debt equity conflict

8/9/2019 Debt Equity Conflict

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Equity-Debtholder Conflictsand Capital Structure

Bo BeckerPer Strmberg

Working Paper

10-070


2/30

EquityDebtholderConflictsandCapitalStructure

BoBeckerandPerStrmberg***

February,17,

2009

Abstract.Weusean important legaleventasanaturalexperimentto

examine equitydebt conflicts in the vicinity of financial distress. A

1991 Delaware bankruptcy ruling changed the nature of corporate

directors fiduciary duties in that state. This change limited incentives

totake

actions

favoring

equity

over

debt.

We

show

that,

as

predicted,

this increased the likelihood of equity issues, increased investment,

and reduced risk taking. The changes are isolated to indebted firms

(where the legal change applied). These reductions in agency costs

were followed by an increase in average leverage and a reduction in

interest costs. Finally, we can estimate the welfare implications of

agency costs, because firm values increased when the rules were

introduced.

We

conclude

that

equitybond

holder

conflicts

are

economically important, determine capital structure choices, and

affectwelfare.

JEL:G32,

G33,

L2


3/30

Managerialdecisionsinfluencethedistributionofvaluebetweendifferentparties.Thiscanleadto

conflictinginterestsamongfinancialclaimants,suchasholdersofequityanddebt(FamaandMiller

1972,Jensen

and

Meckling

1976,

Myers

1977).1

Equity

holders

may

prefer

low

investment,

may

want

to

limitnewequityfinance,andmaylikehighrisks.2Suchcostsarepotentiallyimportantinlightofthe

largeapparenttaxadvantagesofdebtinconjunctionwithmodestleveragelevels(e.g.Graham2000).3

Unfortunately,agencycostsarehardtoidentifyempirically,andtheirimportance,andevenexistence,is

notwellestablished.Forexample,insufficientorexcessivelyriskyinvestmentcanonlybedefinedwith

referencetothesociallyoptimallevel,whichishardtoestimate.Despitethechallengeinvolvedin

measuringagency

costs,

they

have

a

prominent

role

in

capital

structure

theory.

Indirect

methods,

such

asstudyingfirmsinfinancialdistress,aremuchcomplicatedbythecorrelationoffinancialandeconomic

distress(Asquith,Gertner,Scharfstein1994andAndradeandKaplan1998).Sofar,thestrongestcasefor

theexistenceoftheseagencycostsisprobablyindirect,comingfromthefactthatdebtcontracts

includeamultitudeofcovenantsaimingtocurbopportunisticbehaviorofmanagement(Smithand

Warner,1979).

Wepresentanovelapproachtoidentifyingdebtequityconflictsandtheassociatedagencycosts,

employinga1991legaleventasanaturalexperiment.Ournaturalexperimentrevolvesaroundthe

fiduciarydutiesofcorporateofficers.Broadlyspeaking,thesedutiesrequirethatofficerstakeactions

thatareintheinterestofowners.Historically,thepositionofU.S.courtshasbeenthatsuchdutiesare

owedtothefirmasawholeandtoitsowners,butnottootherfirmstakeholders,suchascreditors.4

Creditorsareassumedtobeabletoprotectthemselvesbycontractualandothermeans(e.g.

covenants).Thissituationchangesonceafirmbecomesinsolvent.Atthispoint,fiduciarydutiesare

owedtocreditors,sinceforinsolventfirmscreditorsbecometheresidualclaimants.Aslongasthefirm

issolvent,however,thetraditionalviewwasthatnosuchrightswereheldbycreditors.Thischanged

withtheDelawarecourtsrulinginthe1991CreditLyonnaisv.PatheCommunicationsbankruptcycase5.

1 Although beyond the scope of this paper, the allocation of value and cash flow between lenders of different

seniority, security status or maturity (e.g. Kroszner and Strahan, 2001) and between insiders and insiders (e.g.

Jensen,1986)mayalsobeaffectedbymanagerialactions.2 See Myers (2003) for list of possible agency problems between equity and debt (which can generate costs of

financialdistress).Severalarerelatedtotheoptionlikefeaturesofequity(seeBlackandScholes,1973).3Thereareotherpossiblecostsofdebt,includingdirectbankruptcycostsandotherfinancialdistresscostssuchas

liquidity constraints or firesales ofassets. However, these are typically identified byresearchers (seee.g. Weiss

(1990)andAndradeandKaplan(1998))astoolowtocountervailthetaxadvantageofdebt.Thustradeofftheory

seemstorequireindirectcostsofdebt,suchasthosepotentiallycausedbyagencycostsbetweenequityanddebt.

See e.g. Almeida and Philippon (2007), Elkhami et al (2009), and Korteweg (2009) for recent studies reaching


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Thecaserulingarguedthatwhenafirmisnotinsolvent,butinthezoneofinsolvency,dutiesmay

alreadybeowedtocreditors.Therewasextensivepresscoverageattheruling,andconsiderabledebate

andanalysis

about

the

implications,

in

the

following

months.

The

case

was

widely

perceived

to

have

createdanewobligationfordirectorsofDelawareincorporatedfirms.Forexample,inthefollowing

March,ForbesMagazinereportedthat,followingarecentdecisionbyWilliamAllen,whena

companyisinserioustrouble,thedirector'sresponsibilityshiftssomewhatinthedirectionofthe

creditors(Forbes,1992).Exactlywhatconstitutedthezoneofinsolvencywasnotperfectlyclear.Before

theseissuescouldbesettleddefinitivelybyfurthercourtrulings,Delawarecourtshadbackedoff

somewhatfromtheCreditLyonnais1991duties.Especiallythe2004ProductionResourcesGroupvNCT

and2007

N.

Am.

Cath.

Ed.

Programming

Found.,

Inc.

v.

Gheewalla

cases

ended

up

limiting

the

ability

of

creditorstosuedirectorsforbreachoffiduciarydutyunderDelawarecorporatelaw.

TheCreditLyonnaisv.PatheCommunicationslegalepisodeprovidesaninterestingopportunitytoassess

theextentofcreditorequityholderconflictandtheimpactofsuchconflictonequilibriumcapital

structure.Foraperiodoftime,startinginJanuary1992,directorsofDelawarecorporations,butnotof

firmsincorporatedelsewhere,hadstrongerdutiestocreditors.Thispresumablylimitedtheextentto

whichdirectors

and

managers

were

willing

to

take

actions

favoring

equity

at

the

expense

of

debt,

as

dutiesshifted.

Ofcourse,fiduciarydutiesarenottheonly,andprobablynotthemostimportant,motivatorsfor

corporatedecisionsmaking.Managersaresubjecttofinancialincentives(seee.g.Murphy1999),face

terminationrisk(Kaplan1994),andhavecareerconcerns(Fama1980).Thebusinessjudgmentrule

limitstheimportanceofthefiduciaryduties.6Ontheotherhand,iffiduciarydutiesmatter,theymay

mattermostforfirmsfacingfinancialdistress,wherefinancialincentivesarelikelyfairlyweak.Towhat

extentthesedutiesaffectmanagerialdecisionmakingisanempiricalquestion.Ourempirical

methodologyteststhejointhypothesesthatdutiesdrivesomemanagerialdecisionsandthatCredit

Lyonnaischangedcorporateofficersperceptionoftheirduties.

Usingadifferenceindifferencemethodology,weexaminebothbehavioralchanges(e.g.investment)

andleverageoutcomesfollowingCreditLyonnais.Thedifferenceindifferencemethodologycontrasts

publicfirmsincorporatedinDelawareandtothoseincorporatedelsewhere,andbeforeandafter1991.

Weuse

firm

fixed

effects

to

control

for

any

heterogeneity

or

pre

existing

differences

between

firms

incorporatedinDelawareandthoseincorporatedelsewhere.Wealsoexaminethepredictionthatlow

debtfirmsshouldnotbeaffectedbytheCreditLyonnaisruling.Sincethecaseonlycreatednewduties

forfirmsinthezoneofinsolvency,anychangesincorporatebehaviorwhichweredrivenbyCredit

Lyonnaisshouldbeparticularlyvisibleforfirmsinfinancialdistress,butmightbeabsentaltogetherfor


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overhang.Infirmswithanontrivialprobabilityofdefaultondebtobligations,shareholderscangainby

increasingrisk,assuggestedbyJensenandMeckling(1976),whichisoftencalledriskshifting.Thegain

comesat

the

expense

of

creditors.

