ON FINANCIAL CONTRACTING An Analysis of Bond Covenants

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ON FINANCIAL CONTRACTINGAn Analysis of Bond
Covenants

• Clifford W. SMITH, Jr. and Jerold B. WARNER
• Journal of Financial Economics 7 (1979)
• QF04 892601 ???
• 
  892602 ? ?
• 892622 ???

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• With risky debt outstanding stockholder actions
  aimed at maximizing the value of their equity
  claim can result in a reduction in the value of
  both the firm and its outstanding bonds.
• gthow debt contracts are written to control the
  bondholder-stockholder conflict

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Sources of the bondholder-stockholder conflict

• Dividend payment
• raising the dividend rate
• -gt reducing the value of the bond
• Claim dilution
• issuing additional debt of the same or higher
  priority
• -gt the value of the bondholders claims is
  reduced

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• Asset substitution
• substituting projects which increase the
  firms variance rate-gt the value of the
  stockholders equity raises and the value of the
  bondholders claims is reduced.
• Underinvestment(??????)
• the benefit from accepting the project accrues
  to the bondholder-gt the firm can reject projects
  which have a positive NPV

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Control of the bondholder-stockholder conflict
The competing hypotheses

• The Irrelevance Hypothesis--
• the manner of controlling of the
• bondholder-stockholder conflict does not
• change the value of the firm
• Under a fixed investment policy
• When investment policy is not fixed

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• The Costly Contracting Hypothesis--
• control of the bondholder-stockholder conflict
  through financial contracts can increase the
  value of the firm
• the Commentaries
• Our description of the specific provisions in
  debt contracts is based primarily on an American
  Bar Foundation compendium entitled Commentaries
  on Indentures.

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Restrictions on the firms production/investment
policy

• Restrictions on investment
• Restrictions on the disposition of assets(??????)
• Secured debt(????)
• Restrictions on mergers
• Covenants requiring the maintenance of assets
• Covenants which indirectly restrict on
  production/investment policy

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Restrictions on investment

• Stockholders contractually restrict their ability
  to acquire financial assets in order to limit
  their ability to engage in asset substitution
  after the bonds are issued

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Restrictions on the disposition of
assets(??????)

• ?????????????????
• ????????????????????????

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Secured debt(????)

• Securing debt gives the bondholders title to
  pledged assets until the bonds are paid in full.
• Firms where liquidation is more likely than
  reorganization, the issuance of the secured debt
  will be greater.
• The more specialized the assets, the more costly
  is asset substitution to stockholders, the
  tighter the implicit constraint on asset sale,
  and thus the less likely is the use of secured
  debt.

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Restrictions on mergers

• Merger restrictions limit the stockholders
  ability to use mergers to increase either the
  firms variance rate or the debt to asset ratio
  to the detriment of the bondholders.

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Covenants requiring the maintenance of assets

• The firms operating decisions can also be
  limited by requiring that it take certain
  actions, that it invest in certain projects, or
  hold particular assets.
• requiring the the maintenance of the
• firms properties
• requiring the maintenance of the firms
• working capital

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Covenants which indirectly restrict on
production/investment policy

• If the restrictions on production/investment
  policy were sufficiently expensive to enforce,
  dividend and financing policycovenants would be
  the only efficient way
• of constraining the firms actions

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• Bond covenants restricting the payment of
  dividends
• Cash dividend payments to stockholders if
  financed by a reduction in investment, reduce the
  value of the firms bonds by decreasing the
  expected value of the firms assets at the
  maturity date of the bonds, making default more
  likely. Thus, bond covenants frequently restrict
  the payment of cash dividends to shareholders.

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• Typically, the inventory of funds available for
  dividend payment in quarter t, , can be
  expressed as
• 
  -------(1)
• where, for quarter t,
•  
• is net earnings
• is the proceeds from the sale of
  common
• stock net of transaction costs
• F is a number which is fixed over the
  life of
• the bonds, known as a dip.
• K is a constant, 0? k ?1.

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• The payment of a dividend is not permitted if
  its
• payment would cause the inventory to be
  drawn
• below zero. Thus, the dividend payment must
• satisfy the constraint
  -----(2)
• The dividend covenant act as a restriction not on
  dividends per se, but on the payment of dividends
  financed by issuing debt or by the sale of the
  firms existing assets, either of which would
  reduce the coverage on, and thus the value of,
  the debt.

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• The firms cash flow,, can be expressed as
• 
  ----------(4)
• where, for quarter t,
• is the firms net earnings
• is depreciation
• is the book value of any assets
  liquidated
• Substituting (3) into (4) and solving for yields
• -
  -------(5)

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• The dividend covenant described in eq. (1) and
  (2) coupled with the cash-flow identity that
  inflows equal outflows constrain investment
  policy
• 
  -------(3)
• is the dividend paid,
• is debt principal paid,
• is the firms cash flow
• is the proceeds from the sale of equity net
  of
• transaction cost
• is the proceeds from the sale of bond net
  of
• transaction cost
• is interest paid
• is new investment

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• Assume that an all equity firm sells bonds at par
  with a covenant that it will issue no additional
  debt over the life of the bonds (i.e.,0 for t?0,
  and0, for t?T ). If we also assume that F0,
  and k1, then substituting (5) and (1) into (2)
  yields the condition for dividends in quarter t
  to be positive,
• 
  -------------------(6)

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• While having a tight dividend constraint controls
  the stockholders incentives associated with the
  dividend payout problem, there are several
  associated costs.
• 1. An outright prohibition on dividends or
  
• allowing dividends but setting k less
  than one
• increases the probability that the firm
  will
• force to invest when it has no available
• profitable projects.

