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Do State Laws Matter for Bondholders?

Mansi, Maxwell, & WaldMay 22, 2007

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Introduction

This research builds on 2 most recently published papers:

– The first by Wald and Long (2006), which examines the impact of state laws on corporate capital structure

– The second by Klock, Mansi, and Maxwell (2005), which examines the relation between the Gompers et al. (2003) Index of antitakeover amendments and the cost of debt financing

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Introduction

In this paper, we examine how state laws are valued by the credit markets. We focus our attention on two types of statutory restrictions:

– State payout restrictions (restriction on minimum A/D ratio necessary to make a distribution)

– Restrictions on hostile takeovers

Both of these types of restrictions are designed to protect creditors from expropriation by shareholders and are widely adopted in U.S. debt agreements.

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Agenda

Motivation State payout restrictions and

antitakeover laws Current empirical evidence Research questions Sample selection, proxies, and measures Empirical results Conclusion

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Motivation

Main question is whether state of incorporation (or state law) has an impact on firm value

Incorporation decision– U.S. firm are all subject to same bankruptcy laws

and bankruptcy courts are federal– U.S. firms are subject to same SEC regulation– U.S. firms access same capital markets– U.S. firms pay taxes where they have operations

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Motivation

Evidence on equity side is mixed

– Race to the top Empirical evidence for higher firm value for firms

incorporating in Delaware (Romano (1985) and Daines (2001))

– Race to the bottom Empirical evidence for insignificant increase in

firm value (Subramanian (2004) and Bebchuk & Ferrell (2001), and Bebchuk et al. (2002))

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What Varies Across States?

Laws on payout restrictions

– When debt is present, state laws differ in payouts

– Few states (e.g., Delaware) provide few restrictions

– Firms incorporated in NY, TX and many other states are subject to the net worth rule (TA constraint = 1)

– Firms incorporated in CA or Alaska are subject to a more stringent test (TA constraint = 1.25)

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Can Debt Covenants Substitute for State Laws?

State payout restrictions are similar to certain bond covenants, but they are not individually negotiated

Firms used to write separate debt covenants

But that can be costly (Smith and Warner, 1979; John and Kalay, 1982)

After 1980 or so, many of the basic restrictions were added to state laws (Eisenberg, 1983)

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What Varies Across States?

Antitakeover Laws

– Companies are only subject to the statutes of the state which they are incorporated

– Firms prefer to reincorporate in states with more antitakeover provisions, often to the detriment of shareholders (see Heron and Lewellen, 1998; and Bebchuk and Cohen, 2003)

– State antitakeover laws: antigreenmail laws, control share statute, fair-price statute, freeze-out or business combination statutes, poison pills, constituencies statutes

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State of Incorporation

Why do firms remain incorporated in more restrictive jurisdiction

– High cost of reincorporation

– Regulatory advantages in some states

– Payout restrictions may reduce the agency cost of debt by restricting financial and investment policy

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Costs of Reincorporation

For state payout restrictions to matter, the cost of reincorporation can not be too small – otherwise no credible pre-commitment

On the other hand, if the cost of reincorporation are too high then firms remain incorporated in their home state, never change states, and do not get optimal use of state laws

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Empirical Evidence

Agency cost of debt

– Jensen and Meckling (1976) and Myers (1977)

– Conflicts center on firm payout policy (e.g., Dhillon and Johnson (1994); Maxwell and Stephens (2003))

– Antitakeover provisions (e.g., Billet, King, and Mauer (2004), Klock, Mansi, and Maxwell (2005), and Saffieddine and Titman (1999))

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Empirical Evidence

Payout restrictions and state antitakeover laws

– Wald and Long (2006)

– Heron and Lewellen (1998) – firms prefer to incorporate in states with more antitakeover laws, and these laws decrease firm market values

– Bebchuk and Cohen (2003) – similar findings, and also firms prefer to stay in their home states

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Why Bonds?

Debt represents the main source of financing for firms

Empirical evidence based on equity prices

Tobin Q is typically based on book rather than market value of debt

Bond characteristics are well suited for better pricing

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Research Questions

Two main questions– Are there advantages to firms incorporated in states

with more restrictive payout jurisdictions?– What is the impact of payout restrictions and state

antitakeover laws on credit ratings & yield spreads?