Managers

of

highly

levered

firms

can

borrow

more

and

pay

out

cash

toshareholders.7 Also,equityholdersmiaywishformanagerstoplayfortime,forexamplebyinflating

profits,inordertodelaybankruptcy(Asquith,Gertner,Scharfstein,1994).8

First,whenafirmishighlyleveraged,anddebtisrisky,equityholdershaveadisincentivetoraisenew

capitaltoinvestinsafeprojects,eveniftheseprojectshaveapositivenetpresentvalue.Thereasonis

thatthevalueoftheinvestmentwouldlargelygotocreditorsbymakingdebtlessriskyandexpected

debtrecovery

higher,

while

only

having

a

minor

effect

on

equity

value.

This

conflict

was

first

emphasized

byMyers(1977)andiscommonlyknownasthedebtoverhangproblem. Second,equityholdershave

anincentivetoincreasetheriskinessoftheexistingassets,evenincaseswhenthisreducesthenet

presentvalueofthefirm. Thisisbecausethebenefitsofhigherriskprimarilygotoequityholders

thankstotheirlimitedliability,whilethecostsareprimarilybornbycreditorsduetotheirlimitedupside

payoff.Thisconflictiscommonlyknownastheriskshiftingproblem,andisoriginallycreditedtoJensen

andMeckling(1976). Athirdimplicationofthesetheoriesisthattheinabilityofequityholderstopre

commitnot

to

under

invest

or

shift

risk

should

make

debt

more

costly

(and

less

desirable)

ex

ante,

since

creditorswillprotectthemselvesthroughhigherinterestandrestrictivecovenants.

Wefindevidenceconsistentwithofallthreeofthesepredictions.

First,DelawarefirmsaremorelikelytoissueequityinthewakeofCreditLyonnais.Thisincreaseis

apparentinunconditionaldataasillustratedinFigure1,whichshowshowthefrequencyofpositivenet

equityissuancewasthesameacrossDelawareandnonDelawarefirmsuntil1991,thattherateof

issuancewas

higher

after

1991

for

both

groups,

and

that

the

increase

was

larger

in

Delaware

firms.

The

changeforDelawarefirmsisdrivenentirelybyfirmswithabovemedianleverage,andisabsentinlow

leveragefirms.Payouttoowners(e.g.dividends)isinsomesensetheoppositeofequityissues,and

payoutfavorsequityoverdebt.However,thereisnoreductionindividendsorrepurchasesafterCredit

Lyonnais.9Moreover,investmentincreasedafterCreditLyonnais.10Thisistrueforcapitalexpenditures

aswellasforR&D.Again,theeffectisdrivenentirelybyrelativelyhighlyleveredfirms,whilewefindno

effectforfirmswithlowleverage.Theinvestmentincreaseiseconomicallysignificant(ontheorderof

halfa

percent

of

assets

for

the

average

firm).

Together

with

the

evidence

on

equity

issues,

this

is

consistentwiththeexistenceofdebtoverhangprobleminhighlyleveragedfirms.

7Seee.g.WargaandWelch(1993).

8Otherpaperswithfindingsconsistentwithdebtoverhangandinabilityoffinanciallydistressedfirmstocompete


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Second,wetesttheexistenceoftheriskshiftingproblembyexaminingriskandvolatility.11Wefindthat

afterCreditLyonnais,thestandarddeviationofROAfalls(again,onlyforhighleveragefirms),the

monthlystandard

deviation

of

equity

returns

falls,

and

the

implied

volatility

of

asset

value

falls.

These

effectsarefairlymodestinmagnitude,however.Forexample,annualassetvolatilityfallsbyabout0.4%.

Thefindingsonriskareindirect,inthesensethatweprovidenoevidenceonboarddecisionmaking or

firmpoliciesthatmayhavecausedtheincreaseinrisk(althoughwedoruleoutamechanicallinktothe

levelofinvestment).

Third,weexaminebankruptcyduration,basedontheideathatcreditorspreferbankruptciestobe

short,

and

that

bankruptcy

duration

can

therefore

be

used

as

a

proxy

for

indirect

bankruptcy

costs

(see

FranksandTorous1989, AyotteandSkeel2004,andBris,WelchandZhu2009,).Wefindthatboth

DelawareandnonDelawarebankruptciesbecameshorterafterCreditLyonnais,andthatthefallwas

largerandmoresignificantforDelawarebankruptcies(thedifferenceindifferenceestimateis4.7

months,or19%ofthepreCreditLyonnaisaverage),butthatthedifferenceisinsignificantlydifferent

fromzero.12ThisresultisillustratedinFigure2.

Fourth,ifCreditLyonnaisreducedagencycostsofdebt,equilibriumleverageshouldincreaseandthe

costofdebtfall.Aspredicted,wefindthattheleverageofDelawarefirmsincreasedbyapproximately

0.6%ofassetsafter1991(relativetothechangefornonDelawarefirms),whereasthecostofdebtfell

by17basispoints(comparedtoanaveragevalueof10.3%).

Thewelfareimplicationsofthesefindingsarenotobvious.Itispossiblethatcreditorfriendlydirector

duties,suchastheonesinplaceafter1991inDelaware,reduceagencycostsoffinancialdistress.This

wouldimprovewelfare,andincreasefirmvalue.Inthiscase,bothequityanddebtvaluesshould

increaseupon

the

announcement

of

the

new

ruling.

On

the

other

hand,

the

fiduciary

duties

might

be

a

purereallocationfromequitytodebt,generatingnonetcostsoffinancialdistress.Inthiscase,theprice

ofdebtcouldstillincrease,butthepriceofequitycouldgodown,leavingtheaggregatefirmvalueand

costofcapitalunaffected.Inthiscase,therearenoaggregatewelfareeffects.Onewaytodistinguish

betweenthesetheoriesistoexaminethechangeinequityvaluesaroundthetimeofCreditLyonnais

(undertheassumptionthatdebtvaluesdonotdecrease,whichseemsplausible).

Totest

these

competing

theories,

we

examine

the

response

of

equity

prices

around

the

announcement

oftheruling.13WefindthatDelawarefirmsincreasedinequityvalueby60.6basispoints(relativeto

nonDelaware)firmsonDec,30,1991,thedaythatthecaserulingwasannounced(tstat3.1).We

interpretthisreturndifferentialasameasureoftheannouncementeffectforCreditLyonnais.The

valueweightedreturndifferentialonthedayoftherulingwas41.4bp(tstat5.9).14 Dec,30wasthe

third highest daily Delaware to non Delaware difference in 1991 The five day announcement return was


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206bp(equalweighted,tstat4.9)and55basispoints(valueweighted,tstat3.4). Residualreturns

fromtheCAPMortheFamaFrenchthreefactormodel(bothestimatedinthefirst11monthsof1991)

suggestslightly

smaller

effects:

145

and

77

basis

points

(equal

weighted

and

value

weighted,

tstats

3.5

and1.8).ThesereturnsarealsohigherthantheDelawarenonDelawarereturndifferentialsatother

yearends(soarelikelynotdrivenbytaxconsiderations).

ThevaluationimprovementsforDelawarefirmsfollowingtheCreditLyonnaisrulingsuggestthatequity

debtconflictsdoindeedcomewithsignificantcosts,andthatexante,thosecostsarebornebyequity

(FamaandJensen1983).Animportantimplicationisthatreducingconflictcreatesvalue.Inaddition,

this

is

consistent

with

the

view

of

the

capital

structure

literature

that

there

must

be

large

intangible

costsoffinancialdistresstomotivateobservedcapitalstructures(seee.g.Myers1993).

Thispaperisrelatedtoseveralstrandsofresearch.First,itisgenerallyrelatedtotheliteratureon

stakeholdercorporationsandtheoptimalallocationofcorporatecontrolrights(seeZingales,2000).And

thediscussionofwhetherfiduciaryshouldbeextendedtootherstakeholders(seee.g.Tirole,2001).

