Do State Laws Matter for Bondholders

1
Do State Laws Matter for Bondholders?

• Mansi, Maxwell, Wald
• May 22, 2007

2
Introduction

• This research builds on 2 most recently published
  papers
• The first by Wald and Long (2006), which examines
  the impact of state laws on corporate capital
  structure
• The second by Klock, Mansi, and Maxwell (2005),
  which examines the relation between the Gompers
  et al. (2003) Index of antitakeover amendments
  and the cost of debt financing

3
Introduction

• In this paper, we examine how state laws are
  valued by the credit markets. We focus our
  attention on two types of statutory restrictions
• State payout restrictions (restriction on minimum
  A/D ratio necessary to make a distribution)
• Restrictions on hostile takeovers
• Both of these types of restrictions are designed
  to protect creditors from expropriation by
  shareholders and are widely adopted in U.S. debt
  agreements.

4
Agenda

• Motivation
• State payout restrictions and antitakeover laws
• Current empirical evidence
• Research questions
• Sample selection, proxies, and measures
• Empirical results
• Conclusion

5
Motivation

• Main question is whether state of incorporation
  (or state law) has an impact on firm value
• Incorporation decision
• U.S. firm are all subject to same bankruptcy laws
  and bankruptcy courts are federal
• U.S. firms are subject to same SEC regulation
• U.S. firms access same capital markets
• U.S. firms pay taxes where they have operations

6
Motivation

• Evidence on equity side is mixed
• Race to the top
• Empirical evidence for higher firm value for
  firms incorporating in Delaware (Romano (1985)
  and Daines (2001))
• Race to the bottom
• Empirical evidence for insignificant increase in
  firm value (Subramanian (2004) and Bebchuk
  Ferrell (2001), and Bebchuk et al. (2002))

7
What Varies Across States?

• Laws on payout restrictions
• When debt is present, state laws differ in
  payouts
• Few states (e.g., Delaware) provide few
  restrictions
• Firms incorporated in NY, TX and many other
  states are subject to the net worth rule (TA
  constraint 1)
• Firms incorporated in CA or Alaska are subject to
  a more stringent test (TA constraint 1.25)

8
Can Debt Covenants Substitute for State Laws?

• State payout restrictions are similar to certain
  bond covenants, but they are not individually
  negotiated
• Firms used to write separate debt covenants
• But that can be costly (Smith and Warner, 1979
  John and Kalay, 1982)
• After 1980 or so, many of the basic restrictions
  were added to state laws (Eisenberg, 1983)

9
What Varies Across States?

• Antitakeover Laws
• Companies are only subject to the statutes of the
  state which they are incorporated
• Firms prefer to reincorporate in states with more
  antitakeover provisions, often to the detriment
  of shareholders (see Heron and Lewellen, 1998
  and Bebchuk and Cohen, 2003)
• State antitakeover laws antigreenmail laws,
  control share statute, fair-price statute,
  freeze-out or business combination statutes,
  poison pills, constituencies statutes

10
State of Incorporation

• Why do firms remain incorporated in more
  restrictive jurisdiction
• High cost of reincorporation
• Regulatory advantages in some states
• Payout restrictions may reduce the agency cost of
  debt by restricting financial and investment
  policy

11
Costs of Reincorporation

• For state payout restrictions to matter, the cost
  of reincorporation can not be too small
  otherwise no credible pre-commitment
• On the other hand, if the cost of reincorporation
  are too high then firms remain incorporated in
  their home state, never change states, and do not
  get optimal use of state laws

12
Empirical Evidence

• Agency cost of debt
• Jensen and Meckling (1976) and Myers (1977)
• Conflicts center on firm payout policy (e.g.,
  Dhillon and Johnson (1994) Maxwell and Stephens
  (2003))
• Antitakeover provisions (e.g., Billet, King, and
  Mauer (2004), Klock, Mansi, and Maxwell (2005),
  and Saffieddine and Titman (1999))