• In our paper, we find that – Firms incorporated in states with more restrictive

payout statues (New York) have better credit ratings and lower spreads relative to firms in less restrictive states (Delaware).

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Sample Selection

Data sources– Lehman Borthers Fixed Income database– IRRC data on firm decisions to opt out of state laws– State laws from a number of sources, Lexis/Nexis,

Gartman (2000) and McGurn et al (1989) for antitakeover laws

– Compustat Industrial database (SIC codes 2000-3999)– Executive compensation database– Thomson Financial (institutional ownership data)– Mergent data for firm reincorporation decisions and

fixed income data for debt covenants

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Selection criteria

Based on firms in the LBFI database

Based on financial info. from Compustat

Based on firms in Gartman (2000) index

Final sample of 8,531 firm-year observations on 1,625 firms (for the period from 1987-2003)

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Why 1987 on?

1987 US Supreme Court decision CTS Corp v. Dynamics Corp of America clarified that antitakeover laws were constitutional. Many states then passed antitakeover legislation

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Proxies and Measures

Measuring the cost of debt– Yield spread weighted yield to maturity less its

duration equivalent Treasury yield

Measuring state law and antitakeover variables– Payout restrictions (the minimum asset/debt ratio (0,

1, 1.25)) as in Wald and Long (2005)– Antitakeover laws as in Bebchuk and Cohen (2003)– GIndex as in Gompers et al. (2003) or a subset based

on Bebchuk et al. (2005).

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Control Variables

Firm Specific – Size, Leverage, MTB– Profitability– Intangibles– Firm Risk

Debt Covenants– Event Risk– Payout– Financing

Security Specific– Credit Ratings– Duration– Convexity– Debt Age

• Governance – Inside Ownership– Inst. Ownership

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Incidence of State of Incorporation

State of Incorporation

Frequency Percent Cumulative

Total Asset Constraint

Delaware 4,678 54.84 54.84 0.00 New York 396 4.64 59.48 1.00 Ohio 350 4.10 63.58 1.00 New Jersey 253 2.97 66.55 1.00 Pennsylvania 205 2.40 68.95 1.00 Virginia 182 2.13 71.08 1.00 Texas 178 2.09 73.17 1.00 California 115 1.35 83.32 1.25 Other States 830 9.73 100.00 0 or 1 or 1.25

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Results

Most of the firms in the sample are incorporated in Delaware (about 55%)

This is because Delaware firms are more likely to use debt financing.

Most of the firms in the sample have TA constraint variable of 1.0. Exception is Delaware (TA=0) and California (TA=1.25)

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Descriptive Statistics

Delaware Firms Non-Delaware Firms (TA Constraint = 0) (TA Constraint = 1) Variable Mean Median StDev Mean Median StDev Spread 438.489 273.067 679.707 269.226 155.430 393.228 Antitakeover Index 0.955 1.000 0.298 3.593 4.000 1.560 GIndex 9.553 10.000 2.894 10.029 10.000 2.475 Size 7.531 7.490 1.454 7.688 7.627 1.399 Leverage 0.626 0.562 0.286 0.533 0.481 0.201 ROA 0.127 0.128 0.096 0.140 0.133 0.074 FirmRisk 0.435 0.139 1.289 0.360 0.089 1.354 Ratings BB+ BB+ A/ B BBB+ BBB+ AA-/ BB Duration 5.682 5.510 2.057 6.183 6.086 2.262 Convexity 0.524 0.389 0.439 0.652 0.507 0.494 Age 2.519 2.827 2.775 3.548 3.762 2.978 Payout Covenants 0.495 0.000 0.566 0.370 0.000 0.530 Fin. Covenants 2.070 2.000 1.424 1.782 2.000 1.203 Event Risk Cov. 1.359 1.000 0.754 0.977 1.000 0.780 Insider 0.028 0.005 0.070 0.025 0.004 0.069 Inst-Own 0.534 0.569 0.215 0.531 0.552 0.199 Firm-Year Obs. 4,764 4,764 4,764 3,647 3,647 3,647

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Correlations

Log (spread)

