Why do governments repay external sovereign borrowing? This is a question that has been central to discussions of sovereign debt capacity, yet the answer is still being debated. Models where countries service their external debt for fear of being excluded from capital markets for a sustained period (or some other form of harsh punishment such as trade sanctions or invasion) seem very persuasive, yet are at odds with the fact that defaulters seem to be able to return to borrowing in international capital markets after a short while. With sovereign debt around the world at extremely high levels, understanding why sovereigns repay foreign creditors, and what their debt capacity might be, is an important concern for policy makers and investors. In our paper, Sovereign Debt, Government Myopia, and the Financial Sector, forthcoming in the Review of Financial Studies, we attempt to address these issues.

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In our paper, Corporate Funding: Who Finances Externally?, which was recently made publicly available on SSRN, we provide new information on security issues and external financing ratios derived from annual cash flow statements of publicly traded industrial companies over the past quarter-century. Our use of cash flow statements permits us to differentiate between competing forms of internal financing, including operating profits, cash draw-downs, reductions in net working capital, and sale of physical assets. Unlike leverage ratios which dominate the focus of the extant capital structure literature, our cash-flow-based financing ratios are measured using market values (cash) and are unaffected by the firm’s underlying asset growth rate.

The empirical analysis centers around three main issues, the first of which is to establish the importance of external finance in the overall funding equation. In our pool of nearly 11,000 (Compustat) non-financial firms, the net contribution of external cash raised (security issues net of repurchases and dividends) was negative over the sample period. Moreover, the average (median) firm raised merely 12% of all sources of funds externally. Also, annual funds from total asset sales contributed more to the overall funding equation than net proceeds from issuing debt.

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In our recent JLE paper, State Contract Law and Debt Contracts, we examine the association between state contract law and debt contracts. A recent stream of papers in finance and economics studies the role debt contracts play in mitigating agency problems between equity and debt holders (for example, Baird and Rasmussen, 2006; Chava and Roberts, 2008; Roberts and Sufi, 2009; Nini, Smith, and Sufi, 2009). This area of literature examines both the contract terms and the implications of covenant violations. While these studies generally treat contract law as a uniform product across states and assume that all contracts are enforced in a similar fashion, in practice lenders and borrowers select the state law that will govern the contract. Because the legal rights of both parties vary depending on the law chosen, the state contract law may be associated with enforcement. To examine this relationship, we first categorize each state’s contract law by whether it is favorable or unfavorable to lenders, and then we examine the characteristics of the contracts and the relevant parties across states. Lastly, we test whether the contract terms, frequency of covenant violations, and repercussions of covenant violations are related to the state contract law.

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In our paper, A Century of Capital Structure: The Leveraging of Corporate America, forthcoming in the Journal of Financial Economics, we shed light on the evolution and determination of corporate financial policy by analyzing a unique panel data set containing accounting and financial market information for US nonfinancial publicly traded firms over the last century. Our analysis is organized around three questions. First, how have corporate capital structures changed over the past one hundred years? Second, do existing empirical models of capital structure account for these changes? And, third, if not explained by existing empirical models, what forces are behind variation in financial policy over the last century?

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Detroit’s bankruptcy highlighted the precarious financial situation of many states, cities, and other localities (collectively referred to as municipalities). In an article just published in the UCLA Law Review, we argue that part of the blame for this situation lies with the outdated and ineffective financial reporting regime for public entities and that fixing this regime is a necessary first step toward fiscal recovery. We provide concrete examples of advisable changes in accounting rules and advocate for institutional changes, particularly involvement of the Securities and Exchange Commission (SEC).

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The Financial Industry Regulatory Authority (“FINRA”) has adopted amendments to its equity research rules and an entirely new debt research rule. Member firms should review and revise their policies, procedures and processes to reflect the new rules, and analyze what organizational structure and business process changes will be necessary.

The main differences between FINRA’s Current Equity Rules and the New Equity and Debt Rules (as defined below) are outlined in the original publication, available here. Highlights include:

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The ownership structure of corporate debt is potentially a key factor affecting the cost of financial distress. However, past studies have been hampered by the fact that observing the ownership of debt claims is difficult. In our paper, The Ownership and Trading of Debt Claims in Chapter 11 Restructurings, which was recently featured in the Journal of Financial Economics, we overcome this obstacle by using claim-level holdings and trading data on bankrupt firms collected electronically by claims administration companies. [1] For 136 large US bankruptcy cases filed between July 1998 and March 2009, these data identify the holder of each claim or the name of a custodian, the amount of the claim, information on the claim type, and, for a subset of claims, ownership transfers that occur during the bankruptcy process. We use these data to study the ownership structure of firms that have filed for bankruptcy, how ownership changes during bankruptcy, and ultimately, how ownership structure influences Chapter 11 outcomes (our data set does not include private workouts).

