In a decision issued on September 19, 2016, the U.S. District Court for the Southern District of New York ruled that bondholders were entitled to a “make-whole” redemption premium, as opposed to a repayment at par, following a default by the issuer under the related bond indenture. The decision raises important considerations for issuers of debt securities that contain similar provisions.

On September 19, 2016, the U.S. District Court for the Southern District of New York granted summary judgment to Wilmington Savings Fund Society, FSB, with respect to claims brought against Cash America International, Inc. in Wilmington Savings’ capacity as trustee under the indenture governing $300 million of Cash America’s outstanding notes. Wilmington Savings claimed that Cash America violated a covenant in the indenture when it disposed of 80 percent of a wholly owned subsidiary to its shareholders in the form of a dividend of the subsidiary’s stock. Wilmington Savings also claimed that the proper remedy for Cash America’s breach would be an award requiring Cash America to redeem the notes, including payment of the specified “make-whole” redemption premium under the indenture, as opposed to accelerating the maturity date and a repayment at the par value of the notes.

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Deleveraging is central to capital structure dynamics, yet systematic analysis of the phenomenon is limited to a handful of prior studies that examine changes in average leverage for samples of firms selected to have high and/or recently increased leverage ratios. Having a more complete understanding of the nature and extent of deleveraging is of first-order importance for corporate finance research where the Holy Grail is an empirically credible theory of capital structure. This issue is also important for macroeconomics where there is a need to understand corporate deleveraging in more normal times to have a baseline for gauging its hypothesized major role in generating periods of serious economic torpor such as the Great Depression, Japan’s Lost Decades, and the Great Recession.

In this paper, we examine corporate deleveraging using a firm-level longitudinal approach, and reach sharply different conclusions from prior studies, whose findings suggest that firms with high leverage tend to deleverage only modestly.

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On November 17, the U.S. Court of Appeals for the Third Circuit (the “Court”) made clear its stance on the question of enforceability of make-whole provisions in bankruptcy. [1] Bucking the recent trend seen in cases such as In re MPM Silicones, LLC, No. 14-22503-RDD, 2014 WL 4436335 (Bankr. S.D.N.Y. Sept. 9, 2014), aff’d, 531 B.R.321 (S.D.N.Y. 2015) (“Momentive”), the Court determined that such provisions, which are intended to compensate lenders for interest lost when borrowers pay notes prior to a specific date, are enforceable in bankruptcy notwithstanding the fact that bankruptcy filings often accelerate maturity.

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On January 17, 2017, the Second Circuit Court of Appeals (the “Court”) held that Section 316(b) of the Trust Indenture Act of 1939, as amended (“TIA”), prohibits only non-consensual amendments to an indenture’s core payment terms (the amount of principal and interest owed and the date of maturity) [1]. This holding reversed the decision of the District Court for the Southern District of New York (the “SDNY”) [2], which had held that an out-of-court restructuring that involved the elimination of a parent guarantee and a significant asset transfer was impermissible under Section 316(b) of the TIA because such actions impaired the nonconsenting noteholders’ right to receive payment. [3]

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Empirical evidence suggests that asset pledgeability, debt complexity, and valuable control rights of dispersed debt influence the resolution of financial distress. Firms that borrow from multiple uncoordinated creditors and have more tangible assets often fail to renegotiate debt out of court and inefficiently file for bankruptcy. But the current theoretical literature is at odds with the evidence. Existing models predict inefficient bankruptcy filings to be negatively associated with both asset pledgeability and the number of debtholders. In our paper, we bridge the gap between existing models and evidence on distress resolution proposing a broader financial contracting model and testing its predictions using an exogenous variation in the court’s ability to price assets. We analyze the effect on bankruptcy filings and firm debt capacity after the 1999 U.S. Supreme Court ruling that reorganization plans in which equity holders keep an interest must be exposed to a “market test.”

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Minority equity investments in public companies are on the rise. These are often structured as an investment in convertible preferred stock to give the investor a senior position to other equity while preserving equity upside through the ability to convert to common stock.

This trend is likely sparked by a search for higher yield than is afforded by an investment in debt in a low interest rate environment, less appetite for “big ticket” full buyouts, and the attractiveness to issuers of not using up their permitted debt baskets or leveraging their balance sheet.

While the investor is willing to give up the seniority of a debt position, it is still keenly focused on optimizing its right to receive repayment of its preferred investment on the contractually stipulated redemption date and to receive its contractually stipulated dividends on each dividend payment date.