Ourevidencesuggeststhatextendingfiduciarydutiestoincludecreditorsforfirmsclosetoinsolvency

maybewelfareincreasing. Second,ourpaperisrelatedtoliteratureoncompetitionbetweenstatesin

corporatelaw(see,e.g.,Bebchuk,CohenandFerrell2002).TheCreditLyonnaisdutiesareaprime

exampleofhowimportanttheDelawarecourtsare,andhowthedifferencesbetweenDelaware

corporatelawandotherjurisdictionscanbeofsignificance.Third,thepaperisrelatedtothetradeoff

theoryofcapitalstructureandotherworkontheagencycostsofdebt.Manyofthekeypapersarecited

above.AmongpapersthatfindevidencepointingawayfromequitydebtconflictareParrinoand

Weisbach(1999)andRauh(2009)(inbothcases,thetopicisriskshifting).Amongpaperswithmore

supportivefindingsareEsty(1997)(forfinancialfirms),ShleiferandSummers(1988)(equity

appropriatesvaluefromotherstakeholders),andAsquith,GertnerandScharfstein(1994)(indirect

evidencefromfinanciallydistressedjunkbondissuers).Finally,ourpaperalsorelatestothelegal

literaturethathasanalyzedtheemergenceofDelawareasapreferredbankruptcyvenueinthe1990s

(seee.g..LoPuckiandDoherty(2006)andRasmussenandThomas(2000)).AyotteandSkeel(2004)

documentthatDelawarebankruptciesarefasterthanbankruptciesinothercourts,andarguethatthis

isduetothehigherefficiencyoftheDelawarebankruptcycourts. Ourpaperprovidesanalternative

(andcomplementary)explanationfortheirfinding,namelythatfirmbehaviorchangedforDelaware

firmsinthevicinityofbankruptcy,whichenabledthemtoenterChapter11inahealthierstate,thus

makingbankruptcyresolutioneasier.

Therestofpaperthepaperisorganizedasfollows.First,wediscussthetheoryofequitydebtholder

conflictsandfinancialdistress.ThesubsequentsectionconcernstheCreditLyonnaisrulingandits


8/30

Corporatedirectorsowefiduciarydutiestothecorporationanditsstockholders.Ordinarily,theydonot

owefiduciarydutiestocreditors(oranyotherstakeholders).Onceafirmisinsolvent,thischanges,and

thecorporations

creditors

can

sue

directors

for

breach

of

fiduciary

duties.

Prior

to

Credit

Lyonnais,

the

generallyheldunderstandingofDelawarelawwasthatofficersdidnotowefiduciarydutytocreditors

priortoinsolvency.Thecasechangedthisunderstanding,andcreatedfiduciarydutiessometimepriorto

bankruptcyandinsolvency.15

TheCreditLyonnaiscasefollowedtheleveragedbuyoutofMGMCorporationinNovember1990,

financedbyseveralbanksandTimeWarner(theseller).Thenewlyprivatecompanyhadtrouble

meeting

financial

obligations

almost

immediately,

and

trade

creditors

forced

it

into

bankruptcy

court

withinfivemonths.Aspartoftheexitfrombankruptcy,MGMsecuredacreditlinefromtheU.S.

subsidiaryofCreditLyonnais,aFrenchbank.PatheCommunications,MGM'scontrollingstockholder,

andCreditLyonnaisalsoenteredintoacorporategovernanceagreement.Subsequently,CreditLyonnais

useditscontractualrightunderthatagreementtoreplaceMGMdirectors,includingtheCEO.Pathes

ownersfeltthenewCEOfavoredcreditorsinterests,andsued,claimingamongotherthingsthatthe

newCEObreachedadutyofgoodfaithowedtothem.

Thecase(infact,severallawsuitsthatwereconsideredtogether)wasruledbyChancellorWilliamAllen,

arespectedDelawarebankruptcyjudge.IntheNovember1991ruling,thecourtheldthattheCEOhad

beenappropriatelymindfulofthepotentialdifferinginterestsbetweenthecorporationandits98%

shareholder.Atleastwhereacorporationisoperatinginthevicinityofinsolvency,aboardofdirectorsis

notmerelytheagentoftheresidueriskbearers,butowesitsdutytothecorporateenterprise. In

footnote55oftheruling,thefiduciarydutiesoffirmsinfinancialdistresswerediscussed:inthevicinity

ofinsolvency,circumstancesmayarisewhentheright(boththeefficientandthefair)coursetofollow

forthecorporationmaydivergefromthechoicethatthestockholderswouldmake.

TheCreditLyonnaiscase,andespeciallyfootnote55,quicklybecamethefocusofattentioninthe

businesspressandamonglawyers.ReutersreportedalongnewswireonDecember30,titledCourt

upholdsParrettiOusterfromMGM,focusingonhowthedecisionfavoredcreditorsovertheowners.16

DowJonesNewswireandPRNewswirealsocoveredtherulingonDecember30.TheWallStreetJournal

coveredthestoryextensivelythefollowingday,emphasizingthattherulingconfirmedthebanks

extensivegovernance

role

(but

did

not

explicitly

mentioning

the

fiduciary

duties

of

the

board

or

footnote55).ApartfromtheWallStreetJournal,therewereatleasttwentythreenewspaperstories

aboutthecasethefollowingday(includinginTheBaltimoreSun,ChicagoSunTimes,HoustonChronicle,

FinancialPost,TheGlobeandMail,TheLasVegasReviewJournal,TheSanFranciscoChronicle,theNew

YorkTimes,FinancialTimes,StLouisPostDispatch,andtheWashingtonPost).


9/30

Veryquickly,newsstoriesandanalysisbylegalscholarsemphasizedthatthechangeingovernancetook

theformofnewfiduciarydutiesfordirectorsofDelawarecorporations.Thecasewasperceivedby

manyto

have

outlined

a

fiduciary

duty

of

corporate

officer

to

creditors,

for

firms

in

what

has

usually

beencalledthezoneofinsolvency.OnFebruary,1,1992,TheFinancialTimesBusinessLawBrief

discussedthechangeoffiduciarydutiesandreportedthatboardsofdirectorsofDelawarecompanies

whomightbe'inthevicinityofinsolvency'areponderingtheimplicationsoftheChancellor's

pronouncement(FinancialTimesBusinessLawBrief1992).InMarchof1992,ForbesMagazine

explainedtheimplicationsinplainEnglish:whenacompanyisinserioustrouble,thedirector's

responsibilityshiftssomewhatinthedirectionofthecreditors.Themagazinealsoemphasizedboththe

legalattention

(the

case

had

corporate

lawyers

buzzing

)

and

the

broad

implications

for

directors:

All

thisisofintenseinterestatatimewhenmanyjunkbondfinancedcompaniesarefrequentlyontheedge

ofinsolvency.ThejoboftheirdirectorsmaybecomplicatedbyChancellorAllen'sruling(Forbes1992).

Thecaseisextensivelycitedbyothercases,legalscholars,andpracticinglawyers.Itisdiscussedin

textbooksandlawfirmmemosandtaughtatlawschools.17Referringtothe1993meetingofthe

AmericanBarAssociation,aparticipantcommented:CreditLyonnaisgeneratedconsiderablecomment

and

controversy

over

the

additional

obligations

imposed

on

and

thus

the

potential

liability

of

boards

ofdirectors.18LawsuitscitingCreditLyonnaisappearedinthenextseveralyearsfollowingruling.19The

fiduciarydutiesimpliedbyCreditLyonnaiswereinvokedasmatteroffactineducationalmaterialsfor

practicingbankruptcylawyers:directorsofcorporationsmerelyinthevicinityofinsolvencyowe

dutiestocreditors(HughesandMcGee1995).

Delawarecourtshandledmanybankruptciesandothercorporatelegalmattersduringthesample

periodweconsider,butnoothercaserelatingtobankruptcyseemstohavebeenasimportantorhave

receivedanythinglikethewideattentiondevotedtoCreditLyonnais.ApproximatelyfifteenDelaware

caseswerementionedintheWallStreetJournalduring19911992.WhiletheWallStreetJournalonly

providesacrudeproxyforlegalimportance,itlikelydoesreflectpublicattentionfairlywell.Thecases

mentionedintheWSJrelatedtoproductliability,classactionlawsuits,financialreporting,mergerand

acquisitionsandantitrust.Noneofthecasesdiscusstherulinginanydetail,andmostareonlybrief

notes.Onlyoneofthecasesconcernedfiduciaryduties,inrelationtoamerger(someshareholders

thoughttheboardmadethewrongdecisionaboutatenderoffer).UnlikeCreditLyonnais,noneofthese

casesappeartohavesetimportantprecedents.

Morerecently,DelawarecaselawhaslimitedtheextentoftheCreditLyonnaisfiduciaryduties.

Delawarecourtshavereemphasizedthatcreditorscanprotecttheirintereststhroughcontractual

agreementsandothersourcesofcreditorrights.(ProductionResourcesGroupv.NCTGroup,2004).


