In our paper, Managerial Attitudes and Corporate Actions, forthcoming in the Journal of Financial Economics, we use a survey-based approach to provide new insight into the people and processes behind corporate decisions. This method allows us to address issues that traditional empirical work based on large archival data sources cannot. For example, we are able to administer psychometric personality tests, gauge risk-aversion, and measure other behavioral phenomena. Our mode of inquiry is similar to those of experimental economists (who often administer gambling experiments) and psychologists (who administer psychometric tests). As far as we are aware, no other study attempts to measure attitudes of senior management directly through personality tests to distinguish CEOs from others and U.S top level executives from non-US top level executives. We also relate CEO attributes to firm-level policies.

Our survey quantifies behavioral traits of senior executives and also harvests information related to career paths, education, and demographics. We ask these same questions of chief executives and chief financial officers, among public and private firms, and in both the US and overseas. We can thus compare traits and attitudes for US and non-US CEOs to see if there is indeed a significant difference in attitudes. We also ask questions related to standard corporate finance decisions such as leverage policy, debt maturity, and acquisition activity. This allows us to relate attitudes and managerial attributes to corporate actions. We also examine how managerial attributes such as risk-aversion and time preference relate to compensation at the firm level.

…continue reading: Managerial Attitudes and Corporate Actions

As many of you know, I am now in my second term as an SEC Commissioner and this is my fifth time participating at SEC Speaks. During that time, I have served with three different SEC Chairmen, and a fourth is now in the works. It has been, and continues to be, a great privilege to serve at a time during which the SEC’s role as the capital markets regulator has never been more important. However, I must admit being frustrated that we haven’t done more to protect investors.

Clearly, my tenure as a Commissioner has been dramatically impacted by the financial crisis and the pressing need to address the many failings that were brought to light by that crisis. Throughout my tenure, I have worked to be a strong advocate for fulfilling the Commission’s mission to protect investors, facilitate capital formation, and promote a fair and orderly market. To that end, I want to talk to you today about the need to protect investors through robust and effective market oversight.

I am growing increasingly concerned about the stability of our market structure as we lurch from one crisis to another, be it the flash crash or the Knight trading fiasco. Today, I plan to focus on the dangers that investors face from a trading market structure that has shown too many signs of weakness and instability.

…continue reading: Addressing Market Instability through Informed and Smart Regulation

Introduction

As the banking industry emerges from the 2008 financial crisis, there is no question that it caused great strain on banks of all sizes. Hundreds of community banks failed, and the largest institutions were unable to continue operating without massive, unprecedented government intervention. This region in particular experienced the full impact of the crisis and the stress it placed on small institutions. A key ingredient in the market disruption was inadequate capital protection. Looking forward, it is important that the regulatory community arrive at a capital framework that is appropriate for the range and complexity of risks in today’s financial system.

As someone who served on the Treasury Department’s crisis response team in 2008, it became clear that the market was punishing firms and business models that took on too much risk without sufficient capitalization. Yet, upon returning recently to government service I have been surprised at what I see as a lack of progress towards constraining excessive leverage. Some policymakers point to advancements in the Basel III agreement, developed by the Basel Committee on Banking Supervision, which implements a global leverage ratio for the first time. However, I think that it is difficult to argue that achieving a Tier 1 leverage ratio of three percent my 2018 is significant reform, particularly as this leverage ratio requirement is not solely anchored in tangible common equity.

…continue reading: Prominent Role for Leverage Ratio in Capital Framework

With the phase out of Tier 1 capital treatment for trust preferred securities (TruPS) mandated by Dodd Frank slated to begin January 1, 2013, financial institutions have been active in considering potential strategies to replace outstanding TruPS with other forms of regulatory capital. Last week, Huntington Bancshares completed a novel exchange offer for several specified series of outstanding TruPS. In the offer, Huntington exchanged outstanding floating-rate TruPS for a new series of floating-rate non-cumulative perpetual preferred stock, which – unlike the TruPS – will not lose Tier 1 treatment under Dodd Frank and will also continue to be recognized as a Tier 1 instrument under Basel III.

Huntington’s exchange offer involved four different series of TruPS and the offer was tailored to each series, including through the use of additional cash consideration for two of the series and by employing a waterfall of acceptance priority levels among the four series in the event that the offering was oversubscribed. By conducting the exchange as a registered offering rather than relying on the exchange provisions under Section 3(a)(9) of the Securities Act of 1933, Huntington was able to employ a dealer manager to solicit TruPS holders in an effort to maximize participation. Note, however, that while Huntington’s exchange offer was completed in the scheduled time frame, the SEC must declare an exchange offer registration statement effective prior to closing, and the SEC review process can risk a delayed closing. Under the securities laws, the offer must be open to all holders and must remain open for at least 20 business days.

…continue reading: Creative TruPS Capital Restructurings

In our paper, Corporate Governance and Capital Structure Dynamics, forthcoming in the Journal of Finance, we examine the importance of manager-shareholder conflicts in capital structure choice and characterize their effects on the dynamics and cross section of corporate capital structure. To this end, we develop a dynamic tradeoff model that emphasizes the role of agency conflicts in firms’ financing decisions. The model features corporate and personal taxes, refinancing and liquidation costs, and costly renegotiation of debt in distress. In the model, each firm is run by a manager who sets the firm’s financing, restructuring, and default policies. Managers act in their own interests and can capture part of free cash flow to equity as private benefits within the limits imposed by shareholder protection. Debt constrains the manager by reducing the free cash flow and potential cash diversion (as in Jensen, 1986, Zwiebel, 1996, or Morellec, 2004). In this environment, we determine the optimal leveraging decision of managers and characterize the effects of manager-shareholder conflicts on target leverage and the pace and size of capital structure changes.