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In an effort to increase the visibility of pension commitments, the Governmental Accounting Standards Board (GASB) Statement 68 beginning in 2015: 1) moved pension funding information from the footnotes of financial statements to the balance sheets of employers; and 2) required employers that participate in so-called “cost-sharing” plans to provide information regarding their share of the “net pension liability” on their books as well. The Center for Retirement Research at Boston College recently completed a study that examined the impact of the new GASB rules on cities. Subsequently, the Center broadened the scope of the analysis and examined the impact on school districts and counties as well as cities, and the diminution of liabilities at the state level as a result of the reallocation.

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[On April 4, 2016], the U.S. Treasury Department issued a notice of proposed rulemaking that could significantly affect the debt capitalization of U.S. subsidiary groups owned by foreign corporations (and of foreign subsidiaries owned by U.S. corporations).

The proposed regulations would, among other things, effectively turn debt issued by a U.S. subsidiary group and held by a related foreign parent corporation into preferred equity for U.S. tax purposes, unless the debt was issued for cash that served to increase the capital of the U.S. subsidiary group, after taking any related transactions into account. For example, $1 billion of debt issued by the U.S. group to the foreign parent in exchange for $1 billion of cash would be respected as debt for tax purposes. However, such debt would not be respected as debt if (i) $1 billion of debt was simply distributed by the U.S. group to the foreign parent, (ii) $1 billion of debt was issued by the U.S. group to the foreign parent for cash, but the $1 billion of cash was later (or earlier) distributed to the foreign parent, (iii) the foreign parent sold one U.S. subsidiary to another U.S. subsidiary in exchange for $1 billion of debt in the acquirer, (iv) the foreign parent merged one U.S. subsidiary into another U.S. subsidiary in exchange for stock plus $1 billion of debt, or (v) one foreign affiliate lent $1 billion to a U.S. subsidiary and the U.S. subsidiary distributed the cash to a different foreign affiliate. The proposed regulations are broadly drafted in an effort to cover similar transactions perceived as end-runs or loopholes. These rules would likewise apply to the debt capitalization of foreign subsidiaries by U.S. parent corporations.

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In our article, Systemic Financial Degradation Due to the Structure of Corporate Taxation, which was recently posted to SSRN, we examine how financial sector safety is undermined by the structure of the corporate tax. Regulators have sought since the 2008 financial crisis to strengthen the financial system. Yet a core source of weakness and an additional instrument for strengthening, namely the effect of the corporate tax on the choice between debt and equity, is hardly on the regulatory agenda. Current corporate tax rules allow firms to deduct the cost of debt but not the cost of equity. This penalty for equity encourages high levels of debt, lower levels of equity, and concomitantly riskier firms. But this not an inevitable property of taxation. Alternative tax schemes, that are either capital structure neutral or favor equity instead of debt, exist and have been successfully tested in other countries.

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The market for corporate control has become increasingly global over the past decades, with cross-border mergers and acquisitions (M&As) now accounting for more than a third of M&A activity worldwide. To date, empirical studies that have investigated the potential cross-country spillovers in governance and legal standards mainly focused on the economic implications for shareholder wealth, relating the governance regimes in the countries of bidder and target to shareholder returns, to the takeover premium demanded by target shareholders in deals involving equity offers, to changes in the valuation of non-targeted rival firms and even of entire industries in which cross-border deals occur.

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In our paper, Dual Ownership, Returns, and Voting in Mergers, recently published in the Journal of Financial Economics, we study how the joint ownership of target’s equity and debt affects investors’ behavior and outcomes of M&A transactions.

Prior research in this area implicitly assumes that each investor holds either stocks or bonds, but not both types of securities simultaneously. We document, however, that a significant (and steadily rising) percentage of the equity of many U.S.-listed corporations is owned by financial conglomerates whose affiliates are also major company bondholders. If affiliated fund managers coordinate their actions around M&A deals, financial conglomerates with dual ownership of target equity and debt—“dual holders”—have different incentives than pure shareholders. Our results could be broken down in the following three groups.

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In a case commonly referred to as Marblegate, a federal district court recently held that a debt restructuring by for-profit education provider EDMC violated a non-impairment provision in the Trust Indenture Act (TIA), a Depression-era statute governing bond indentures. The restructuring presented bondholders with a choice between exchanging their bonds for equity and being left with claims against an empty shell by virtue of a foreclosure by secured creditors. The decision, which is currently under review by the Court of Appeals for the Second Circuit, has attracted a lot of attention in bond markets and has affected debt restructurings across the country. According to the decision, the TIA prohibits debt restructurings outside bankruptcy that “impair” a dissenting bondholder’s recovery, even if they do not change payment terms or make the bonds payable in something other than cash. The decision relied heavily on the legislative history of the statute and concluded that transactions like the one in Marblegate were precisely what Congress intended to prohibit.

