Scholars have traditionally assumed that lenders that protect themselves using credit derivatives like credit default swaps (CDS) have limited interest in debt governance. The rationale behind this proposition seems straight-forward. Lenders that have bought credit protection should have little incentive to invest in monitoring and disciplining a borrower where they know they will be repaid under the CDS. Indeed, scholars argue, lenders that have purchased CDS protection have considerable interest in seeing a borrower fail. When this happens, they can easily and cheaply exit their investment by triggering repayment on the CDS.

This paper, the New Market in Debt Governance, recently made available on SSRN, challenges this consensus and proposes a new theory of governance in the context of credit derivatives trading. While scholars have traditionally focused on lenders that protect themselves using CDS, they overlook the role of financial firms that sell this credit protection and thereby assume economic risk on the underlying borrower. These protection sellers take on the risk of a borrower defaulting, but possess no legal tools with which they can discipline the borrower to stave off default. As a result, unlike ordinary lenders, protection sellers have no direct means to control a borrower’s risk-taking. They possess no legal powers to influence how much leverage a borrower takes on, its use of collateral, cash reserves or its acquisitions and enterprise strategy. Given this precarious position, it follows that protection sellers possess powerful incentives to seek out ways to influence how a borrower company is run to better control how risky it is allowed to become.

…continue reading: The New Market in Debt Governance

Amid the current debate over tax policy in Washington, there is a bipartisan consensus on one issue: the corporate tax rate, which is currently 35 percent, should be reduced to roughly 25 percent. At the same time, budgetary pressures preclude any significant increase in the deficit to accomplish corporate tax reform.

In light of these competing demands, most corporate tax reformers advocate broadening the corporate tax base to pay for any rate reduction. Unfortunately, few politicians have put forth base-broadening measures that would generate revenue sufficient to significantly lower the corporate tax rate on a revenue-neutral basis.

In fact, revenue-neutral corporate income tax reform is likely to be very difficult, because corporate tax expenditures represent a relatively small portion of total corporate tax revenues. A preliminary analysis by the Joint Committee on Taxation suggested that the elimination of all corporate tax expenditures—except for the deferral of tax on foreign source profits, a provision whose repeal would be politically and economically infeasible—would allow for the corporate tax rate to be reduced to only 28 percent.

Therefore, if policymakers want to reduce the corporate tax rate on a revenue-neutral basis, they will likely have to adopt other types of reforms to broaden the corporate tax base. Ideally, those reforms should offer the potential for significant revenue gains and reduce economic distortions.

…continue reading: Corporate Tax Reform

In the paper, Classified Boards, the Cost of Debt, and Firm Performance, which was recently made publicly available on SSRN, I analyze the effects of classified boards on bondholders’ wealth and the cost of debt, as well as the implications on firm performance. The empirical results suggest that classified boards are strongly associated with a lower cost of debt, and the effect is robust to the inclusion of other governance variables the literature has shown to be relevant to the cost of debt, especially the G-index.

…continue reading: Classified Boards, the Cost of Debt, and Firm Performance

In the paper, Ownership Structure and the Cost of Corporate Borrowing, forthcoming in the Journal of Financial Economics, we study the financial consequences of the divergence between control rights and cash-flow rights in a large sample of companies across 22 East Asian and Western European countries during the period from 1996 to 2008. Specifically, we analyze the effects of control rights-cash-flow rights divergence on firms’ cost of borrowing and provide new insights into the link between the separation of ownership and control and corporate value.

…continue reading: Ownership Structure and the Cost of Corporate Borrowing

In the paper, Inside Debt, which is forthcoming in the Review of Finance, we show that CEOs should be paid with debt in their own firm, to deter them from taking risky actions (e.g. sub-prime lending) that hurt bondholders, as was common in the recent financial crisis. Our theory justifies the substantial use of debt compensation documented by recent evidence, and underpins recent proposals to tie CEOs to the value of their debt to prevent future crises (as recently implemented at AIG).

Three decades of theoretical research on CEO pay have focused almost exclusively on justifying compensating CEOs with equity-like instruments alone, such as stock and options. This has likely been driven by the long-standing belief that, empirically, executives don’t hold debt. However, this belief arose not because CEOs actually don’t hold debt, but because disclosure of debt compensation was extremely limited and so researchers missed this component of compensation. New disclosures mandated by the SEC from March 2007 show that CEOs hold substantial debt in their own firms (known as “inside debt”) in the form of deferred compensation and defined benefit pensions. Indeed, in some cases, CEOs hold even more debt than they do equity. Since the use of debt sharply contrasts with existing theories which advocate only equity, some commentators have argued that it must be inefficient. By contrast, we show that inside debt can be optimal, and that it should be used in the types of firms in which they are indeed used in reality.

