asEwER Journal of Financial Economics 43 (1997) 241.274

Spinoffs and wealth transfers: The Marriott case

Robert Parrino

(Rcaivid September 1994: final version nsivcd March 1996)

This paper crtmincs changc3 in bondhoidcr and sharettoldcr wealth resulting from the 1993 Marriott spinoff. It documents a wealth transfer from boodbolders to shahokkrs and a da4ine in the total value tif the firm following tbe spinotT announaancnt. Sub scqtunt modifications to the qind: plan rcduocd tbc bond- loss. but tbc value of Marriotfs notes and dcbentutes remained WM.6 mihou bdow tbcir pre4anouncermznt kvd on tbc distribution date. lndrurr>.-adjusted sharehokkr gains during the same period wee only SW.6 million. frzmsaab co6ts and inctficirncLs tesulting from the spiaoBerplainmuchdthededincintheto(aiv~ueoltbc~

Key ww& Spinoff; Restructuring Agency costs Financti policy /EL clasificotiac G32; G34

In October 1993. Marriott Corporation distributed the equity in its manage mcnt busincsscs to shareholders This spinoff reduced financial constraints that had resulted from a deterioration in the firms pprformana durinp the early

[kta pawidcd by Hospitality Valuation Smias. Kcmpcr FinancuL fenill Lynch Smith Travel Resarch. chc Univccaty of Texas System investment o&c. ud Ban Witler is gralcfutly a&now- kd@. I would like to thank David Blackwell. Kenneth Borokbovich ikad Chiquua Go&n Ha&a. Mark Husan. David Ikcnberry. Sandy Koch, scoC1 Lee, 1. Rusdl Kampk Rul Laur Mn Martin. Lisa Meulbroek (the &nx), Rune& Rau, Ehud Rona Laun Strrks. Michael Wcisbmcb. and the editors (Richard Ruhack and Karen Wruckl for their conunatts Tbc paper abo bendited tram comments by saninrr participants at the University of Texas. the University td Houston. and the 1994 Financial Ma nagaunt Association Meeting.

0304-405X/97,S15.00 3 I997 Elscvicr Scicna S.A. All rights reserved P/I S0304-405X(96)00SR5-9

242 R. Pumno~Journol of Financial Economic,> 43 llW7) 241. 274

1990s. A decline in cash flows from operations and a weak market for hotel property sales had left Marriott with a historically high level ofdebt, prompting rating agencies to lower their ratings of Marriotts public notes and debentures to the lowest investment grade. The spinoff improved the ability of the manage- ment businesses to fund new investments by limiting bondholder claims on their cash flows. However, it also left the parent with only real estate assets and the relatively small airport and highway concessions business to service most of the companys long-term debt.

The Marriott spinotT illustrates how the separation of a ftrms businesses tlrough a pro rata distribution of the equity in some of those businesses can transfer wealth among securityhoiders. This restructuring is highly unusual in that Marriott distributed shares that represented almost 80% of the value of its equity and substantially incmased the leverage of the parent. Previous studies suggest that spinoff distributions typically involve shares worth only 10% of the total market value of the equity (Hite and Owers. 1983; Miles and Rose&l& 1953) and that. on average. the kveracle of the parent changes little (Chipper

.I~J CmiI+, 1?8t: T : :.I. + .U ;pr.100 hranskrrcd wealth from bondholdets to shareholders and caused the total value of the companys public securities to decline.

This spinoff is also noteworthy in that Marriotts bondholders were able to force the company to alter its plans even though no provisions in the bond- holder indenture agmement prohibited the restructuring Rondhoklers initiated a coordinated eRort to block tbe spinofT almost immediately after it was announced in October 1992 and suaxxdai in forcing Marriott to change the structure of the spinofTand bondholder claims in ways that reduced the magni- tude of the wealth transfer. The post-spinoff kverage of the parent was lower than originally anticipated by the company and bondholders emerged from the spinoff with new claims that included higher coupon payments.