10/30

regardlessofthecorporationssolvency,directorsmustcontinuetoactinthebestinterestofthe

corporationanditsowners.Thus,creditorshavenodirectclaimforbreachoffiduciarydutyagainst

directorsof

a

Delaware

corporation:

the

creditors

of

aDelaware

corporation

that

is

either

insolvent

or

inthezoneofinsolvencyhavenoright,asamatteroflaw,toassertdirectclaimsforbreachoffiduciary

dutyagainstthecorporationsdirectors.20

Still,forseveralyearsfollowingtheCreditLyonnaisruling,

thegeneralviewofmarketparticipantswasmostlikelythatmanagementowedfiduciarydutiesto

creditorswhenthefirmwasinthezoneofinsolvency.

TheCreditLyonnaisrulingsetaprecedentforfirmsincorporatedinDelaware,buthadnoprejudicial

power

for

other

firms.

Because

about

half

of

U.S.

public

corporations

are

incorporated

there,

the

case

providesausefuldivisionofpublicfirmsintotreatedanduntreatedgroups.Thisdivisionreliesonafirm

distinctionbetweenDelawareandnonDelawarecorporatelaw.However,otherjurisdictionsmay

incorporateideasandlearnfromDelaware(seeLinos2006).Ourempiricalstrategyreliesonthe

comparisonoffirmsincorporatedinDelawarerelativetothoseoutsideDelaware,sosuchleakage

mightbeproblematic.Webelievethisproblemislimitedforthreereasons.First,fiduciarydutiescanbe

thesubjectoflegislation,andtherebyoutsideofthescopeofprecedents.21Wehaveimplementedour

tests

excluding

states

without

constituency

statutes,

i.e.

where

fiduciary

duties

are

legislated

(but

not

excludingDelaware),withsimilarresults.Second,werestrictourteststofiveyearsbeforeandafterthe

CreditLyonnaiscase.Thus,evenifthereisleakageoflegalrulesfromDelaware,butitisnotveryfast,it

shouldnotaffectourresults.Finally,ifthereweresomeleakageevenduringtheshortwindowwe

study,thatwilltendtoobscuretheimpactofCreditLyonnais.Thus,ifwefindsignificantchangesafter

thecase,aswedo,thisconcernsuggeststhatwemayunderestimatethemagnitudesslightly.

Data

WecollectfirmlevelinformationonaccountingdataandstateofincorporationfromCompustat,

coveringthe19861997period.Weusefiveyearsbefore(19871991)andfiveyearsaftertheevent

(19921997),andincludedatafrom1986tobeabletocalculatechangesinvariables.Weuse

Compustatsincorporationcode.Ofthe6,608firmsin1991,weidentify44.4%asincorporatedin

Delaware.TheDelawarefirmstendtobeslightlylarger(medianassets$82.0millionversus$71.8million

fornonDelawarefirms),consistentwithBebchukandCohen(2003).TheCompustatincorporationdata

isbackfilled(i.e.,atanypointintime,Compustatreportsthecurrentstateofincorporation).This

reducesconcernsaboutendogeneity,butmayintroducemeasurementerror.Forasubsampleof485

firmsweverifiedthestateofincorporationduringoursample,andtherewere37differences,i.e.less

than8%offirmsappearedmisclassified. Moodie(2004)reports327reincorporationstoDelawareand

34 from Delaware by New York Stock Exchange (NYSE) listed firms during the 19602002 period The


11/30

RiskMetricsdatabase(coveringS&P1500andafewotherlargefirmseverytwoorthreeyearsfrom

1990)reports286incorporationchangesover19902006,i.e.anannualfrequencyofaround1.0%.The

onlyperiod

with

a

significant

difference

in

the

rate

of

reincorporations

is

1999

and

2000,

when

the

rate

is1.5%peryear.Ofthe103firmsinthissamplethatreincorporatedbetween1990and1998,68

switchedtoorfromDelaware.Excludingthesefirms(orasubsetofthemthatswitchedcloserintimeto

theruling)fromourregressionshasnonoticeableeffectonanyofourestimates.

FirmcontrolvariablesaredefinedfromCompustatandCRSPvariablesasfollows.ROAisEbitdadivided

bytotalassets(At).ROSisearningsbeforeinterest,tax,depreciationandamortization(Ebitda)divided

by

sales.

The

log

of

market

value

is

the

natural

logarithm

of

the

number

of

shares

outstanding

times

the

endofyearshareprice.Leverageisassetsminuscommonequity(bookvalue)andminustaxliabilities,

dividedbyassets.Marketleverageisassetsminuscommonequity(bookvalue)andminustaxliabilities,

dividedbyassetsminuscommonequity(bookvalue)andminustaxliabilitiesplusmarketvalueof

equity.WedefineQasassetsminuscommonequity(bookvalue)plusthemarketvalueofequityminus

taxliabilities,dividedbyassetsminus0.1timescommonequity(bookvalue)andplus0.1timesthe

marketvalueofequity.22Finally,twoyearstockreturnisthetwoyearlogchangeinstockprice.We

eliminate

observations

where

ROS

is

outside

[

1,1],

where

ROA

is

outside

[

0.5,0.5],

where

Depreciation

overAssetsisoutside[0,0.3],andwhereLeverageisoutside[0,1].23

DependentvariablesusingCompustatdataareinvestment(CapxdividedbyAt),CapexandR&D(Capx

plusXrd,dividedbyAt),andCapexandR&DoverSales(CapxplusXrd,dividedbySale).Forregressions

withthesevariables,weexcludeobservationswherethedependentvariableisoutside[0,0.5],[0,1.3]

and[0,3],respectively.NetdebtisdefinedasDlcplusDlttminusCh,dividedbyassets.Inregressions

withthisdependentvariable,observationsareexcludedwherenetdebtisoutsidethe[0.7,1.3]range.

Wealsouseanindicatorvariabletakingthevalueonewhenafirmsinvestmentisabovethemedian

investmentratioinitsindustryyear.Equityissuesaredefinedasthechangeinbookequityminus

changesinretainedearnings(andadjustedfordeferredtaxesasine.g.Baker,SteinandWurgler2003),

normalizedbylaggedassets.Valuesoutsidethe[0.16,0.9]rangearedropped,followingthewinsorizing

inBaker,SteinandWurgler(lowassetfirmssometimesproduceverylargeratios, sosomewinsorizingis

necessary,butusingwiderornarrowercutoffshaslittleeffectonthevariable).Weformanindicator

variableforobservationswithpositivevaluesforequityissues.

QuarterlyCompustatdataisusedtocalculatethestandarddeviationofROA(EBITDAoverlaggedassets)

changes.Thevariableisannualized.Equityvolatilityiscalculatedastheannualizedmonthlystandard

deviationofstockreturn,takenfromCRSP,fortheprecedingcalendaryear.CRSPpricedataisalsoused

tocalculateimpliedassetvolatilityusingtheMerton(1974)modelfollowingtheprocedureofVassalou


12/30

andXing(2004).Thisiscalculatedannuallyusingdailypricedata. Forvolatilitytests,weexclude

observationswherethedependentvariableisverylarge(volatilityofROAisoutside[0,1], equity

volatilityis

outside

[0,1]

or

asset

volatility

is

outside

[0,0.5]).

WeuseddailyfactorreturnsfromKennethFrenchswebsite,togetherwithCRSPdailyreturns,to

estimateCAPMandFamaFrench3factormodelsforJanuarytoNovember1991.Weonlyusedreturns

calculatedfromconsecutivetransactionprices(notbidaskspreads).Theloadings(betaestimates)were

usedtocalculateoneandfivedayresidualsfortheperiodfollowingtheannouncementoftherulingin

theCreditLyonnaiscase(Dec,30,1991).Averagestockreturns,aswellasaverageCAPMandFF

residuals,

equal

and

value

weighted,

were

calculated

for

firms

incorporated

in

Delaware

and

firms

incorporatedinotherstates,respectively.

Wecalculatebankruptcydurationsasthetimefromfilingtoexit,usingLynnLoPuckis databaseon

largecorporatebankruptcies(assetsofatleast100million priortofiling,in1980dollars).

SummarystatisticsareinprovidedinTable1.

ResultsInthissection,weevaluatetheeffectoftheCreditLyonnaiscourtrulingonfirmsinDelaware.We

employadifferenceindifferencemethod(seee.g.Bertrand,Duflo,andMullainathan,2004),usingthe

factthatfirmsinDelawareweresubjecttoadifferentlegalenvironmentafterNovember1991,butthat

firmsoutsideDelawarewerenot.Weexaminearangeofcorporateoutcomes,anduseregressionswith

firmandyearcombinationsdefiningtheunitofobservations.Thispermitscontrollingextensivelyfor

firmlevel

variables.