…continue reading: Inside Debt

In the paper, The Cost of Debt, which is forthcoming in the Journal of Finance, we use panel data from 1980 to 2007 to estimate the marginal cost function for corporate debt. This is the first explicit estimate of the cost of debt function in the literature. We use variation in debt tax benefit curves to help us map out the marginal cost function. We employ two identification strategies: (i) a full panel approach using all time-series and cross-sectional information from 1980 to 2007, (ii) a time series approach focused on the 1986 Tax Reform Act.

The estimated marginal cost of debt functions are positively sloped. The location of the function depends on firm characteristics such as asset collateral, size, book-to-market, asset tangibility, cash flows, and whether the firm pays dividends. Our findings are robust to firm fixed effects, year fixed effects, across time periods, and when accounting for fixed adjustment costs of debt. We provide an easy-to-use formula that allows others to create firm-specific marginal cost of debt functions. We also provide firm-specific recommendations of optimal debt policy against which firms’ actual debt choices can be benchmarked, and we quantify the welfare costs to the firm from deviating from the model-recommended optimum.

…continue reading: The Cost of Debt

In our paper, Collateral, Risk Management, and the Distribution of Debt Capacity, which is forthcoming in the Journal of Finance, we provide a dynamic model of collateralized financing in which collateral constraints are endogenously derived based on limited enforcement. In the model, firms have access to complete markets, subject to collateral constraints, and thus are able to engage in risk management. We show that there is an important connection between firm financing and risk management since both involve promises to pay by the firm, which are limited by collateral.

Our model predicts that firms with low net worth exhaust their debt capacity and hedge less, since financing needs override hedging concerns, consistent with the empirical evidence. In contrast, this evidence is considered a puzzle from the vantage point of the standard theory of risk management, which takes investment as given. Rampini and Viswanathan (2009) study an infinite horizon model and show that the same trade-off between financing and risk management obtains generally.

…continue reading: Collateral, Risk Management, and the Distribution of Debt Capacity

In the paper, Equity-Debtholder Conflicts and Capital Structure, which was recently made publicly available on SSRN, we present a novel approach to identifying debt‐equity conflicts and the associated agency costs, employing a 1991 legal event as a natural experiment. Our natural experiment revolves around the fiduciary duties of corporate officers. Broadly speaking, these duties require that officers take actions that are in the interest of owners. Historically, the position of U.S. courts has been that such duties are owed to the firm as a whole and to its owners, but not to other firm stakeholders, such as creditors. Creditors are assumed to be able to protect themselves by contractual and other means (e.g. covenants). This situation changes once a firm becomes insolvent. At this point, fiduciary duties are owed to creditors, since for insolvent firms creditors become the residual claimants. As long as the firm is solvent, however, the traditional view was that no such rights were held by creditors. This changed with the Delaware court’s ruling in the 1991 Credit Lyonnais v. Pathe Communications bankruptcy case. The case ruling argued that when a firm is not insolvent, but in the “zone of insolvency”, duties may already be owed to creditors.

…continue reading: Equity-Debtholder Conflicts and Capital Structure

In our paper A Gap-filling Theory of Corporate Debt Maturity Choice, which was recently accepted for publication in the Journal of Finance, we develop a new theory to explain time-variation in corporate maturity choice. As in BGW (2003), our theory allows for predictability in bond market returns and has the feature that corporate issuers tend to benefit from this predictability – ­i.e., they use short-term debt more heavily when its expected returns are lower than the expected returns on long-term debt. Crucially, however, we do not assume any forecasting advantage for corporate issuers: they have no special ability to predict future returns, or to recognize sentiment shocks. Instead, the key comparative advantage that corporate issuers have relative to other players in our model is an advantage in macro liquidity provision.

…continue reading: A Gap-filling Theory of Corporate Debt Maturity Choice

In our recently updated working paper Stockholder and Bondholder Reactions to Revelations of Large CEO Inside Debt Holdings: An Empirical Analysis, we investigate investor reactions to the first disclosures of the values of CEOs’ pensions and deferred compensation. These two items together comprise managers’ “inside debt” claims against their firms, since each represents a fixed liability owed by the companies to their executives at a future date.

We identify 231 companies whose CEOs have positive inside debt holdings and whose proxy statements with 2006 compensation data are filed in early 2007 during the first wave of disclosures under the SEC’s new executive compensation disclosure regulations. About 45% of these CEOs have excessive inside debt, as their personal inside debt-equity ratios exceed the external debt-equity ratios of their firms. As expected, we find evidence of transfers of value away from equity and toward debt upon revelations that top managers hold large pension and deferred compensation claims. Our results show that bond prices rise, equity prices fall, and the volatility of both securities drops at the time of disclosures by firms whose CEOs have large inside debt.

…continue reading: Market Reactions to CEO Inside Debt Holdings