Tbe limits that the spinoR pkxed on bondholder claims suggest that it was designed to benefit all shareholders However, the Marriott family. which owned 25.8% of the common stock, benefited in ways that public shareholders did not. The spinoff reduced the likelihood that the family would lose control of the management businesses and much of its wealth if economic conditions con- tinued to deteriorate The spinoffalso enabled Marriott to continue to grow the management businesses without diluting the familys control.

The paper is organized as follows. Section 2 describes !M data and methodo- logy used to measure securityholder returns An overview of Marriotts busi- nesses at tbe time of the spinotTannouncement and the pre-spin08 performance of the firm is provided in Section 3. !kctioo 4 documen t.s how the values of Marriotts public securities changed between the announcemen t and the distri- bution. Section 5 discusses the effect of the spinoff on firm value and Section 6 describes the be&its of the spinoff to the Marriott family. Conclusions are presented in Section 7.

R. Pamno Journal of Financial Economks 43 0997) 241 274 243

Closing prices from the New York Stock Exchange and bond dealer bid prices are used to document the effect of the spinoff on the value of all of Marriotts publicly traded securities. These securities, which had an aggregate market value of&&232 milliou at the end of the quarter preceding the spinoff announcement. -ted approximately 8 I % of the total value of Marriotts long-term debt and equity (Table I ). The remaining 19% consisted of S493 million in mortgage debt, U93 million in private unsecured notu and 5290 million outstanding on a revolving line of cred;t.

Daily closing price, dividend. and volume data for the common stock are from The Wall Street JOWMI and The Daily Stock Price Record. Daily market-

Tabk I M~lCofpontiLmliabilllwsand~- cqluly on Scptcmbcr I I. WI? tS mrllwms) ._- . ..--- ----

&d Mark4 vatuc vatuc

--.--- -.--.---_ -----. ..-. - . . - __ _ -.-...-...

cumo1 liabihtics 51.329 scoiol tong-tmm debt

!salior oous and 6tbcntum I.872 $2.019 Mortgage dkbt 493 aheroots I93 Rcdviog line of credit -so Total

coavcrtlbk suboldimIai detd -% - 226 ottlcl toog-tcml liabilities I.250 Coourtibk pdcrd stock 200 35 Cowmsoo equity and rchud earnings 516 I .7?2 Total tiditks and - equity $6.425 Total market uluc of public sccuritks s4 3 c-

- _____ -_ _.-.____-- _.._ _,-_ __.-- -_-.

The quarter immahtcly ptuaiing the spmotT an IKNowmrnI cndd on !septcmtlcr I i. 1992.

mlcnrbordiaareddcbt.prrCrrreduodr.rn4 ammo0 stock valuer arc computal usmg cbsiog pifa~tbc~;orLStodrEsctu~onScpcemberll.l997Thc~alucdthc~iornotarnd debmum is cumpuud using de&r bid ptks for !kptcmher Ia !99L

*Marriott bad I3 senior notesand dcbcnturcs outstandingon September Il. I992. Their boot; valuts nogal hen 599 to S250 million and their m8Witics hm nine months to r0 )cln.

8.2% Iiquid ykkt option odes (LYONS) issad in June I991 and maturing in JUIX -X06. Frh of I& 675.ooO LYONS um convertible into 13.277 shares of Marriott C *~rporation common stock.

Includes a casualty self-insurana reserve d approximately S200 millioa. ddcrmd income d S2Oit milliondderrediaawactaxcsoC564~~iUionadot~~bilitiasucb~Jobliglionrundcr(hc frequent stay plograol and l#&m!d colopmsation.

F~rmillionshtcrdamveniMc~scod;wcre~inDaxmberIWlwithadi~ol 8.25%. Each pined share was convertibk into 2874 shares of Marriott Cuporation common stock.

