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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We have recently seen an increase in contentious disputes, some public and many not, between companies and their debt investors. Clashes between borrowers and their lenders are as old as debt itself, but what we are seeing now is something different. In these situations, debt investors are not merely seeking to enforce their contractual entitlement to payment, or to challenge transactions that will impair the borrower’s ability to pay. Rather, they are purchasing debt on the theory that the borrower is already in default and then actively seeking to enforce that default in a manner by which they stand to profit. Call it Default Activism: default as opportunity rather than risk.

In our recent post The Rise of the Net-Short Debt Activist, we discussed one type of default activism: namely, a “net-short” strategy under which an activist amasses a large “short” position in a company together with a smaller “long” position, and then uses the long position to assert that the company is in default on its debt, so that it can reap gains on its short position.

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Millions of Americans rely on mutual fund investments to pay for their retirement, but mutual funds contain hidden, previously under-appreciated risks.

Our new study, forthcoming in the Journal of Empirical Legal Studies, provides evidence that mutual funds borrow in an attempt to improve their performance. But those attempts not only fail to boost average returns, they also increase the volatility of returns, potentially creating serious problems for those who need to withdraw their money at a time when the market is down.

The Investment Company Act of 1940 permits mutual funds to have a capital structure that is up to one-third debt. Our paper is the first to study the performance of open-end funds that exploit their statutory borrowing authority.

We constructed a database using information contained in annual filings of open-end domestic equity funds covering 17 years from 2000 to 2016. A surprising number of funds—18 percent—bulked up at some point by borrowing money for leverage. These borrowing funds underperform their non-borrowing peers by 62 basis points per year on a total return basis, while also incurring greater risk. After accounting for risk, borrowers underperform by 48 to 72 basis points annually. We find that funds borrow in an unsuccessful effort to juice performance after having lagged in the mutual fund rankings.

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Classic finance theory—from the framework created by Jensen and Meckling—observes that while debt can mitigate the conflict between equity and management, the issuance of credit creates a conflict between debt and equity. To explore the latter conflict, we take advantage of the insight that once a firm creates a debt-equity conflict through the issuance of debt, if the firm’s management, on behalf of equity, is to exploit the firm’s creditors, the optimal vehicle for such exploitation is additional debt, senior debt in particular. Despite recent conjecture that risk averse managers eschew the exploitation of credit, we predict, and find, that the debt-equity conflict, fueled by distressed firms’ issuance of secured credit, is a live problem for firms, one worthy of consideration.

Consistent with our hypothesis, critics of secured finance, argue that financially vulnerable firms use priority credit to externalize (at least in an ex post sense) the risk of failure. On this view, the winners are a coalition of a debtor’s shareholders and secured creditors, which share investment’s upside, at the expense of the debtor’s unsecured creditors, who bear the downside. And because the debtor may be more interested in enhanced risk that favors junior interests than expected return to the firm, the expected loss may well exceed the expected gain. The threat of such inefficient overinvestment has led some to call for a reduction in secured credit’s priority.

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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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Almost half of all the coal produced in the United States is mined by companies that have recently gone bankrupt. As we explain in a recent article in the Stanford Law Review, those bankruptcy proceedings have undermined federal environmental and labor laws. In particular, coal companies have used the Bankruptcy Code to evade congressionally imposed liabilities requiring that they pay lifetime health benefits to coal miners and restore land degraded by surface mining. Using financial information reported in filings to the Securities and Exchange Commission and in the companies’ reorganization agreements, we show that between 2012 and 2017, four of the largest coal companies in the United States succeeded in shedding almost $5.2 billion of environmental and retiree liabilities. These regulatory debts constituted 22% of the total debt discharged.