TA Constraint

Antit. Index

Covenants

Firm Size

Debt Rating

Firm Risk

Insider

TA Constraint -0.236

Antit. Index -0.157

0.728

Covenant 0.402

-0.125

-0.087

Size -0.418

0.068

0.068

-0.340

Rating -0.784

0.286

0.199

-0.482

0.523

FirmRisk 0.026

-0.033

-0.001

-0.022

-0.033

-0.025

Insider 0.144

-0.018

-0.036

0.163

-0.201

-0.210

-0.009

Inst-own -0.232

-0.015

0.053

-0.165

0.370

0.250

-0.029

-0.207

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Multivariate Analysis

We examine the relation between state laws and antitakeover measures and credit ratings/cost of debt and various controls for firm specific variables

We control for clustering and heteroskedasticity as in Peterson (2006)

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Credit Ratings and State Laws

Primary Specification

GIndex

Non-Linear Leverage

Non-Linear Volatility

Ownership Variables

(1) (2) (3) (4) (5) TA Constraint 0.552b

(2.071) 0.377b (2.237)

0.397b (2.349)

0.378b (2.243)

0.334a (1.898)

Antitakeover Index

0.031 (0.400)

GIndex

0.114c (3.611)

0.114c (3.649)

0.116c (3.676)

0.068a (1.925)

Leveragesq 2.836c (4.275)

FirmRisksq -0.018b (-2.260)

Insider -4.698a (-1.867)

Insidersq

2.423 (0.436)

Inst-own -1.062a (-1.810)

Adj. R-Squared 0.672 0.644 0.649 0.645 0.624 Obs. 6,979 4,515 4,515 4,515 3,440

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Credit Ratings Results

In all specifications, a larger (more strict) TA constraint is associated with a significantly higher credit ratings

For Model 1, a TA constraint of 1 is associated with a ratings increase of 0.552, more than half a rating step

Changes between models due mainly to smaller sample sizes

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Yield Spreads and State Laws

Cross-sect Time Series

State Anti-takeover

Laws

Dummies for Payout

Restriction

GIndex

Fama

MacBeth (1) (2) (3) (4) (5) TA Constraint -0.215c

(-11.918) -0.231c (-9.297)

-0.076c (-4.005)

-0.080c (-5.715)

TA Constraint = 1 -0.218c (-11.979)

TA Constraint = 1.25 -0.202c (-3.312)

Antitakeover Index

0.006 (1.044)

GIndex

-0.017c (-4.472)

-0.019c (-9.954)

Firm risk 0.002 (0.370)

0.002 (0.377)

0.002 (0.365)

0.011a (1.775)

0.012b (2.548)

Adjusted R-Squared 0.756 0.756 0.756 0.786 0.840 Observations 8,531 8,531 8,531 4,007 4,007

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Yield Spread Results

Results suggest that the overall total asset constraint variable is negatively related to the cost of debt financing

The index of antitakeover laws variable has no significant impact on bond yields

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Robustness Checks Dependent Variable = Yield Spread Ownership

Variables Non-

Delaware Covenant Controls

Covenant Controls

Investment Grade

Non-Invest Grade

(1) (2) (3) (4) (5) (6) TA Constraint -0.064c

(-3.083) -0.271c (-2.580)

-0.184c (-5.370)

-0.184c (-5.497)

-0.062c (-3.040)

-0.099c (-2.902)

Gindex -0.014c (-3.496)

0.000 (0.000)

-0.017c (-4.315)

-0.018c (-2.634)

Insider -0.360 (-1.146)

Insidersq

0.316 (0.585)

Inst-own -0.139b (-2.098)

Event Risk Cov.

0.000 (-0.014)

Payout Cov.

0.021 (0.595)

Financing Cov.

0.026a (1.717)

Pay & Fin Cov.

0.025b (2.556)

Adj. R-Squared 0.783 0.756 0.740 0.740 0.672 0.627 Firm-Year Obs. 3,047 1,692 2,232 2,232 2,746 1,261

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Conclusion

We provide evidence that more stringent payout constraints in state laws have a negative impact on bond yield spreads

State laws that restrict firm payouts can reduce the firm’s cost of debt

These restrictions function similar to how Smith and Warner (1979) describe the function of debt covenants

The impact of antitakeover laws on bond yields is insignificant