244 R. Purrino/Journol of Financial Economics 43 (1997) 241 -274

adjusted common stock returns equal the excess of daily returns on Marriotts common stock over the corresponding daily returns predicted by a market model, R, = x + /lR,,,, + e,. The S&P 500 index proxies for the market portfolio. The methodology employed by Mikkelson and Ruback (1991) is used to esti- mate the market-adjusted returns over the period beginning 60 trading days before the spinoff announcement (July 10.1992) and ending 60 trading days after the distribution (January 4.1994). Two estimated sets ofc&Ecients incorporate potential changes in the market model parameters. The first two coefRcients, zl and fl,, are estimated using daily returns over the 200 trading days ending 61 trading days before the announcement. The other two coeRicients, zz and &, are estimated over the 200 trading days beginning 61 trading days after the distribu- tion. Market-adjusted returns prior to the announcement are computed using x1 and /?,. while all subsequent returns are computed using zz and fi2. The market model parameter estimates are as follows: zr = - 0.04. /I, = 1.3540. zz = 0.0005. and /f2 = 1.5512. A Chow test does not reject the hypothesis that the model paraak;ters are the same in the two periods (F(198.198) = 0.25).

111:\ li~-y...+~-!3 ~~:rn -;, itoch returns equal the excess of daily Marriott stock returns over the daily returns on a hotel industry index. A market model approach is not used to adjust the Marriott stock returns for industry changes because the shares of two firms in the industry index were not publicly traded before 1992 The firms in the industry index come from an initial list of 135 public firms with U.S. hotel operations. The index is restricted to hotel tirms because there were no public firms with over 50% of their cash Rows from contract food servias and a market value of equity exceeding SM million on October 21992 The final list contains six firms that meet the following four criteria:

I) prices for the firms shares are published in the NYSE AMEX, or OTC Doily Stock Price Record;

2) the firm operates or owns at least ten hotels in at least three states and the market value of its equity is at least S30 million on October 2. 1992 (this criterion excludes firms with relatively ilhquid sharesk

3) a majority of the firm*s operating profits are from lodging businesses and less than one-third of its lodging-related profits are from casino operations (this criterion limits the effect of non-hotel industry performana on the index returns); and

4) the firm is not operating under Chapter I1 bankruptcy protection.

Finns with significant casino operations arccxdurkd because thctr shares genetaUy pcrfoonnad well during the uurly pcriud due to a m in tbc caxino industry. Tbc sensitivity of the in&x rctumx to this Rztrictiom wax cxamir-4 by including two large lodging firms that had ban excluded bccausc ot thdr casino operations: Hilton Hotels Corporation and Promux Companies lttc (Harralu Hampton Inn Embassy Suites, and Homewood SuitexL The cumulative industry index rcturtxs cxtirnatcd with thee two firms (eight firms total) are higher bevern the rnnounamcat and the

R. PamnoiJoumal of Financial Ecunomics 43 (1997) 241-274 245

The six firms in the index are Hospitality Franchise Systems, Inc. (Days Inn, Howard Johnson, and Ramada), La Quinta Motor Inns, Inc., La Quinta Motor Inns L.P., Marcus Corporation (Budgetel and full service hotels), Red Lion Inns L.P., and ShoLodge, Inc. (Shoneys Inn). Daily industry index returns are calculated as the simpk average of the stock split- and dividend-adjusted daily returns for the common stock of the six firms. (A value-weighted index return from the annou nament to the distribution is higher than the equal-weighted index return, suggesting that the choice of an equal-weighted index does not bias tbe industry-adjusted returns downward.) The r-statistics for the industry- adjusted retu.ns are calculated using a methodology similar to that employed by Ritter (1991).