Coal companies disposed of these regulatory obligations by placing them in underfunded subsidiaries that they later spun off. When the underfunded successor companies liquidated, the coal companies that originally incurred the obligations managed to get rid of their regulatory obligations without defaulting on the pecuniary debts they owed to their creditors. Peabody Energy pioneered this strategy in 2007, when it spun off a subsidiary called Patriot Coal. Patriot received 13% of Peabody’s coal reserves, 40% of its healthcare obligations, and $233 million in environmental clean-up costs. A year later, Arch Coal divested itself of 12% of its assets and 97% of its retiree and healthcare liabilities by giving those assets and liabilities to Patriot. At that point, Patriot held more than $2 billion in environmental and healthcare liabilities that had originally been incurred by Peabody and Arch. When Patriot filed for bankruptcy, first in 2012 and again in 2015, it wiped out legacy Arch and Peabody environmental and retiree obligations. Similarly, when Peabody itself filed for bankruptcy in 2016, it shifted hundreds of millions of dollars in environmental obligations onto a subsidiary called Gold Fields, which was spun off as a liquidating trust. Gold Fields had assets of roughly $6 million against claims of almost $13 billion, including at least $745 million in environmental claims.

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In our prior memos The Rise of the Net-Short Debt Activist and Default Activism in the Debt Markets, we discussed the phenomenon of “Debt Default Activism,” in which investors purchase debt on the thesis that a borrower may already be in default, and then seek to profit from the alleged default, by, for example, triggering a credit default swap (or “CDS”) payout or trading various interests around the negative news generated by the default allegation.

In February, the most prominent example of Debt Default Activism came to a conclusion. Aurelius, a bondholder of telecom services provider Windstream that was reported to be economically “net-short” Windstream through CDS, prevailed in litigation with Windstream over a complicated debt covenant issue.

Windstream’s “long-only” debtholders, whose rights were nominally vindicated by the decision, were not happy. They had voted overwhelmingly to waive the alleged covenant default (the court concluded that those consents were not valid) in order to avoid exactly the result that ensued: Windstream’s bankruptcy. The long-only creditors had good reason to aid Windstream’s attempt to stave off Aurelius’ challenge. With Windstream’s bankruptcy, the value of their positions plummeted, illustrating that Debt Default Activism can harm not only corporate borrowers but also their creditors.

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What role does collateral play in corporate borrowing? At one level, the answer is straightforward. Collateral consists of hard assets, which are not subject to asymmetric valuations in markets and which the borrower cannot alter easily. Collateral gives comfort to a lender that even if she does little to monitor the borrower’s activity, and even if a borrower’s cash flow proves inadequate to service the debt, the lender’s claim is protected by underlying value. An extensive theoretical literature spanning law, economics, and finance shows that collateral protects the lender’s claim against strategic default by the borrower and alleviates financial frictions stemming from borrower moral hazard and adverse selection. In addition, some have suggested that collateral is an effective way of protecting debt against subsequent dilution by the debtor. When an effective system of seniority of claims is not available, creditors who register the collateral backing their debt with a collateral registry effectively establish the seniority of their debt claim, at least up to the value of that collateral.

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These days, humanity’s top priority is our personal health and safety as well as that of our families and our employees. The fact that I am still working signals another key priority: keep the cash coming through the company door—and preserve it as much as possible. There is a lot of discussion about these priorities and the various trade-offs they entail, how they should be ordered and how companies should organise and govern themselves to effectively address them. But the topic of this post is not today but the “day after”.

Sooner or later corporate boards and leaders will emerge from their domestic trenches to rebuild their company’s—and the world’s—economic future. And the future will not be what was imagined in pre-coronian times. This note proposes a seven-point framework for organising corporate leadership’s thinking on this radically different “day after”. The seven points are: interconnectedness; the macro-political economy; perceptions of risk; consumer preferences; technological acceleration; work organisation; and the role of the state. In my view, there will be notable shifts in all these areas, although opinions may differ as to what these shifts will entail and what they will mean for each firm.

It is the job of the board to build a view of this new world and the opportunities and threats it presents to each firm. These seven points will hopefully help to crystallise these views, to develop useful scenaria against which the firm might identify such opportunities and threats, and to map a strategic way forward. They might also elucidate potential “doomsday” moments and build reverse stress approaches for their avoidance.