We

use

return

on

assets,

return

on

sales,

the

log

of

assets

(book

value),

the

log

of

sales,thelogofequitymarketvalue,depreciationoverassets,bookleverage(definedasassetsminus

equityminusdeferredtaxes,overassets),andmarketleverage(definedasassetsminusbookequity

minusdeferredtaxes,overassetsminusbookequityplusmarketequity),twoyearlaggedstockreturn,

andTobinsq(cappedat10). Wealsoincludefirmfixedeffects. Firmfixedeffectsallowcontrollingfor

manysourcesofunmeasuredheterogeneitybetweenfirms,reducingthepotentialforomittedvariables

problems.24 Becauseofthefirmfixedeffects,firmsthatonlyappearbeforeorafterthe1991cutoffdo

nothelp

identify

the

Credit

Lyonnais

coefficient

in

our

regressions

(they

do

help

identify

other

coefficients).Therefore,compositionalchangesintheDelawareandnonDelawarefirmpopulationswill

beeconometricallyunimportantforouridentification.

Payoutandequityissues

When a firm is distressed it may be in the interest of equity holders to increase payout and limit new


13/30

*After1991),whichidentifiesthemarginaleffectofCreditLyonnais.25Weclustererrorsbythe

interactionofyearandtheDelawaredummythroughout.Wehavealsousedstateof

incorporation*yearclustering

or

simply

state

of

incorporation.

These

alternatives

give

very

similar

t

stats,occasionallysomewhathigher.Clusteringbyfirmgivesmuchsmallerstandarderrors.

RegressionsarereportedinTable1.Thereisnoeffectfordividends(columnone)orrepurchases

(columntwo).Thisimpliesthat,apartfromwhatsexplainedbyfirmcontrolsandoveralltimeseries

patternscapturebyfixedeffects,Delawarefirmsdidnotexperienceachangeinpayoutpolicycompared

tononDelawarefirmsinthewakeofCreditLyonnais.26

Covenantsmay

explain

why

we

see

no

effect

of

Credit

Lyonnais

on

payout:

payout

was

circumscribed

forfirmsinandneardistressevenbeforeCreditLyonnais.Perhapsfiduciarydutieshadnofurtherbite,

soCreditLyonnaisdidnotmatterfordividendsevenifitdidchangedutiesinameaningfulway.

Covenants,beingcontractclauses,arelikelytobemoreeffectiveatlimitingbehavior(e.g.payout)than

atencouragingit(e.g.investment).Theymaythereforespecificallysuggestwhyweobservenoeffecton

payout,butlargesignificanteffectsinotherareas,aswewillshowbelow.Commoncovenantsthatlimit

payoutincludethosethatlimittheratioofdebttoequityortangiblenetworth(sincedividendsand

repurchasesreduce

the

denominators).

Incontrastwiththepayoutresults,wefindapositivecoefficientontheCreditLyonnaisdummyfor

equityissues. TherelativeincreaseinequityissuancesofDelawarefirmsis62basispointsofassetsper

year,aboutatenthofthesampleaverage.Thecoefficientissignificantatthe10%levelusingerrors

clusteredattheyear*Delawarelevel(i.e.twentyclusters).Nextweregressanindicatorforequityissues

abovezeroontheCreditLyonnaisindicatorandcontrols.Thisvariablediscardstheinformation

containedin

the

amount

of

equity

issues,

but

is

less

affected

by

outliers.

The

estimated

effect

is

positive

andsignificant,suggestingthatCreditLyonnaisincreasedthelikelihoodoffirmsissuingequityby2.67%.

Withthisresultinhand,wecanaskifthereisadifferencebetweenhighandlowdebtfirms,sinceCredit

Lyonnaisshouldhaveaffectedtheincentivesofthefirstgroupmuchmore.27Wethereforesplitthe

samplein(approximately)twobasedonbookleverage,andrepeattheregressionincolumnfourfor

eachsubsampleseparately.Aspredicted,thereisalargeandsignificanteffectforhighleveragefirms,

butnoeffectforlowleveragefirms(thecoefficientestimateispositivebutnotsignificantlydifferent

fromzero).28

25 We have tried including separate dummies for each individual state of incorporation. However, this variation


14/30

Theresultsforpayoutandequityissuesprovidesomeevidenceconsistentwithdebtequityconflicts.In

particular,thehigherequityissuesafter1991inDelawareareinlinewiththepredictionsofthedebt

overhanghypothesis.

The

other

main

implication

of

that

theory

is

that

distressed

firms

inefficiently

reduceinvestment,whichweturntonext.

Investment

Wenowconsiderwhetheragencyconflictsresultinlowerinvestmentcausedduetodebtoverhang. We

usethreemeasuresofinvestment:CAPEXoverassets,CAPEXandR&Doverassets,andCAPEXandR&D

oversales.TheregressionsarepresentedinTable3.Unlikepayout,investmentislikelynotsubjectto

much

limitation

by

covenants

(covenants

that

limit

investment

in

the

upward

direction

are

common,

but

weconsideranincreaseininvestment).

Inthefirstcolumn,weregressameasureofinvestmentontheCreditLyonnaisdummyandcontrols.

Theoverallfitoftheregressionisgood,mostlyreflectingthehighexplanatorypoweroffirmfixed

effects. ThecoefficientestimatefortheCreditLyonnaisindicator(Delawarefirmsafter1991)ispositive

andstatisticallysignificantatthe1%level.Inotherwords,after1991,investmentishigherforfirms

incorporatedinDelaware,comparedtofirmsincorporatedelsewhere,controllingforfirmaveragesand

tenperformanceandaccountingvariables.Themagnitudeisfairlylarge,amountingtoanincreasein

CAPEXby49basispointsofassets.Themeanofthisvariableis6.8percentofassetsperyear,sothe

effectisequaltosevenpercent ofmeaninvestment.Sincethisisanestimatetakenovertheentirefirm

population,theimpliedaggregateinvestmentforegonebydistressedfirmsbeforeCreditLyonnaismay

benontrivial. Incolumntwo,weinsteaduseadummyvariableindicatingwhetherafirmsinvestment

isabovethemedianforfirmsinthatindustryinthatyearasthedependentvariable.Thisavoidsany

concernsaboutoutliers.Thecoefficientestimateis0.0274,implyingthatCreditLyonnaisreducedthe

probabilityofinvestingbelowindustryyearmedianby2.74%.Incolumnthree,weincludeR&D

expendituresinthedependentvariable.Thismaycorrespondbettertothetheory(i.e.Myers1977

concernsallformsofinvestmentincludinginintangibles),butreducesthesamplesizeduetothe

imperfectreportingofR&DexpenditureinCOMPUSTAT.Theimpliedmagnitudecorrespondstoabout

fourpercentofmeaninvestment.Incolumnfour,wenormalizebysalesinsteadofassets,withsimilar

results(theestimatedeffectis0.93%ofsales,correspondingtosevenpercentofmeaninvestment).

Aswith

equity

issues,

we

split

the

sample

by

leverage

and

compare

the

effect

on

investment

for

the

sub

samples.WeestimatethebasicCAPEXregressionseparatelyineachsubsample.TheeffectofCredit

Lyonnaisisisolatedtothehigherleveragesubsample,aspredictedbythedebtoverhangtheory.There

isnoeffectoninvestmentbylowleveragefirms.Theestimatedeffectforhighleveragefirmsis59basis

points,oraboutninepercentofcapexaverageinvestmentforthisgroup.


15/30

WetestifthereisareductioninriskofDelawarefirmsafter1991andifanysuchpatternisdrivenby

relativelyhighleveragefirms. Thisisachallengingtesttoimplement,becausetherearefewgood

measuresof

operational

risk.

We

use

three

proxies,

each

potentially

subject

to

criticism.

First,

we

use

thetrailingstandarddeviationofeightquarterlychangesinROA.Thisrequiresafairamountof

accountingdata,yetprovidesanoisyestimateofriskthatislikelytobeslowtoreflectchangesin

corporatepolicy.Theadvantageofthismeasureisthatweavoidusingfinancialprices,whichmaybe

affectedbyotherfactorsthanoperatingpolicy.Thesecondmeasureismonthlyequitypricevolatility

overthelastyear.Becauseitreliesononeyearofhistoryinsteadoftwo,itmaybebetteratpickingup

timeserieschanges.However,equityvolatilitymaybeaffectedbycorporateleverageaswellasvarious

marketfactors.