la contrast to previous studies, which examine the relatively few d&t issues that are traded on the New York Exchange, this paper uses deakr bid prices to determine changes in the value of the 13 senior note and debenture issues that were outstanding at the time of the spinotr announcement. These prices were provided by financial institutions that trade the Marriott securities, Bloomberg Business News Service. and Standard and Poors for 45 days during the period from 60 trading days before the spinoIT armoulKxmen t to 60 trading days after thedistribution.Severalso(l~werrusedb#austacompktesetoCI3priacsis den mavailable from a singk source on a given day. A comparison of bid prices from the alternative sO.rr~cs reveals no systematic di&rence& suggesting that data from a particular source are unlikely to bias tbe price estimates. Bid ~wcrcobtainedforeachissuefordays -60. -31. -IS, -10, -5through 5. IQ 15,2Q and approximately every 1 I trading days thereafter through day 316(January4,1994).CMtbe143bidpr&scolkctedfortbe lldayssurrounding tbe spinoff announcemen t I36 were obtairkd from a single firm that actively traded Marriott notes and debentures.

All of tbe note and de&nture prices ate adjusted to mfkct cbcnges in tna~let yields after July JO, 1992 (day -60). These adjustments are made usrng 8883 industrial bond indexes reported by the Bloomherg Business News smioc. BBB3 indexes are used because they correspond to tbe credit rating of the Marriott senior notes and debentures at the time of the spinoffannouneement.

Siwc Bloomberg reports only yields tar the above indexes, these yields are first restated as prices, indexed to a value of 10 on July 10.1992 Tbe prices for the Marriott notes and debentures are then individually adjusted using the percentage change in the value of the index that most closely matches the maturity of each issue. Jhis adjustment is computed using the relation

P,.i = pl.j - (P- tt0.j Afr.w). (1)

dixtribution than tbe in&x tetums estimated without than. Coarcquc13tly. the industry-adjusted ~umsom the Marriott common stock are lower when Hdton and Promu: alrc included in the index than when they am not.

246 R. Pam~no/Joumal of Financial Economics 43 (1997) 241-274

where Pt,j is the price of bond j on day r and AltsM is the percentage change in the value of the index for bonds with maturity M between day -60 and day 7. The overbar indicates the adjusted value.

The market-adjusted note and debenture prices are multiplied by the number of bonds outstanding to obtain the total value of each issue. These values are then summed to obtain the aggregate value of the notes and debentures. An adjustment to the bond values after October I.1993 r&e& the retircmeat of $174 million of these securities with Marriott stock and cash. Aggregate bond values after this date equal the market-adjusted value of the bonds that mained outstanding plus the market value of tbe shares that were distributed and the value of the cash payment. The values of two notes that matured between the announcement and distribution dates are calculated by assuming that the procads from their retirement are reinvested to earn 8% per year. The value of a third note. which was eliminated through a defeasana 01 the di&budou date, is set equal to its faa value after that date.

Llruly returns for the subordinated convertibk debentun5 and preferred stock are computed using closing price and dividend data reported in The Wull Street Jowrrcrl. These returns are not adjusted for market changes. Two-factor market models, with ten-year BBB3 industrial bond returns and S&P 500 returns as factors, were estimated for these securities, but have no significant explanatory power.

In 199L Marriott had revenues of S8.7 billion and operating profits of S4% million. The lodging amnagcmetu group, which indudad hotel, timcsharc, aad golf facility management busiaesscs contributa! 52% ($4.5 billion) of the revenues and 68% ($338 million) ofthe operating profits (Tabk 2). The company owned, managed, or franch&d 746 hotels. Marriotts otbcr rcvcllues and operating profits came from tbe contract services group. which consistai of food service and facilities maqprunt, airport and highway m r&ancnt community maniyment, and restaurant supply dis!ri+$n busiwsscs Tbc food rmicc and facilities manamt bu&esq with 1992 revenue ofapproxim- atdy S3 billion, provided fimkes to a wide range ofdients induding corpora- tions health care f&ilitieq and secondary schools and colleges. Tbe Host/Travel plazas airport and highway concessions business, with revenues of SO.9 billion, Operated dons in airports, on tollroads. and in stadiums, am and otber public attractions. Tbe retirement community management and distribu- tion businesses were both rdativciy small. With two-thirds of its operating profit from lodging-related businesses, Marriott was generally viewed as a hotel company.