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Financial reports should provide useful information to both shareholders and creditors, according to U.S. accounting principles. However, directors of corporations have fiduciary duties toward equity holders only. In our paper, Does Fiduciary Duty to Creditors Reduce Debt-Covenant Avoidance Behavior?, we examine whether this slant in corporate governance biases financial reports in favor of equity investors. In particular, we examine whether the likelihood that firms manipulate their reporting to circumvent debt covenants is higher when directors owe fiduciary duties only to equity holders, rather than when they owe fiduciary duties also to creditors. Debt covenants set limits on leverage and performance, and act as a tripwire allowing creditors to take timely actions to reduce bankruptcy risk and costs. When managers manipulate financial reports to circumvent these debt covenants, they transfer wealth from creditors to shareholders.

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The presence of equity-based incentives in executive pay, by linking the value of compensation to stock return volatility and to stock price, are seen as aligning the interests of managers with those of shareholders (Brockman et al. [2010]; Coles et al. [2006]; Dow and Raposo [2005]; Lo [2003]).

Another effect of these incentives is, however, the potential increase in the agency costs of debt related to asset substitution problems, with managers being tempted to replace safe activities with riskier ones, thus transferring wealth from debtholders to shareholders. Nevertheless, creditors understand the risk-taking incentives in executive pay and the related potential negative effects for their wealth. In this regard, Brockman et al. [2010] show that the debt maturity shortens when the risk-taking incentives in CEO pay are larger.

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In our article, Do Creditor Rights Increase Employment Risk? Evidence from Loan Covenants, which was recently accepted for publication in the Journal of Finance, we provide evidence that binding financial contracts have a large impact on employees and are an amplification mechanism of economic downturns.

A fundamental question in both finance and macroeconomics is whether financing frictions and, more broadly, firm financial conditions, have real effects. Existing empirical research on this question focuses primarily on corporate investment (e.g., Whited (1992), Rauh (2006), and Chava and Roberts (2008); Benmelech, Bergman, and Seru (2011) is a recent exception that instead focuses on employment). However, a long tradition of theoretical research in both macro (e.g., Bernanke and Gertler (1989)) and corporate finance (e.g., Berk, Stanton, and Zechner (2010)) as well as the exceptional job losses in the aftermath of the financial crisis and in the Great Recession of 2008 and 2009 highlight the potential importance of financing effects on employment, which raises two important empirical questions: Are corporate financing and labor policies related, and how? The goal of our paper is to make progress on these questions by examining the response of corporate labor policies to loan covenant violations.

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On June 30, 2016, the United States Senate passed the “Puerto Rico Oversight, Management and Economic Stability Act” (“PROMESA”) and it was quickly signed into law by President Obama. [1] PROMESA enables the Commonwealth of Puerto Rico and its public corporations and other instrumentalities in financial distress to restructure their debt. [2] The goal of PROMESA is to “bring solvency to Puerto Rico, build a foundation for future growth and ensure the island regains access to capital markets”. [3] PROMESA, though, is not limited to restructuring and enforcement of debt obligations or securities. If you lent money or extended other forms of credit, or provided goods or services, to Puerto Rico or any of its instrumentalities, PROMESA may affect you.

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Leveraged buyouts are a powerful tool to alter incentives in firms and improve their corporate governance. Despite these benefits, the use of the buyout transaction varies wildly over time. In the U.S., peak buyout years exhibit close to one hundred public-to-private transactions and trough years as few as ten. What explains this dramatic time-variation in activity? Prior literature and the popular press largely focus on how the cost of debt impacts buyout activity, as debt is a key input to the buyout transaction. Another popular explanation is a periodical form of irrational exuberance for buyouts.

In Buyout Activity: The Impact of Aggregate Discount Rates (forthcoming, Journal of Finance), we argue that these approaches miss the forest for the trees: the overall cost of capital, rather than debt alone, is the primary driver of buyout activity. We document that common changes in the cost of debt and the cost of equity—also known as the aggregate risk premium—best explain booms and busts in buyout activity. We also outline the economic mechanisms by which the risk premium influence the buyout decision.

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In a new paper, Political Lending, we investigate a previously unexplored channel that could be used by firms to enhance the wealth of individual politicians: the amount and terms of the personal debt taken on by politicians and their close family members. Personal debt is economically significant as liabilities are close to 40% of the overall net worth of the average U.S. congressional member.

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Facing a self-declared “death spiral” of public debt, the Governor of Puerto Rico announced a debt moratorium earlier this year, halting payments to bondholders. A series of missed payments followed, including a landmark default on constitutionally guaranteed bonds in July. At the same time, Congress passed the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA or “promise” in Spanish), which combines a debt restructuring system with federal controls over the island’s finances. But enacting PROMESA is only a first step. Coordination and engagement with creditors is the next step—and an even more complicated one—in Puerto Rico’s long journey towards solvency and fiscal stability.

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