Tuesday, November 01, 2005

Delaware Incorporation and Bonds

"Does Delaware Incorporation Affect Bondholder Wealth?"
by Francis, Hasan, John, and Waisman.

First the answer: Yes.

Bonds rarely spark the interest of stocks, but this one is sort of cool.

Francis, Hasan, John, and Waisman examine the interest rates spreads of corporate issues based on where companies are incorporated. They find that firms that are incorporated in Delaware pay a penalty (in the form of higher rates) for being under Delaware's corporate rules.

In their words:
"We find that Delaware incorporated firms are associated with higher yield spreads in comparison to non-Delaware firms. Specifically, on average, the difference between bond yields due to Delaware incorporation can be as high as 25 basis points when we compare Delaware to Ohio, Pennsylvania or Massachusetts incorporated companies, which are well known for antitakeover laws that protect managers"
This is consistent with the idea that takeovers can reduce bondholders' wealth and reiterates the view that how contracts are structured (and where!) does influence firm value.

The authors also examine equity returns around debt issues across different states of incorporation. They find that the state of incorporation also may be a factor in determining equity returns around debt issues. This response is attributed to lower costs of debt capital stemming from the reduced agancy cost of debt in these states. Again in their own words:
"stockholder wealth enhancement hypothesis contends that state antitakeover laws would benefit stockholders and increase the value of the firm by lowering the firm’s agency costs of debt. In general, the conflicting interests of bondholders and stockholders may cause two types of agency problems. First, a risk incentive (asset substitution) problem.....If bondholders anticipate this action on the part of stockholders, they demand a higher interest rate to account for the greater risk they encounter, and are willing to pay less for the bonds at the time of issuance, which leads to a reduced value of the firm (Kahan and Klausner, 1993). Second, an underinvestment problem occurs if the value of the firm’s investment opportunities is revealed to be less than the face value of the maturing debt plus the costs of undertaking the investment project (Myers, 1977).
Which is pretty standard for any corporate finance class, but the finding is then surprising.
"we find that, on average, firms incorporated in states with stronger takeover laws, such as Ohio, Pennsylvania and Massachusetts, experience positive abnormal stock returns around the announcement of bond issuance, whereas firms incorporated in states which offer relatively milder takeover restrictions, such as Delaware, experience significantly negative abnormal returns around the bond issuance event, consistent with the stockholder wealth enhancement hypothesis."
Their overall conclusion however:
"...although as far as shareholders are concerned, it is yet unclear whether Delaware wins a race to the top by addressing their rights or a race to the bottom by addressing the needs of management, as far as bondholders are concerned, Delaware ultimately wins a race to the bottom. These findings strongly suggest that it is important to look at the total effect of governance terms, including state laws, before drawing conclusions on regulatory and security design policies, and that it is important to evaluate these laws considering all majorcorporate stakeholders.

Bill Francis, Iftekhar Hasan, Kose John, and Maya Waisman.
"Does Delaware Incorporation Affect Bondholder Wealth?"
(Upload date: Aug 17, 2005).

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