R. Pamno:Joumal of Finonrial Economics 43 (1997) 241.274

Tabk 2 Marriott Corporation major lines of business and 1992 operating profits

--- _---_.--_ .__-._ __ .__ __. _ _ __._ ._. _ _ _

Lodging Management Group tW.5 billion in revenue) Hot& owfck ms0ft.s and suite5

Mmiou Owtcrship Resorts (timeshare) Mmiott Golf fgou facility mJnagcmcntl

Cootract Smias Group (54.2 billioo in rwcnuc) Food !krvie and Fac5litks Management

Host~ravel Plazas lairport and highway conassions) Marriott Lktribuhon !Setvices (resIaurant supply diSUibUliOO)

Senior Living Service tretircmcnt communiry managcmemt Rcstaunnts

MJrriotI lllul _-___. --.-- _-. - .--- ._ ______. --__-__

Esrion~cd from documents hkd hy Marriott -8th the SE

248 R. PamnolJoumal o/i?nancial Economics 43 (1997) 241-274

the hotels it managed. Marriott acknowledged the relation between the stability of its cash flows and its debt capacity in its annual reports. For instance, the 1991 annual report states that the companys debt capacity is determined by the amount and variability of its cash flows (p. 3 1). The combination of low capital requirements and high debt capacity enabled the Marriott family to retain control of the firm even as Marriotts revenue increased 5 12% between 1980 and 1992.

Marriotts operating profits increased each year from 1986 to 1989 in both the lodging management and contract services groups. Beginning in 1990, however, the U.S. recession ended this record of steady growth. The rate ofgrowth in the demand for domestic hotel rooms plunged from WIOO rooms per year in 1989 to onIy 2,000 rooms per year in 1991. driving down occupancy rates and hotel profits as growth in the supply of new hotel rooms continued at higher kvels.* Profits in the contract services group also dropped after 1989 as demand weakened.

The recession occurrt.4 at a particularly crucial time for Marriott. As shown in Tabtz 3. the firm? inventory of h :A properties being devrloped for sak was ti~ AI air-time mgn. Sinu: this mventorv was tinanced largely with debt, Marriott was highly levered and required substantial cash for interest payluents A $134 million decline (from $509 to f375 million) in cash flow from operations reduced the company% cash flow coverage ratio (the ratio of cash flow from operations to interest expense) from 2.75 in 1989 to 2.05 in 1990. This weakening financial position prompted Moodys to downgrade Marriotts debt in 1990 and again in 1991.

Marriott could have used proceeds from hotel sales to reduce debt. However, hotel values in the U.S. dropped 18% between I989 and 1991, making it difficult for the company to sell hotels for prices that it considered acceptable. The impact of the weak hotel market on Marriotts financial position after 1990 can be seen in Table 3. From 1986 to 1989. Marriott invested an average of f77S million each year in new hotel development and sold ownership interests of roughly the same value. However, hotel sales declined dramatically after 1989. Proceeds from hotel safes dropped from $900 million in 1989 to $600 million in 1990 and to only $33 million in 1991. Even though capital expenditures fell to

%IC supfdy and &mad tigwu arc lrom Smith Travel Rexarch (STR) of Gallatin. Tcnncssa. STR atimatcs the cbustk supply d hotel rooms from pubhkd hotel directoks and demand fraa OpCrh.I6 data provikd by hod operators IO 1993, the STR dat&asc induckd inform&on on 31.ooO lodgiqf popmics Operating data xuch a.5 occupancy and avcrags room rates were mportcd by operators of approximatdy 17.CNlO of tbcsc popcrtk in 1993.