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• 2. The tighter restriction on dividends
  implied
• by a lower k also increases the
  stockholders
• incentive to engage in asset
  substitution, and
• increase the gain to the firms
  shareholders
• from choosing high variance, negative
  net
• present value projects. However, a
  lower k
• also confers benefits, since it
  reduces the
• stockholders incentive to engage in
  
• creative accounting to increase
  reported
• earnings.

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• One prediction of our analysis is that short-term
  debt instruments (such as commercial paper) are
  less likely to contain dividend restrictions than
  long-term debt.

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• Control of investment incentives when the
  inventory is negative
• If inventory of fund available is negative, no
  dividend can be paid.
• firms value decreases
• debt/equity ratio and the
  probability of
• default on its debt.
• Hence at the times when a dividend prohibition
• comes into play, the firm is also likely to be
  faced
• with greater incentives to engage in asset
• substitution and claim dilution.

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Bond covenants restricting subsequent financing
policy

• Limitations on debt and priority
  
• Covenants suggested in commentaries limit
  stockholders actions in this area in one of two
  ways either through a simple prohibition against
  issuing claims with a higher priority, or through
  a restriction on the creation of a claim with
  higher priority unless the existing bonds are
  upgraded to have equal priority.

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• If as the firms opportunity cost set evolves
  over time, new investments must be financed by
  new equity issues or by reduced dividends, then
  with risky debt outstanding part of the gains
  from the investment goes to bondholders, rather
  than stockholders. So a prohibition of all debt
  issues would reduce the value of the firm because
  wealth maximizing stockholders would not take all
  positive net present value projects.

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Bond covenants modifying thepattern of payoffs
tobondholders

• Sinking fund
• ???????????????,????????????????????????????????
  ??19631965??,?82??????????????????
• ???????????,??????(trustee)???????,????,????????
  ????????????????????,????????????,?????????

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• A sinking fund reduces the possibility that
  the dividend constraint will require investment
  when no profitable projects are available.
• Myers (1977) has suggested that sinking funds
  are a device to reduce creditors exposure in
  parallel with the expected decline in the value
  of the assets supporting the debt.

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Convertibility provision

• A convertible debenture is one that gives the
  holder the right to exchange the debentures for
  other securities of the company, usually shares
  of common stock and usually without payment of
  further compensation.

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• The conversion privilege is like a call
• option written by the stockholders and
• attached to the debt contract. It reduces
• the stockholders incentive to increase
• the variability of the firms cash flows,
• because with a higher variance rate, the
• attached call option becomes more valuable

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Callability provisions

• ??????????????????,???????????????????????(call
  price)???????? 1000?,??????????????????(call
  premium)????????????????????????????????????,?????
  ??,?????0?
• ????????????????????????,???????????????????,???
  ????(deferred call),??????????,???????????(call-pr
  otected)?

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• One cost of buying out bondholders in a
  recapitalization results from the additional
  premium the bondholders demand for the firm to
  repurchase the bonds. Since the firm cannot vote
  bonds which it repurchases, a bilateral monopoly
  results from the attempt to repurchase the
  outstanding bonds. With a bilateral monopoly it
  is indeterminate how the gains will be divided
  between stockholders and bondholders.

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Covenants specifying bonding activities by the
firm

1. Required reports
2. Specification of accounting techniques
3. Officers certification of compliance
4. The required purchase of insurance

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1. Required reports

• All financial statements, reports, and proxy
  statements
• Reports and statements filed with government
  agencies
• Quarterly financial statements
• Financial statements audited by an independent
  public accountant

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2. Specification of accounting techniques

• Ex
• The required current investment is increased
  by (1-k)the change in reported earnings
• --How the bondholders protect themselves from
  creating accounting??

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• 3. Officers certification of compliance
• To be sure that there is no knowledge of any
  default
• 4. The required purchase of insurance
• In order to monitor the operation and the
  maintenance of the firm and provide a loss
  control program
• The corporations cash flow variability will be
  small by the purchase of loss control program

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The enforcement of bond covenants

1. The legal liability of bondholders
2. The role of the trust indenture and the trustee
3. Default remedies

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1. The legal liability of bondholders

• When bondholders exercise a significant degree of
  control over the firm
• Creditors whose debt contracts contain
  restrictions which cause the firm to breach its
  contract with third parties
• Creditors can also incur liability for Federal
  Securities Law violations

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2. The role of the trust indenture and the
trustee

• Trustee
• Bribing problem
• How to solve
• --The Trust Indenture Act of 1939
• --Private placement

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3. Default remedies

• Renegotiation
• The debt contract is often renegotiated in order
  to eliminate the default.
• Bankruptcy

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Conclusion

• The role of bond covenants
• Reduce the costs associated with the conflict of
  interest between bondholders and stockholders
• When using the production / investment policy,
  the monitoring costs are very high.
• Dividend policy and financing policy involve
  lower monitoring costs

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• 2. Implications for capital structure
• --The costs associated with the
  bondholder-stockholder conflict rise with the
  firms debt / equity ratio
• ? The costs associated with writing and enforcing
  covenants influence the level of debt the firm
  chooses.

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• 3. Some other extensions
• --The interrelationship between covenants
  restricting dividend, financing, and production /
  investment policy
• --The impact of the bondholders-stockholder
  conflict on the firms total contracting costs