To

mitigate

the

first

of

these

problems,

we

also

use

implied

asset

volatility

from

the

Merton(1973)modelasourthirdmeasureofrisk.

Regressiontestsofchangesinriskaround1991arepresentedintable4.Incolumnone,thedependent

variableisthevolatilityofROA.TheestimatedcoefficientfortheCreditLyonnaisindicatorisnegative

andsignificantlydifferentfromzeroatthe10%level.Themagnitudeis25basispoints,correspondingto

aboutfourpercentofthemeanofannualROAstandarddeviation.Theoverallfitoftheregressionis

good,mostlyreflectingthehighexplanatorypoweroffirmfixedeffects.29Incolumntwo,thedependent

variableisequityvolatility.Here,thenegativeeffectissignificantatthe1%level.Thecoefficient

estimateis80basispoints,correspondingtoaboutfivepercentofthemeanofequityvolatility.The

impliedmagnitudeforassetvolatilityisslightlysmaller,44basispoints,significantatthe5%level.

Aswithprevioustests,wewishtocomparelowandhighdebtfirms.Incolumnfourandfive,werepeat

theregressionfromcolumnthree(i.e.,usingassetvolatilityasthedependentvariable)forasamplecut

inapproximatelyhalfbasedonbookleverage.Thereisanegativeandsignificantnegativecoefficient(71

basispoints)

for

the

high

leverage

sample,

and

a

smaller

(53

basis

points)

insignificant

effect

for

the

low

debtsample.30

TheresultsinTable3areconsistentwithdeliberatereductioninvolatilitybycorporationsinDelaware

afterCreditLyonnais.Aswiththeearlierfindings,resultsaredrivenprimarilybyhighleveragefirms.The

evidenceisindirect,however,andprovidesnodirectevidenceofwhatmanagerialchoicesproducethe

extrarisk.Itisnotclearwhichtypesofmanagementorboarddecisionsthatmaychangetheriskprofile

of(non

financial)

firms.

Nevertheless,

it

appears

that

risk

is

lower

for

the

firms

affected

by

Credit

Lyonnais.

Bankruptcyduration

Wenextconsiderthedurationofbankruptcies.Thishasbeenusedasameasureofindirectbankruptcy

b F k d T (1989) d B i W l h d Zh 2009 Th i i i h i


16/30

inbankruptcymayhurtbusinessoperationsandproductmarketperformance,andthatalonger

bankruptcythereforemaybemoreharmfultocreditors.

WefindthatbothDelawareandnonDelawarebankruptciesbecameshorterafterCreditLyonnais,

fallingby6.3monthsoutsideDelawareandby11.0monthsinDelaware(seeFigure2).Thedropin

Delawareissignificantlydifferentfromzeroatthe1%level,andthedropoutsideDelawareis

insignificant.However,thedifferenceindifference,4.7months,or19%ofthepreCreditLyonnais

average,isinsignificantlydifferentfromzero,largelybecausethewideconfidenceintervalaroundthe

dropfornonDelawarefirms.

Thisevidence,

while

statistically

weak,

is

consistent

with

faster

bankruptcies

in

the

wake

of

Credit

Lyonnais,therebylikelyreducinglossesimposedoncreditors.Giventhestatisticalweakness,andthe

factthatthereisasimultaneous(butsmaller)dropoutsideDelaware,weconsiderthisevidence

suggestive

Capitalstructureimpact

IfCreditLyonnaisreducescostsoffinancialdistress,itoughttoincreaseequilibriumleverage.For

example,the

trade

off

theory

predicts

that

lower

distress

costs

allow

firms

to

take

advantage

of

the

tax

shieldsprovidedbyhigherleverage.InTable5,wethereforeregressmeasuresofleverageonfirm

controls,firmandtimefixedeffects,andtheCreditLyonnaisindicator.Fortestswherethedependent

variableinvolvesleverage,thecontrolsexcludebookandmarketleverage.

Incolumnsoneandtwo,wefindthatCreditLyonnaiscoincideswithsmallincreasesinbothbookand

marketleverage,33and27basispointsrespectively(bothsignificantlydifferentfromzeroattheten

percent

level).

The

small

economic

magnitude

of

these

estimates

may

not

be

too

surprising

given

the

factthatdeliberateactionsdriveonlymodestyeartoyearchangesinleverage (e.g.,firmsmarket

leverageislargelydrivenbyequitypricechangesWelch,2004).

Toaccuratelymeasurethefirmstrueindebtednessitmaybeimportanttomeasuredebtnetofcash

(Almeida,CampelloandWeisbach2004).NetdebtisalsoincreasedfollowingCreditLyonnais,witha

pointestimateof89basispoints.Thiseffectislargerthantheeffectforgrossleverage,correspondingto

fourpercentofthestandarddeviationofthedependentvariable(themeanfornetdebtislow,0.17,so

theestimatedeffectislargerincomparedtothemean).Theeffectishighlysignificant.Incolumnfour,

wetestwhetherinterestcostswereaffectedbytheCreditLyonnaisruling,controllingforleverage.If

agencycostsofdebtwerereducedbytheruling,interestcostsshouldfall.Indeed,controllingfor

leverageandothercontrols,interestcostsarelowerby25basispointsfollowingCreditLyonnais,which

can be compared to a mean interest rate of 10.4 percent (i.e. the reduction in interest costs are around


17/30

caseinterestpaidwouldbeexpectedtogoup).Takentogether,higherleverageandlowerinterestrates

suggestthatthereductioninequitydebtconflictthatCreditLyonnaisproducedhadanimpacton

capitalstructure.

Valuation

Toassessthewelfareimpactweturntoequityvalues.Animplicationofmosttheoriesofagencycostsof

debtisthatequityholderswillpaythecostsfromtheseanticipatedconflictsexantewhenthefirmraises

debt,throughhigherinterestratesandrestrictivecovenants,andpayusinglessdebt(thusmissingout

on,e.g.,taxadvantages).Wecantestthisusinginformationinstockprices.

Toassess

the

valuation

impact

of

Credit

Lyonnais,

we

compare

the

returns

of

Delaware

and

non

DelawarefirmsatthetimetheCreditLyonnaisrulingwasdelivered.Ingeneral,therelativevaluationof

DelawareandnonDelawarefirmsisstable.Indailyreturnsduring1991,thestandarddeviationofthe

equalweightedaggregatemarketindexis71basispoints,butthestandarddeviationoftheDelaware

nonDelawaredailyreturndifference(alsoequalweighted)isonly24basispoints.Thus,wemaybeable

toidentifyevenfairlymodesteffects.DelawarefirmsingeneralshouldbenefitfromCreditLyonnais,for

examplethroughlowerinterestrates,buttheeffectshouldnotbehomogenousacrossfirmsofdifferent

capitalstructure.LowleveragefirmshavelesstogainformCreditLyonnais,andunleveredfirmsmayget

nobenefit(althoughiftheymayraisedebtinthefuture,theremaybesomebenefit).Firmswithhigher

leveragewouldappeartohavemoretogain,sincetheycansavemoreoninterestcosts,andwould

appearmoreatriskforvariousgamesatcreditorsexpense.Theseeffectswillbedilutedifstockprices

takeintoaccountexpectedfuturechangesinagencycostsandfirmsarenotexpectedtomaintain

currentcapitalstructuresindefinitely.Forexample,afirmwithlittledebtmayseenoeffectivechanges

immediately(consistentwithe.g.ourinvestmentresults),butifitisexpectedthatthefirmmayhave

debtinthefuture,firmvaluemayincreasewithCreditLyonnais.Forownersoffirmswithveryhigh

leverage,thebenefitsofCreditLyonnaismaybesomewhatnegated,sinceequityholdersmayactually

gainfromriskshiftingandothergames.WethereforepredictareverseUshapetotherelationbetween

leverageandannouncementperiodreturndifferentialsbetweenDelawareandnonDelawarefirms.

ThecaserulingwasannouncedonDec,30,1991,wasimmediatelyreportedonnewswiresandwas

coveredextensivelybythepressthefollowingday.31WeassignDecember,30,astheannouncement

day,but

it

is

plausible

that

the

news,

if

relevant

to

market

prices,

would

only

be

reflected

in

market

pricesafterafewmoredays,oratleastafternewsreportsonthedayafter.Asitturnsout,magnitudes

change,thedirectionofresultsisnotverysensitivetothenumberofdaysincludedinthe

announcementreturns.

