Do Bondholders Care About Managerial Stability? Evidence from the Financial Services Industry by Wei Du, Maya Waisman, Haizhi Wang, Mingming Zhou :: SSRN

Do Bondholders Care About Managerial Stability? Evidence from the Financial Services Industry by Wei Du, Maya Waisman, Haizhi Wang, Mingming Zhou :: SSRN:

Du, Waisman, Wang, and Zhou provide an interesting look at a topic that frankly I never considered: whether post employment non compete contracts in financial service firms are priced by market participants and whether the enforcement of these contracts is good for bondholders.



From the abstract:

"...this study examines whether and to what extent the capital markets recognize the risk associated with the mobility of human capital. We evaluate the state-by-state variations in the enforceability of noncompetition agreements in the United States to test the market-discipline hypothesis and find a significant negative relation between the degree of enforcement of noncompetition agreements and the yield spreads for bonds issued by financial institutions. We also find that the negative relation is more prominent for investment-grade bonds and bonds with long-term maturities. In addition, we find that investors care more about managerial stability when bond issuers have weak protection of shareholder rights."

From the paper:

"Noncompetition agreements can function as strong binding mechanisms that significantly increase managerial stability and reduce the mobility of human capital (Garmaise 2010). The legal enforcement of covenants not to compete varies widely across jurisdictions in the United States. For example, a majority of states allow and enforce noncompetition agreements as long as they are ―reasonable and necessary,‖ though California virtually forbids such covenants. This variation in legal enforcement provides a natural setting to apply the insights of the law and finance literature (La Porta et al. 1997, 1998). 

This paper examines whether bondholders demand different yield spreads if the legal enforcement of noncompetition agreements affects the mobility of human capital. Following existing research (Morgan and Stiroh 2001), we collect data on new bond issues from financial institutions and document that the statewide enforcement level is negatively correlated with bond spreads, which means that investors do recognize the risk associated with the mobility of human capitals and price the risk accordingly. We also find that bonds investors care more about the managerial stability of financial institutions having weak protection of shareholder rights. "

Interesting.

Cite:

Du, Wei, Waisman, Maya, Wang, Haizhi and Zhou, Mingming, Do Bondholders Care About Managerial Stability? Evidence from the Financial Services Industry (June 18, 2011). Available at SSRN: http://ssrn.com/abstract=1885752

A look around at a few weekend news items

For those of you so caught up in the Super Bowl you missed reading the Business pages this weekend, here are a few highlights:

Earnings-based strategy has high risk factor | Chicago Tribune:

"A study by University of Illinois finance professor Allen Poteshman for the 10 years through May 2000 showed that there's a particular danger in holding growth stocks during the three-day period around an earnings report versus holding value stocks during the same time. Value stocks outperformed growth stocks by an average of 95 basis points per quarter."

Later in the same article was an interesting look at earnings' quality. Short version: playing games with accounting numbers may trick the market for a while, but in long run, higher quality earnings is key.

"there's more than one way for a company to beat earnings expectations. Sanjeev Bhojraj, a finance professor at Cornell University, looked at companies that beat expectations through low-quality earnings--maneuvers involving accrual accounting or short-term reductions in expenses like research or advertising.

These companies did well in the short run, handily outperforming companies that missed expectations with "high-quality" earnings. But long-term investors would have done well to put more emphasis on earnings quality than on headlines.

And then an interesting look at the Value-line anomaly from The NY Times. Short version? After beating market for quite a while, Value-Line has not done so well, BUT statistically it is still too early to say much.

"Value Line’s record in its earliest years was good enough to impress even Fischer Black...[who] would concede that Value Line’s record was an exception to his previously held belief [of market efficiency]. It is doubtful that Professor Black, who died in 1995, would have reached this conclusion had he been able to focus only on the performance of Value Line’s Group 1 stocks during this decade. In 2006, those top-ranked stocks lagged the Dow Jones Wilshire 5000 by nearly 13 percentage points...Professor Aronson found that their performance in recent years “is consistent with normal random variation in historical performance.” He concludes that there is no statistical basis for saying that “the Value Line ranking system has deteriorated."....One lesson is that in most cases, except when there is evidence of criminality or sheer incompetence, we shouldn’t switch advisers or strategies because of a few years of mediocrity.”

Sears announced they will appeal the court ruling that sided with bondholders over whether Sears had the right to redeem bonds prior to expiration. (who says Bondholders and Shareholders don't fight?) In the meantime, Sears took a charge to cover the loss.

And finally the Napa Valley Register has an interesting look at why people have an big incentive to take firms private and then later take the same firm back public:

"The first time Joseph Neubauer took Aramark Corp. private in 1984, the deal was worth $889 million.

When he and other managers led a leveraged buyout of the nation’s largest food services company a second time, the price tag zoomed to $6.24 billion.

And the biggest winner among shareholders at Aramark, which Friday completed its first week as a newly private company? Neubauer and his family, whose holdings soared in value to almost $1 billion."

breakingviews | Sample Story

For those of you that have never had a corporate class from me, you don't know how often we discuss the Nexius of contracts. Well here is a great example!

breakingviews | Sample Story:
" BAA is caught between a rock and a hard place. Its bondholders are demanding better terms - a so called change-of-control clause - on bonds that have yet to settle. Bond investors fear Spain's Ferrovial's highly leveraged approach will cause their investment-grade debt to be downgraded....

But BAA's first responsibility is to its shareholders. It shouldn't change the terms of the bonds because that could act as a poison pill - a deterrent to a takeover bid. And it is up to BAA's shareholders and not its management to decide if an offer - that is, if one is tabled - is attractive.

Besides, a deal is a deal. Bond investors have committed. Unfortunately, they did not negotiate hard enough for a change-of-control clause ahead of time and they may regret it now, but that's their responsibility. "

Good stuff!

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.

Interesting!

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