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Introduction

Rich and poor countries alike are facing an unprecedented economic crisis as they attempt to contain the impact of the COVID-19 pandemic. A downturn of this magnitude can cause tremendous long-term damage, with critical economic linkages between employees, businesses, and banks at risk of disappearing forever. Scores of firms will close permanently unless urgent action is taken. The threat is even more significant for emerging economies, where the economic costs of social distancing are likely to be higher, and where vulnerable small and medium sized enterprises with low cash reserves account for a much larger share of the economy than in rich countries, which moreover can rely on extensive social and economic safety nets. Poor countries, moreover, have far more precarious health-care systems. The funds required to support vulnerable workers and businesses, and to care for COVID-19 patients, could be as high as 10% of their GDP. As a comparison, in the US the rescue measures passed in the last month alone account for at least 10% of GDP, and are likely to increase even more. (The $2.3 trillion dollar rescue package in the US is 10.6% of US GDP in 2019; here). A number of European countries have commited loans, equity injections and guarantees up to 35% of GDP. (IMF 2020, Fiscal Monitor April 2020, Figure 1.1).

The COVID-19 crisis has led to a sudden collapse in capital flows to emerging and developing countries. According to estimates by the Institute of International Finance, non-resident portfolio outflows from emerging market countries amounted to nearly $100 billion over a period of 45 days starting in late February 2020. For comparison, in the three months that followed the explosion of the 2008 global financial crisis, outflows were less than $20 billion. (here).

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The SEC has declared immediately effective (yet another) proposed change to the rules of an exchange—this one from the NYSE. The NYSE has adopted new Section 312.03T of the NYSE Listed Company Manual, which will provide a temporary exception, through June 30, 2020, from the application of the shareholder approval requirements for specified issuances of 20% or more of the outstanding shares (Section 312.03) and, in certain narrow circumstances, by a limited exception for issuances to related parties or other capital-raising issuances that could be considered equity compensation (Sections 312.03 and 303A.08). Although not entirely congruent, the exception appears to be modeled closely on the comparable Nasdaq exception that was approved just over a week ago. (See this PubCo post.) In light of the unprecedented disruption in the economy as a result of COVID-19, many listed companies “are experiencing urgent liquidity needs during this period of crisis due to lost revenues and maturing debt obligations.” The temporary exception is designed to respond to this unprecedented emergency and to help companies access necessary capital quickly.
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The existing Chapter 11 bankruptcy process is time-consuming and financially costly for firms, which causes many firms that file for bankruptcy to eventually liquidate due to the value dissipation during bankruptcy (see, e.g., Morrison (2007) and Hotchkiss et al. (2008)). This leads to significant social and private costs, and reduces the documented tax-shield and agency-cost-reduction benefits of corporate leverage. In No-fault Default, Chapter 11 Bankruptcy, and Financial Institutions, we propose and theoretically analyze the idea of a “no-fault-default” structure for corporate debt, which facilitates harvesting the benefits of leverage without the associated deadweight costs of bankruptcy.

The main idea of no-fault-default debt is to enable the firm to transform its debt claims into equity claims upon default on the debt, thus allowing a reallocation of control rights to bondholders with minimal disruption of the business operations of the firm. Put differently, when a bondholder demands payment at maturity, the company can choose to make the payment or surrender equity in the company. If the company does not have enough funds to make the promised payment to the bondholders, the bond converts automatically into equity—a transaction not requiring bankruptcy—and the firm also issues new debt with a longer maturity in exchange for the old debt. If the current shareholders wish to maintain corporate control, then they would need only to put up additional cash needed to buy the new equity. As with normal debt, other features like covenant restrictions—such as provisions which trigger early payment to the bondholders—can be included. We also show that no-fault-default debt remains feasible, with some modifications (such as adding a conversion option) even in the presence of well-known frictions like risk-shifting moral hazard.

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In a recent paper, I point out that access to credit sometimes provides a provide a path out of poverty and even a gateway to real prosperity for those who use the funds to start a business, but when credit is granted improvidently it can lead to financial ruin for the borrower up to and including homelessness and food insecurity. In light of the extreme range of consequences from the granting of consumer credit, it is peculiar that the various extant regulatory approaches to consumer lending do not distinguish between these two wildly disparate effects of the lending process. Rather current approaches to regulation focus almost exclusively on disclosure of certain features of the loan and the annual percentage rate (“APR”) associated with the loan.

