ON FINANCIAL ON FINANCIAL CONTRACTINGCONTRACTING

An Analysis of Bond An Analysis of Bond CovenantsCovenants

Clifford W. SMITH, Jr. and Jerold B. WARNER

Journal of Financial Economics 7 (1979)

QF04 892601 宋芳華 892602 何 尹

892622 曾至苹

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.

=>how debt contracts are written to control

the bondholder-stockholder conflict

Sources of the bondholder-stockholder conflict

Dividend payment raising the dividend rate -> reducing the value of the bond Claim dilution issuing additional debt of the same or

higher priority -> the value of the bondholder’s claims is

reduced

Asset substitution

substituting projects which increase the firm’s variance rate-> the value of the stockholder’s equity raises and the value of the bondholder’s claims is reduced.

Underinvestment( 不做足額投資 )

the benefit from accepting the project accrues to the bondholder-> the firm can reject projects which have a positive NPV

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

The Costly Contracting Hypothesis-- control of the bondholder-stockholder confl

ict through financial contracts can increase the value of the firm

[ the Commentaries ] Our description of the specific provisions i

n debt contracts is based primarily on an American Bar Foundation compendium entitled Commentaries on Indentures.

Restrictions on the firm’s production/investment policy

Restrictions on investment Restrictions on the disposition of assets

( 資產處置限制 ) Secured debt( 擔保負債 ) Restrictions on mergers Covenants requiring the maintenance of a

ssets Covenants which indirectly restrict on pr

oduction/investment policy

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

Restrictions on the disposition of assets( 資產處置限制 )

股東會試圖將公司資產移轉到自己手中

此條款限制股東轉移資產給自己和不作足額投資的能力

Secured debt( 擔保負債 ) 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.

Restrictions on mergers

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

Covenants requiring the maintenance of assets

The firm’s 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 firm’s properties requiring the maintenance of the firm’s working capital

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 firm’s actions

Bond covenants restricting the payment of dividends

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

Typically, the inventory of funds available for dividend payment in quarter τ, , 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.≦ ≦

1*

0 0 0

( ) ( ) ( )t t tt t t

D k E S F D

*D

tStE

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 firm’s existing assets, either of which would reduce the coverage on, and thus the value of, the debt.

*max[0, ]D D

The firm’s cash flow,, can be expressed as: ----------(4) where, for quarter t, is the firm’s net earnings is depreciation is the book value of any assets liquidated

Substituting (3) into (4) and solving for yields - -------(5)

t t t t tE d R L

tE

td

tL

t t t t t t t t t tD E d R L I S B R P

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 firm’s 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

t t t t t t tD R P I S B tD

tP

t

tS

tB

tR

tI

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, and=0, for t≠T ). If we also assume that F≡0, and k≡1, then substituting (5) and (1) into (2) yields the condition for dividends in quarter τ to be positive,

-------------------(6)

00

( )t t tt

B I L d

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.

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 firm’s 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.

1*

0 0 0

( ) ( ) ( )t t tt t t

D k E S F D

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.

Control of investment incentives when the inventory is negative If inventory of fund available is negative, no dividend can be p

aid. firm’s 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.

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.

If as the firm’s 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.

Bond covenants modifying thepattern of payoffs to

bondholders Sinking fund 債券的本金可以在到期時一次償還，也可在到期前償還。公開發行的債券會透過償債基金及贖回條款方式償還。在 1963 ～ 1965 年間，有 82% 公開發行的債券擁有償債基金這項條款。

償債基金是為了償還債券，由債券受託人（ trustee ）管理的一個帳戶，一般而言，發行公司每年提撥一筆錢給受託人；受託人可以從市場上購入債券，或以隨機選取方式購買債券，通常是以面值購入。

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.

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.

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 firm’s cash flows,

because with a higher variance rate, the

attached call option becomes more valuable

Callability provisions

贖回條款賦予發行公司可以在特定期間內，按預定的價格買回其發行的所有債券。通常贖回價格 (call price)會比此債券的面值 $1000高，贖回價格和溢價之間的差額稱為贖回溢價(call premium) 。贖回溢價通常會隨時間而變小。常見的合約一開始會把贖回溢價訂為一年的利息，然後隨時間遞減，至到期日為0。

贖回條款在債券發行之後的前幾年通常不能行使。例如，發行公司可能被限制不能在前十年贖回債券，這稱為遞延保護(deferred call) ，在這段不能贖回的期間，我們稱債券受到贖回保護(call-protected)。

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.

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

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

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”??

1*

0 0 0

( ) ( ) ( )t t tt t t

D k E S F D

3. Officers’ certification of compliance To be sure that there is no knowledge of any

default4. The required purchase of insurance In order to monitor the operation and the

maintenance of the firm and provide a loss control program

The corporation’s cash flow variability will be small by the purchase of loss control program

The enforcement of bond covenants

1. The legal liability of bondholders

2. The role of the trust indenture and the trustee

3. Default remedies

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

2. The role of the trust indenture and the trustee:

Trustee Bribing problem How to solve

--The Trust Indenture Act of 1939

--Private placement

3. Default remedies:

Renegotiation —The debt contract is often renegotiated i

n order to eliminate the default.

Bankruptcy

Conclusion

1. 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

2. Implications for capital structure --The costs associated with the

bondholder-stockholder conflict rise with the firm’s debt / equity ratio

The costs associated with writing and enforcing covenants influence the level of debt the firm chooses.

3. Some other extensions --The interrelationship between

covenants restricting dividend, financing, and production / investment policy

--The impact of the bondholders-stockholder conflict on the firm’s total contracting costs