating the market value of cash held by firms. In general, we estimate the value of a marginal dollar of cash to be about $1.20. However, we find large cross-sectional differences consistent with existing theory on what investors think are most important in firm valuation. We document that the quality and volatility of the firm's investment opportunity set as well as the magnitude of stockholder-bondholder conflicts impact the value shareholders place on cash holdings. Firms with good growth options have their cash valued at a premium to those with poor growth prospects. Additionally, cash is valued less in firms with stable investment programs and those nearer to financial distress. We do not find that access to the capital markets affects shareholder's valuation of cash holdings. Overall, it appears that the investment opportunity set, rather than the financing opportunity set of the firm affects the value that shareholders place on a firm's cash holdings.

Measuring investment distortions arising from stockholder–bondholder conflicts

We examine the importance of stockholder–bondholder conflicts in capital-structure choice. Numerical techniques are used to compute the expected wealth transfer between stockholders and bondholders when a firm adopts a new project. We characterize the set of positive NPV projects that stockholders prefer to ignore and the set of negative NPV projects that stockholders want to accept. The results illustrate how these distortions vary with firm and project characteristics. We also estimate the impact of stockholder–bondholder conflicts on investment decisions for 23 different firms and examine the extent to which stockholder-bondholder conflicts explain observed cross-sectional variation in capital structures.

Executive Stock Options and the Mediation of Stockholder-Bondholder Conflicts

Financial leverage does not distort investment decisions if executives are paid to maximize total firm value rather than equity value. Existing models of this idea imply that stock-based incentives should be negatively related to firm leverage, a prediction that has little empirical support. We show that the risk distortions induced by financial leverage can be overcome without diluting effort incentives by adjusting the exercise price of executive stock options. We also show that the necessary adjustments are similar to the common practice of granting options at-the-money. We then empirically examine the risk incentives of executive stock option plans in a large sample of Canadian firms. The evidence consistently supports the hypothesis that executive stock options mitigate the risk-taking incentives of shareholders in levered firms.

An empirical investigation of the role of indenture provisions in determining bond ratings

This paper documents the occurrence of indenture provisions of newly issued bonds and the relevance of these provisions to a bond's rating. A chronicle of the various combinations of restrictive covenants reveals that four covenant combinations account for over 90% of the issues. The evidence also suggests that convertibility of an issue vitiates stockholder-bondholder conflict because these issues have few, if any, restrictive covenants. Also, the indenture provisions of low rated, subordinated issues appear to reflect a concern about the underinvestment problem while the opposite holds for high rated, nonsubordinated issues. The addition of indenture provisions to a bond rating model is shown to create a model superior to previous rating models. This finding highlights the complex nature of the corporate financial contracting process. Consistent with past evidence, Moody's ratings are predicted more accurately than S&P's ratings and split rated issues are predicted less accurately than commonly rated issues.

Stockholder-bondholder conflict and dividend constraints

This paper examines a large, randomly chosen, sample of bond indentures focusing on the constraints they set on dividend payments that have the potential to transfer wealth from the bondholders (i.e., payments which are financed by a new debt issue or reduced investment). The nature of these restrictions support the hypothesis that bond convenants are structured to control the conflict of interest between stockholders and bondholders. Further, the empirical evidence suggests that these constraints are not binding — i.e., stockholders do not pay themselves as much dividends as they are allowed to. Explanations of this puzzling empirical regularity are suggested.