W fi d h D l fi i d i l b 60 6 b i i ( l i D l fi )


18/30

January,6,1992,sawa206basispointrelativeincreaseinDelawarefirmvalues,equalweighted,witha

tstatisticof4.9.Thevalueweightedfivedayreturnwas55basispoints(tstat3.4).Residualreturns,

whichcontrol

for

factor

loadings,

may

allow

cleaner

identification

of

the

announcement

effects.

ResidualfromtheCAPMortheFamaFrenchthreefactormodel(bothestimatedforeachstockinthe

first11monthsof1991)were145(tstat3.5)and77(tstat1.8)basispoints,respectively.32

Theseeffectsonequityvaluesprovidefurtherevidencethatdebtequityconflictcausefinancialdistress

costs,thatthesecostscanaffectfirmvaluesinanegativeway,andthatexante,thecostsareborneby

equityholders,consistentwithFamaandJensen(1983).

Itmay

be

interesting

to

compare

the

response

to

the

Credit

Lyonnais

announcement

across

firms.

For

example,veryhighleveragefirmsmightgainlessfromCreditLyonnais(becausethereownerswantedto

riskshiftorunderinvest).Similarly,lowleveragefirmsmighthavegainedless(becausetheyhadno

debtonwhichtosaveinterestcosts)ormore(theyhadmorescopetoincreaseleverageinresponseto

changedconditions).Figure3presentsathirddegreepolynomialfittothereturndifferenceacrossfirms

withvariouslevelsofbookleverage.33 Theestimatedrelationbetweenleverageandreturndifferentials

roughlyfollowsaninverseUshape.Atlowlevelsofleverage,thereturndifferentialisincreasingin

leverage,reaching

an

estimated

peak

around

0.15,

where

the

predicted

return

is

50

basis

points,

after

whichreturndifferentialisfallinginleverage.Thegraphfallstoalowpredictionofabout12basispoints

aroundaleverageof0.6,andthenturnspositive.However,thisisestimatedinthetailoftheleverage

distribution(theempiricalleveragedistributionisplottedinthegraph,forreference).Therefore,the

preciseshapeofthecurveisnotpreciselyestimated.A95%confidenceintervalfortheestimated

regressionlineisplottedonthegraph,showingthisuncertaintyaboutthepreciseshape.Thegeneral

patternisconsistentwiththepredictionthattheaveragebenefitsofCreditLyonnaiswerelargestfor

firmswith

positive

but

modest

leverage,

but

low

or

insignificant

for

high

leverage

firms.

ConclusionsTheCreditLyonnaiscasecreatedfiduciarydutiestowardcreditorsinDelawareincorporatedfirmsin

zoneofinsolvency.BecausethisdidnotaffectfirmsincorporatedoutsideDelaware,CreditLyonnais

providesanaturalexperimentforexaminingwhetherandhowequitydebtconflictaffectsfirm

behavior.In

our

tests

we

control

for

time

and

firm

fixed

effects

and

eliminate

changes

affecting

the

wholefirmpopulationbydifferencingwithnonDelawarefirms.Wefindimportantchangesinbehavior

afterCreditLyonnais.Firmsincreaseequityissuesandinvestment,consistentwithdebtoverhang.Firms

reducedoperationalandfinancialrisk,consistentwithriskshiftingandassetsubstitutiontheories.

32


19/30

CreditLyonnaisappearstohavehadnoimpactonfirmswithlowleverage,aspredicted,sincethese

firmswerenotinthezoneofinsolvency,almostcertainlywerenotfinanciallydistressed,andlikelywere

farfrom

bankruptcy.

Instead,

the

effects

are

isolated

to

the

subset

of

firms

where

leverage

is

above

the

median.ThisisconsistentwithCreditLyonnaisbeingthetruedriverofourresults,andisinconsistent

withexplanationsinvolvingcontemporaneouschangesspecifictoDelawarefirms.

Weconcludethatfirmindistresssometimeshaveanincentivetoundertakeactionsthathurtsdebtand

favorsequity.Suchbehaviorleadstoindirectcostsoffinancialdistress,discouragingleverageand

reducingoverallfirmvalue.Indeed,wefindthatCreditLyonnaiswasfollowedbyslightincreasesin

leverage,andamodestincreaseinaveragefirmvaluesaroundthetimeofannouncement.Firmsthus

appeartohavereapedimmediatebenefitsofloweragencycostsintheformofbetteraccesstodebtat

lowercosts. Inaddition,stockpricesrespondedpositivelytotheruling,especiallyforfirmswithhigh

butnotultrahighdebt,confirmingthewelfareimpactofagencycosts.

Ourresultsareconsistentwiththeoriesofcapitalstructurebasedonagencycosts.Suchcostsarean

importantpartofhowthetradeofftheoryofcapitalstructureisusuallyunderstood(seeMyers2003).

Moreover,agencycostsduetodebtequityconflictshaveimportantimplicationsbeyondthesimple

tradeoff

framework,

which

would

be

interesting

to

explore

in

future

research.


20/30

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23/30

Figure1Equityissues:difference-in-difference

Thegraphpresentsdifferenceindifferenceestimates(19871991vs.199297,Delawareincorporationvs.

incorporationinanonDelawarestate)ofthefrequencyofpositiveequityissues.Bothethedifferencesarepositive

andsignificantatthe1%level.Thedifferenceindifferenceis2.90%(equityissuesincreasedinDelaware

incorporatedfirmsrelativetoNonDelawarefirms),significantlydifferentfromzeroatthe1%level.

0.67 0.67

0.740.76

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

NonDelaware Delaware

1987

199119921996


24/30

Figure2Bankruptcyduration:difference-in-difference

Thegraphpresentsdifferenceindifferenceestimates(19871991vs.199297,Delawareincorporationvs.

incorporationinanonDelawarestate)ofthedurationofbankruptcies.Bankruptciesareclassifiedbasedondateof

filing.Thedifferenceindifferenceis 4.7months,insignificantlydifferentfromzero(pvalue15.9%).

23.524.8

17.2

13.8

0.0

5.0

10.0

15.0

20.0

25.0

30.0

NonDelaware Delaware

19871991

19921996


25/30

Figure3Announcementreturns:Delawarevs.non-Delawarefirms,by

leverage

ThegraphpresentsathirddegreefittedpolynomialforvalueweightedreturndifferenceacrossDelawareandnon

Delaware

firms

for

Dec,

30,

1991

(the

trading

day

of

the

Credit

Lyonnais

v.

Pathe

Communications

ruling),

in

basis

points,byleverage.Leverageistheratiooflongtermdebt(CompustatitemsDLCandDLTT)tobookassets

(CompustatitemAT).Theaveragereturndifferential(valueweighted)acrossallfirmsis41basispoints.The95%

confidenceintervalfortheregressionline isindicatedwiththinlines.Thegreylinewithmarkersshowsthe

empiricaldistributionofleverage.

0

10

20

30

40

50

60

0.05 0.05 0.15 0.25 0.35 0.45 0.55 0.65 0.75

Leverage

Returndifferentialby

leverage(3rd

degree

polynomialfit)

Empiricalleveragedensity

(nottoscale)


26/30

25

Table1:Summarystatistics

Return

on

Assets

Return

on

Sales

Assets Sales Market

Value

Divide

nds/

Assets

Equity

issues/

Assets

Capex/

Assets

Capex

andR&D

/Assets

Capex

/Sales

Standard

deviation

ROA

Equity

volatility

Asset

volatility

Bankruptc

yduration

Mean 0.086 0.103 1226.9 1043. 840.8 0.012 0.0868 0.068 0.129 0.1704 0.0656 0.146 0.401 19.60

Median 0.110 0.102 72.520 72.04 67.58 0.000 0.0072 0.046 0.098 0.0836 0.0392 0.122 0.320 16.28

Standard dev 0.145 0.221 7321.8 5282. 4017. 0.031 0.2150 0.073 0.119 0.3188 0.0889 0.101 0.327 16.60N 57,00 55,20 60,686 60,47 62,47 53,75 51,224 58,79 31,57 30,495 25,080 44,75 56,58 208Mean(Delaware) 0.086 0.101 1119.6 931.6 766.8 0.011 0.0961 0.067 0.140 0.1954 0.0669 0.144 0.405 19.00Mean(Other) 0.086 0.106 1337.7 1159. 912.0 0.013 0.0776 0.068 0.118 0.1457 0.0641 0.148 0.396 20.79