A better regulatory approach would be to utilize the analytic framework developed in this paper, which utilizes the effects of borrowing on the balance sheet of the household taking on consumer debt. The key to this framework is based on the fact that it is easy to determine how the proceeds from a particular loan will be allocated, because borrowers must generally inform lenders about how the proceeds of a loan will be deployed. With this basic, non-technical, yet critical item of information, it is possible to determine whether, ex ante (which in this context means at the moment the loan is made), the immediate effects of the loan on the borrower’s balance sheet.

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The establishment and use of internal investigations, whistleblowing and external monitoring is a topic of current importance for scholarship, legislation and corporate practice. Internal investigations into (suspected) legal violations by companies, sometimes triggered by whistleblowing and, of late, sometimes tracked by external monitoring are components of corporate compliance. These three information and enforcement channels relate to the core area of corporate management and they are a task of the management and/or the board. The Board must investigate suspected legal violations in the company, but it has broad discretion as to the manner in which the specific violation of law should be addressed and as to the necessary scope of the inquiry. In practice, a typical sequence of a stages and steps has been established in practice for internal investigations: (1) Indication of an incident: plausibility assessment, preparation, possible ad hoc measures, investigation; (2) Legal assessment of the interim result based on the facts at hand, data analysis and interviews; (3) Result and reporting: measures, tracking, follow-up and identification of lessons learned. There is a broad and detailed body of comparative legal experiences from the USA, the United Kingdom, Switzerland and other European countries on internal investigations, whistleblowing and external monitoring. These experiences are reported in detail in the corresponding article in the European Company and Financial Law Review (ECFR) 2021, October issue.

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For those seeking watershed moments in contemporary contract law, the area of corporate debt seems an unlikely target. Though gargantuan in size, debt markets have a storied reputation as a refuge for the risk averse—participants expecting stable payouts, low volatility, and few surprises. Nevertheless, corporate debt contracts are themselves notably lengthy and complex. When parlayed with the immense financial sums at stake, that complexity can become a recipe for calamity. And in late 2020, calamity struck in the form of a nearly $1 billion accidental payoff sent to Revlon Inc.’s distressed creditors—not by Revlon itself but rather by Citibank, the administrative agent for the loan. When several lenders refused to return the cash, Citibank commenced what many reckoned would be a successful (if embarrassing) lawsuit to claw it back. But in a dramatic 2021 opinion, a New York federal court sided with the debtholders, applying an obscure equitable doctrine known as the “Discharge for Value” defense. The lenders could keep their wayward windfall, and Citibank got stuck with a sizeable write-down. The decision is currently on appeal to the Second Circuit; but whatever its ultimate resolution, the case seems destined to feature prominently in contracts classes and textbooks for years to come.

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Booming debt markets throughout 2021 helped drive a record-breaking year of deal-making activity. Borrowers across industries, geographies and credit ratings maintained access to financing on historically attractive terms. We mark the New Year by looking at developments driven by the roaring debt markets, and considering what lies ahead as the calendar turns.

The Financing Markets in 2021: Record Breaking

Undeterred by the second year of the pandemic, 2021 was a record breaker for financing markets. New issuance volumes for both high-yield bonds and loans set full-year records before Thanksgiving, and those record high volumes were accompanied by record low yields. Investment grade bond issuance levels were the second highest on record, eclipsed only by levels reached in 2020.

The attractive financing available in 2021 supported dealmaking at an all-time record pace, including M&A transactions such as Salesforce.com’s $27.7 billion acquisition of Slack; Jazz Pharmaceuticals’ $7.2 billion acquisition of GW Pharmaceuticals; ii-vi’s $7.0 billion acquisition of Coherent; IAC’s $2.7 billion acquisition of Meredith Corporation’s National Media Group; Herman Miller’s

$1.8 billion acquisition of Knoll; and Siris Capital’s innovative $1.5 billion double-acquisition of Equiniti Group and American Stock Transfer & Trust Company. The financing markets also supported other types of M&A activity, including XPO Logistics’ $7.8 billion spin-off of GXO Logistics and the $9.3 billion “Reverse Morris Trust” transaction between 3M’s food safety business and Neogen.

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