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A make-whole premium is a contractual penalty a borrower must pay for prepaying a loan. In several recent bankruptcy cases, the court ruled that the debtor triggered its make-whole obligations by voluntarily filing for bankruptcy and thereby accelerating all of its debts. In such cases, the questions then arise whether, and at what level of priority, the make-whole premium is recoverable as a statutory matter from the bankruptcy estate.

In a forthcoming book chapter, I argue that a make-whole premium automatically triggered by a bankruptcy filing shifts risk onto the debtor’s general creditors and thus increases the agency costs of debt. Risk-shifting occurs because a make-whole that is automatically triggered by a bankruptcy filing is an instance of correlation-seeking: the incurring of a contingent liability whose risk of being triggered correlates positively with the debtor’s insolvency risk. Correlation-seeking generates social costs that reduce the joint surplus from lending arrangements. The anticipation of it induces creditors to incur monitoring costs and debtors to incur bonding costs. When correlation-seeking is undeterred, it encourages overinvestment: the committing of capital to projects that are expected to benefit the firm’s shareholders only because they are subsidized by a transfer of value away from general creditors.

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The article Corporate Debt Maturity Profiles, forthcoming in the Journal of Financial Economics, studies a novel aspect of a firm’s capital structure, namely the dispersion of debt maturities. Extant literature offers little guidance on this aspect of capital structure, and lack of evidence is at variance with practitioners emphasizing that rollover risk affects debt maturity choice. Surveys of financial managers often suggest that avoiding so-called “maturity towers” (i.e. spreading debt maturity dates over time) is a key factor when firms choose debt maturities.

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This paper is motivated by two considerations. First, prior research argues that as a firm grows older, it should use more debt as it has more assets-in-place and fewer growth options. Second, prior research argues that as firms age after going public, their governance should adapt to their changing needs. Thus, our paper combines both considerations to examine how the age of a firm since going public affects how its governance influences its capital structure choices.

To address this issue, we must confront a number of empirical issues ignored by related prior research. For example, the factors influencing the decision to use debt may differ from the factors that determine how much debt the firm uses. This issue is more serious than often recognized since a large number of U.S. corporations, about 21.8% of Compustat companies during our sample period, use no long-term debt financing and are called “all equity” firms.

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The view that bankers’ compensation created the incentives that led to the latest financial crisis has prompted numerous proposals to regulate pay at financial institutions. [1] However, despite the attention devoted to executive pay by regulators, extant research provides mixed support for the hypothesis that CEO compensation in the run-up to the crisis influenced bank risk taking. Thus, although some authors find a positive relation between CEO risk-taking incentives and bank risk or policy choices, others find no such relation. Notably, Fahlenbrach and Stulz (2011) [2] find no significant relation between the most commonly used measure of the risk-taking incentives generated by executive compensation (vega) and bank performance during the crisis. [3]

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Final bill retains key aspects of House and Senate proposals with some surprise last-minute modifications.

On December 15, 2017, a conference committee composed of members of the US House of Representatives and the US Senate approved a Conference Report (the Report) reconciling the tax reform bills passed by each chamber. Both the House and the Senate approved this final legislation on December 20, 2017.

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A casual observer of recent policy debates might reasonably conclude that sovereign debt crises of the sort that have ravaged Argentina, Greece, Ukraine, and Venezuela would be less frequent and less damaging if only debtors and creditors could tweak a few words in their bond contracts. Contract reform got a boost from successful enforcement litigation against Argentina in the United States. The government’s 2001 default helped make coordinated change in standardized bond terms the consensus alternative to controversial sovereign bankruptcy proposals: it was elegant, pragmatic, and inoffensive by comparison. More than a decade later, enforcement against Argentina hinged on a single clause, blocked payments to cooperating creditors, and netted some holdouts more than ten times their original investment by 2016. The message could not be clearer: change the clause, fix the problem. (more…)

In our paper, Are Financial Constraints Priced? Evidence from Textual Analysis, forthcoming in the Review of Financial Studies, we develop a new measure of financial constraints based on the narrative portions of company annual reports and use this measure to revisit the question of whether financial constraints affect stock returns. Financial constraints arise from frictions such as information asymmetries that make external funds more costly than internal funds, sometimes prohibitively so. An example of a financially constrained firm is a rapidly growing company that has good investment projects but faces difficulties obtaining all of the necessary outside financing to fund its growth. Although financial constraints are easy to understand on this conceptual level, it remains an empirical challenge to quantify them and thus to understand their implications. For example, the academic literature has produced many measures of financial constraints based on accounting data, but these measures are likely noisy, as accounting statements contain no direct information on potential investment projects or desired financing needs.

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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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