Correlation

Matrix

ReturnonAssets 1.00 0.557 0.013 0.058 0.116 0.316 0.272 0.190 0.183 0.350 0.001 0.332 0.311

ReturnonSales 1.000 0.165 0.112 0.113 0.346 0.230 0.044 0.209 0.287 0.011 0.366 0.262

Assets 1.000 0.727 0.555 0.028 0.062 0.072 0.044 0.020 0.001 0.131 0.113

Sales 1.000 0.678 0.025 0.096 0.018 0.043 0.035 0.001 0.141 0.134

MarketValue 1.000 0.112 0.057 0.031 0.019 0.021 0.002 0.161 0.126

Dividends/Assets

1.000

0.098

0.042

0.146

0.083

0.007

0.194

0.128

Equityissues/Assets 1.000 0.028 0.240 0.316 0.002 0.149 0.357

Capex/Assets 1.000 0.488 0.207 0.005 0.082 0.005

CapexandR&D/Assets 1.000 0.554 0.268 0.116 0.282

Capex/Sales 1.000 0.239 0.105 0.279

StandarddeviationROAchanges 1.000 0.001 0.006

Equityvolatility

1.000

0.582

Assetvolatility 1.000

Notes:SampleisCompustatfirmsfrom1987to1997. ReturnonassetsisEBITDAoverassets,retrunonSalesisEBITDAoverSales,MarketValueisnumberofsharesoutstandingtimesendof

yearshareprice.EquityissuesarecalculatedasinBaker,SteinandWurgler(2003):thechangeinbookequityminusthechangeinretainedearnings,dividedbyassets,andiswinsorized,The

equity issuerdummyisequaltooneifequityissuesareatleast1%ofassets.Standarddeviationistheannualizedstandarddeviationofeightquarterlyroachanges(iflessthanone).Equity

volatilityistheannualizedmonthlystandarddeviationofreturnsoverthelastthreeyears(iflessthan0.5).AssetvolatilityistheMerton(1974)modelimpliedannualassetvolatility(iflessthan

one).


27/30

26

Table2.Equityissues,payout

Dependentvariable:

Dividends/Assets

Repurchases/Assets

Equity

issues/

Assets

Equity

issues/

Assets>0

Equityissues/Assets>0

Equityissues/Assets>0

(1) (2) (3) (4) (5) (6)

Sample: Allfirms Allfirms Allfirms Allfirms Highleverage Lowleverage

Delaware*Post

1991

0.0000

0.0003

0.0062

**

0.0267

***

0.0312

**

0.0191

(0.0002) (0.0003) (0.0026) (0.0085) (0.0122) (0.0121)

Firmcontrols X X X X X X

YearFixedEffects X X X X X X

FirmFixedEffects X X X X X X

Rsquared 0.836 0.399 0.521 0.323 0.367 0.397

Observations N=40,493 N=38,563 N=40,451 N=40,451 N=20,879 N=19,571

Numberofclusters 20 20 20 20 20 20Notes:EachcolumnpresentsthecoefficientestimatesfromanOLSregression.Firmcontrolsarereturnonassets,returnonsales,thelogofassets(bookvalue),thelogofsales,thelog

ofequitymarketvalue,depreciationoverassets,leverage(definedasassetsminusequityminusdeferredtaxes,overassets),andmarket(definedasassetsminusbookequityminus

deferredtaxes,overassetsminusbookequityplusmarketequity),twoyearstockreturn,andq(cappedat10).Highleveragecorrespondstothesetoffirmswithleverageabove0.5,

lowleveragetothosefirmswithleveragebelow0.5.Standarderrorsareclustered,whereclustersaredefinedbyyearandwhetherafirmisincorporatedinDelaware.

*significantat10%;**significantat5%;***significantat1%


28/30

27

Table3. InvestmentandR&D

Dependentvariable:

Capex/

Assets

Capex/

Assets>

Industry

Yearmedian

Capex+R&D/

Assets

Capex+

R&D/Sales

Capex/

Assets

Capex/

Assets

(1) (2) (3) (4) (4) (5)

Sample: Allfirms Allfirms Allfirms Allfirms Highleverage Lowleverage

Delaware*Post1991 0.0049*** 0.0274*** 0.0051*** 0.0093*** 0.0059*** 0.0017

(0.0011) (0.0065) (0.0013) (0.0025) (0.0017) (0.0017)

Firmcontrols X X X X X X

YearFixedEffects X X X X X X

Firm

Fixed

Effects

X

X

X

X

X

X

Rsquared 0.659 0.548 0.780 0.839 0.710 0.695

Observations N=39,339 N=41,325 N=20,940 N=20,965 N=20,379 N=18,959

Numberofclusters 20 20 20 20 20 20Notes:EachcolumnpresentsthecoefficientestimatesfromanOLSregression.Firmcontrolsarereturnonassets,returnonsales,thelogofassets(bookvalue),thelogof

sales,the

log

of

equity

market

value,

depreciation

over

assets,

leverage

(defined

as

assets

minus

equity

minus

deferred

taxes,

over

assets),

and

market

(defined

as

assets

minus

bookequityminusdeferredtaxes,overassetsminusbookequityplusmarketequity),twoyearstockreturn,andq(cappedat10).Highleveragecorrespondstothesetoffirms

withleverageabove0.5,lowleveragetothosefirmswithleveragebelow0.5.Standarderrorsareclustered,whereclustersaredefinedbyyearandwhetherafirmis

incorporatedinDelaware.



29/30

28

Table4. Volatilityandrisk

Dependentvariable:Volatility

of

ROAEquity

volatility

Asset

volatility

Asset

volatility

Asset

volatility

(1) (2) (3) (4) (5)

Sample: Allfirms Allfirms Allfirms Highleverage Lowleverage

Delaware*Post1991 0.0025* 0.0080*** 0.0044** 0.0071* 0.0053

(0.0013)

(0.0017)

(0.0023)

(0.0037)

(0.0043)

Firmcontrols X X X X X

YearFixedEffects X X X X X

FirmFixedEffects X X X X X

R

squared

0.797

0.738

0.679

0.628

0.748

Observations N=22,738 N=34,759 N=31,873 N=17,702 N=14,170

Numberofclusters 20 20 20 20 20Notes:EachcolumnpresentsthecoefficientestimatesfromanOLSregression.Firmcontrolsarereturnonassets,returnonsales,thelogofassets(bookvalue),thelogofsales,

thelogofequitymarketvalue,depreciationoverassets,leverage(definedasassetsminusequityminusdeferredtaxes,overassets),andmarket(definedasassetsminusbook

equityminusdeferredtaxes,overassetsminusbookequityplusmarketequity),twoyearstockreturn,andq(cappedat10).Highleveragecorrespondstothesetoffirmswith

leverageabove0.5,lowleveragetothosefirmswithleveragebelow0.5.Standarderrorsareclustered,whereclustersaredefinedbyyearandwhetherafirmisincorporatedin

Delaware.



30/30

29

Table5. Leverage andinterestcost

Dependentvariable: Leverage Market

leverage Netdebt Interestcost Interest

cost

>

10%

(1) (2) (3) (4) (5)

Sample: Allfirms Allfirms Allfirms Allfirms Allfirms

Delaware*Post1991 0.0033* 0.0027* 0.0110*** 0.0025*** 0.0229**

(0.0017)

(0.0015)

(0.0021)

(0.0008)

(0.0083)

Firmcontrols X X

Firmcontrols(without

leverage)X X X

YearFixedEffects X X X X X

FirmFixedEffects X X X X X

Rsquared 0.860 0.953 0.814 0.534 0.443

Observations N=41,325 N=41,325 N=38,418 N=28,495 N=41,325

Numberofclusters 20 20 20 20 20Notes:EachcolumnpresentsthecoefficientestimatesfromanOLSregression.Firmcontrolsarereturnonassets,returnonsales,thelogofassets(bookvalue),thelogofsales,the

logofequitymarketvalue,depreciationoverassets,leverage(definedasassetsminusequityminusdeferredtaxes,overassets),andmarket(definedasassetsminusbookequity

minusdeferredtaxes,overassetsminusbookequityplusmarketequity),twoyearstockreturn,andq(cappedat10).Firmcontrolswithoutleverageisthesamesetofcontrols

exceptleverage

and

market

leverage.

Standard

errors

are

clustered,

where

clusters

are

defined

by

year

and

whether

a

firm

is

incorporated

in

Delaware.


debt equity conflict

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