Debt Protection

Equity needs constant, expensive supervision.

Debt has a much easier task: collect promised amounts, or seize assets.

Some typical covenants.

Bankruptcy is really bad for management.

Manipulation of bondholder rights is possible, but it is not easy.

Equity payoffs depend very sensitively on good management control and actions and accurate accounting (verification). Even if they are firmly in charge, equityholders have the unenviable task of determining whether poor performance is the fault of management, the market, or both.

Unlike equity, creditors do not need to play a large role in the day-to-day operations of the company in order to receive most of their due. Ascertaining the value of collateral is cheaper than ascertaining the value of equity (with its future growth options). And if cash is not paid when promised—regardless of whether it is because the market environment is bad, because management has performed poorly, or because management just hides assets—the company falls into automatic default (usually bankruptcy and/or corporate liquidation), and creditors can take control of the company and/or the collateral. Therefore, creditors need not spend much time and money investigating managers.

We have already discussed in Chapter 16 that creditors usually demand and receive covenants, by which the firm must live. Covenants may include collateral, priority, the naming of an auditor, the specification of minimal financial ratios (e.g., dividend payout ratio), and many more terms. Default occurs when covenants are not met. Importantly, coordinated creditor action upon delinquency is not required, because such mechanisms are designed at inception. (If the creditor is a single large bank, this is not necessary.) In the case of a public bond, the covenants designate a trustee to oversee performance of covenants. The trustee has the obligation to declare a bond in default when the covenants are not met. (The process is mechanical.) Therefore, in contrast to equity holders, bond holders do not commonly suffer from free-rider problems.

Management will try to avoid default like the plague. The reason is not just that equity owners, on whose behalves managers supposedly act, lose access to the firm's future projects. The more important reason is that corporate management is replaced in virtually all bankrupt companies. This gives management and shareholder-owners an enormous incentive to avoid default/bankruptcy.

Although there are some escape mechanisms that permit management to manipulate the covenants, these are rare and slow. The first such mechanism is a "forced exchange offer," in which managers set up a prisoner's dilemma that makes it in the interest of every individual bondholder to exchange their current bonds for less worthy bonds but of higher seniority—even though it is not in the bondholders' collective interest. The second mechanism is a covenant amendment, which must be approved by the bond trustee and voted on by bondholders. The third mechanism is asset sales or divisional splits, which require major corporate surgery. For example, when Marriott Corporation announced that it would split into two companies (hotel operator Marriott International, MRT, and a real-estate investment trust Host Mariott, HMT) in 1992, its share price rose by 10%. Marriott's bondholders sued, because the old Marriott debt now would be owed only by one descendent, Host Marriott. Moody's Special Report covering 1970-1992 stated on page 4 that:

Perhaps the most notorious fallen angel of the year was Marriott Corp., which alone accounted for $2.6 billion of downgraded debt. In October, Marriott announced a controversial spin-off that would relieve the profitable hotel operations business of the heavily indebted real estate and concessions business. Such a move would have

23 5 THE EFFECTIVENESS OF CORPORATE GOVERNANCE

the effect of creating one very healthy and essentially debt-free company, Marriott International Inc., and another substantially weaker debt-laded firm, Host Marriott Corp. While issuer-bondholder talks are ongoing in the Marriott case, investors worry that such lopsided spin-offs may become more popular in the future.

Nevertheless, these are the exceptions rather than the rule. It is generally much harder for management to escape bondholder discipline than it is for them to escape stockholder discipline. In turn, this can even help shareholders—even though liquidation almost always hurts shareholders, the threat of future liquidation upon poor managerial performance can motivate managers and thereby help dispersed public shareholders up-front.

We have earlier talked about how large shareholders cannot only discipline managers but also The role of large extort special privileges. A similar issue can arise with creditors. That is, although we have creditors.

discussed primarily the case in which creditors cannot trust corporations, the opposite can also be the case. (And it can just as much prevent the firm from obtaining viable debt financing.) A

creditor may be able to pull its line of credit and thereby threaten management or expropriate the firm's equity (receiving control of the firm). Banks attempt to build a reputation for not doing so in order to reduce such borrower concerns.

Q 23.15 Why does management often prefer to avoid financial distress?

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