13
Empirical Evidence

• Payout restrictions and state antitakeover laws
• Wald and Long (2006)
• Heron and Lewellen (1998) firms prefer to
  incorporate in states with more antitakeover
  laws, and these laws decrease firm market values
• Bebchuk and Cohen (2003) similar findings, and
  also firms prefer to stay in their home states

14
Why Bonds?

• Debt represents the main source of financing for
  firms
• Empirical evidence based on equity prices
• Tobin Q is typically based on book rather than
  market value of debt
• Bond characteristics are well suited for better
  pricing

15
Research Questions

• Two main questions
• Are there advantages to firms incorporated in
  states with more restrictive payout
  jurisdictions?
• What is the impact of payout restrictions and
  state antitakeover laws on credit ratings yield
  spreads?
• In our paper, we find that
• Firms incorporated in states with more
  restrictive payout statues (New York) have better
  credit ratings and lower spreads relative to
  firms in less restrictive states (Delaware).

16
Sample Selection

• Data sources
• Lehman Borthers Fixed Income database
• IRRC data on firm decisions to opt out of state
  laws
• State laws from a number of sources, Lexis/Nexis,
  Gartman (2000) and McGurn et al (1989) for
  antitakeover laws
• Compustat Industrial database (SIC codes
  2000-3999)
• Executive compensation database
• Thomson Financial (institutional ownership data)
• Mergent data for firm reincorporation decisions
  and fixed income data for debt covenants

17
Selection criteria

• Based on firms in the LBFI database
• Based on financial info. from Compustat
• Based on firms in Gartman (2000) index
• Final sample of 8,531 firm-year observations on
  1,625 firms (for the period from 1987-2003)

18
Why 1987 on?

• 1987 US Supreme Court decision CTS Corp v.
  Dynamics Corp of America clarified that
  antitakeover laws were constitutional. Many
  states then passed antitakeover legislation

19
Proxies and Measures

• Measuring the cost of debt
• Yield spread weighted yield to maturity less its
  duration equivalent Treasury yield
• Measuring state law and antitakeover variables
• Payout restrictions (the minimum asset/debt ratio
  (0, 1, 1.25)) as in Wald and Long (2005)
• Antitakeover laws as in Bebchuk and Cohen (2003)
• GIndex as in Gompers et al. (2003) or a subset
  based on Bebchuk et al. (2005).

20
Control Variables

• Firm Specific
• Size, Leverage, MTB
• Profitability
• Intangibles
• Firm Risk
• Debt Covenants
• Event Risk
• Payout
• Financing

• Security Specific
• Credit Ratings
• Duration
• Convexity
• Debt Age
• Governance
• Inside Ownership
• Inst. Ownership

21
Incidence of State of Incorporation
22
Results

• Most of the firms in the sample are incorporated
  in Delaware (about 55)
• This is because Delaware firms are more likely to
  use debt financing.
• Most of the firms in the sample have TA
  constraint variable of 1.0. Exception is
  Delaware (TA0) and California (TA1.25)

23
Descriptive Statistics
24
Correlations
25
Multivariate Analysis

• We examine the relation between state laws and
  antitakeover measures and credit ratings/cost of
  debt and various controls for firm specific
  variables
• We control for clustering and heteroskedasticity
  as in Peterson (2006)

26
Credit Ratings and State Laws
27
Credit Ratings Results

• In all specifications, a larger (more strict) TA
  constraint is associated with a significantly
  higher credit ratings
• For Model 1, a TA constraint of 1 is associated
  with a ratings increase of 0.552, more than half
  a rating step
• Changes between models due mainly to smaller
  sample sizes

28
Yield Spreads and State Laws
29
Yield Spread Results

• Results suggest that the overall total asset
  constraint variable is negatively related to the
  cost of debt financing
• The index of antitakeover laws variable has no
  significant impact on bond yields

30
Robustness Checks
31
Conclusion

• We provide evidence that more stringent payout
  constraints in state laws have a negative impact
  on bond yield spreads
• State laws that restrict firm payouts can reduce
  the firms cost of debt
• These restrictions function similar to how Smith
  and Warner (1979) describe the function of debt
  covenants
• The impact of antitakeover laws on bond yields is
  insignificant