…continue reading: Corporate Governance and Capital Structure Dynamics

In the paper, Do Institutional Investors Influence Capital Structure Decisions?, which was recently made publicly available on SSRN, we analyze whether institutional holdings influence capital structure decisions, and whether firms’ financial leverage affects institutional investors’ decisions to hold their equity. Theories of capital structure imply that firms choose their leverage in response to market frictions such as agency costs and asymmetric information. Meanwhile, institutional monitoring and information-gathering affect firms’ agency costs and information environment, opening channels through which institutions may influence firms’ choices of leverage. In the agency framework, institutional investors serve as an external disciplinary mechanism for management, lessening the need for internal disciplinary mechanisms such as debt. In the asymmetric information framework, institutional investors decrease information asymmetry between outside and inside shareholders, which reduces the adverse selection costs of equity and lowers the cost of equity relative to debt, serving to decrease the amount of debt needed for a separating signaling equilibrium.

…continue reading: Do Institutional Investors Influence Capital Structure Decisions?

In the paper, Deviation from the Target Capital Structure and Acquisition Choices, forthcoming in the Journal of Financial Economics, I explore the effects of a firm’s leverage deficit on its acquisition choices. In particular, I examine the extent to which a firm’s leverage deficit affects the likelihood of the firm making an acquisition as well as the effect of its leverage deficit on the payment method and on the premiums paid for the target firm. Because managers are likely to anticipate the constraints of overleverage on acquisition choices, I also analyze managerial decisions on capital structure in the light of potential acquisitions. Specifically, I test whether managers of overleveraged firms reduce their leverage deficits when they foresee a high likelihood of making acquisitions. Finally, I examine how capital markets react to the acquisition announcements of firms that deviate from their capital structures. Managers of overleveraged firms will face constraints on the form and level of financing and are more likely to be selective in their acquisition choices if they fail to decrease their leverage deficits substantially. Therefore, I hypothesize that managers of overleveraged firms will pursue only the most value-enhancing acquisitions, which, in turn, will foster favorable market reactions to the news of their acquisitions.

…continue reading: Deviation from the Target Capital Structure and Acquisition Choices

In the paper, Accounting Standards and Debt Covenants: Has the “Balance Sheet Approach” Led to a Decline in the Use of Balance Sheet Covenants?, forthcoming in the Journal of Accounting and Economics as published by Elsevier, I examine whether the “balance sheet approach” has led to a decline in the use of balance sheet covenants. Debt contracts, and especially private loan agreements, frequently include accounting-based debt covenants. Many of these covenants require the borrower to maintain a threshold level of some financial ratio or measure. A broad range of financial measures are employed in these financial covenants. Some are written on earnings from the income statement; the borrower may be required to maintain a minimum level of earnings relative to their interest expense (interest coverage) or their total debt (debt-to-earnings). Similarly, covenants are also written on values from the balance sheet; these include covenants requiring a minimum level for the book value of equity (net worth) or a maximum amount of debt in the capital structure (leverage). If the borrower fails to maintain a covenant threshold, the debt enters technical default. In technical default, the creditor has the option to attempt action against the borrower; a common consequence is renegotiation with stricter contract terms.

…continue reading: Accounting Standards and Debt Covenants

In our paper, The Evolution of Capital Structure and Operating Performance after Leveraged Buyouts: Evidence from U.S. Corporate Tax Returns, which was recently made publicly available on SSRN, we study post-LBO financial performance and behavior for approximately the universe of U.S. LBO firms taking place between 1995 and 2007.  We overcome the lack of public financial data for most LBOs firms that has limited prior research by instead analyzing confidential federal corporate tax return data. Since all U.S. corporations, including those that are privately-held, must file tax returns, we can observe post-LBO income and balance sheet information for nearly all U.S. LBO firms.

We use our large, representative sample to test a number of long-standing hypotheses regarding the motivation for LBOs and their role in the economy. Arguably the most influential view on LBOs is that of Jensen (1989), who regards the LBO structure as superior to the structure of the publicly-traded firm. He argues that the concentration of ownership and high level of debt in the LBO structure disciplines managers. The high level of debt eliminates free cash flow that managers might otherwise waste on “empire-building” activities. Indeed, levering up the firm more than would be optimal from a long-term perspective puts pressure on management to earn its way out of the firm’s debt load.

…continue reading: The Evolution of Capital Structure and Operating Performance after Leveraged Buyouts

In our paper, Optimal Capital Structure, which was recently made publicly available on SSRN, we develop a method that can be used to determine optimal capital structure for any given firm. Being able to make specific, firm-by-firm debt policy recommendations is an important addition to the current state of affairs. Though much progress has been made in capital structure research, traditional approaches neither explicitly separate out the benefits and costs of debt to facilitate estimation optimal debt ratios, nor precisely quantify the cost of suboptimal leverage.

…continue reading: Optimal Capital Structure