The 18Y0 QIIIZ ix computal from the hotd valuatmn index report4 by Hospitality Valuation !kvicc~(HVS)dMincda.fUcw York.Theindca~antir~sseparate HVSbotel valucindexcxfor23 major US cities The city indexes are dcvdopcd using data provided by STR and HVS cxtimatcs d local anls and fequind investor feturnk

R. Pam~no!Jovmal y/i?nanciai Economics 43 (1997) 241 274 249

Table 3 Marriott Corporatton hatoncal balance sheets. hotel property sales development expenditures, and senior debt ratings ._ -... ..-_ -. . .-. - . . . -- _-.-

1986 19lt7 1988 1989 1990 1991 1992 -.- --____-_-----..--_-_-_-__

Cwt.so/i&ted b~bncv .s/uvt.s us fff haul !-ear end (5 mtllionsr

Asms

currcn1 asuts ml 919 9% Properly and equipment 2207 2w578 2575 Assets held kr sak:

Hotels dcvulqcd k r sak 2 213 475 other 384 288 571

olkrasscls I.158 I .372 I .370 Total assets 4Jn)Gii 5.97:!

Liabilitks and sharehokkrs~ equity Current liabdiltes I.018 I.123 I.292 L4mg-tcrm debt 1,663 2499 2.857 Convcrtibk subordinated J&t

(LYWQ Other long-temt liabdtlks 908 938 I.122 Conwttibte prcfcrmd stwk Comm stock and retatncd

earnings 991 811 701

I.173 I.428 1.023 1.4% 2.298 2.174 2485 3.461

927 577

1.707

6.732

I.416 I.637 I.335 1.4% 3.286 3.S% 2979 2.732

I.402

62X 407 479 snc

900

890

I.062 I .?o? 212 21

I.450 1.368 I.453

6.926 GiiL410

210 22K lJt4 I.197 I.169

,x0 200

Qo 32 346

733 199 46

Moody5 rating for scmor note5 on Dooanbcr 31 A3 A3 A3

l Estimated from documents tikd by Mamott urth the SEC.

A3 Bad Baa3 ad

reflect changing economic conditions in the industry. the book value of hotels heJd for sale increased from what was already an all-time high of5927 million in 1989 to S1.303 million in 1991.

In an etrort to strengthen its weakening financial position. Marriott replaced some of its senior debt with subordinated debt and convertible preferred stock issues in 1991. The subordinated debt. which consists 4 convertible zero coupon notes (LYONS), reduced the amount of cash required for interest payments by approximately $18 million per year or 6.8% of the S265 million total interest expense in 1991. Both the LYON and preferred issues lcwered the riskiness of Marriott% remaining senior notes and debentures by reducing interest obliga- tions and the total amount of senior debt outstanding.

250 R. ParrinolJownal of Financial Economics 43 (1997) 241-274

At the beginning of 1992, Marriotts ability to finance new investments with low-cost debt was limited by its Baa3 bond rating. Furthermore, an equity financing would have diluted the Marriott familys ownership. This financial inflexibility prompted the firm to search for a means of removing the unsold hotels and the associated debt from its balance sheet. On October 5, 1992, Marriott announced its spinoff plan.

4.1. The announcemenr

Under the spinoff plan announced in October 1992 the lodging management, food service and facilities management. senior living services, and distribution businesses were to be spun off into a new entity called Marriott International (International). The parent, to be renamed Host Marriott (Host), would retain ownership of the hotel and senior living service properties other real estate ;Tt:k ;:. Ald fi,, khb. -f-,- . .dkl Play busins International would manage the hotel properties under long-term contracts similar to those with unalISated owners. Marriott family members would continue to oversee all of the busi- nesses and the senior mana@rs would be split between the two post-spinoff companies. The Appendix provides a detaikzd chronolw of events surrounding the spinofr.

Marriott ofkials argued that the separation of the management businesses from the rest of the firm would create value in several ways. First. it would allow the company to mote fully exploit growth opportunities in the management businesses J.W. Marriott, Jr, the firms chairman, stated that International. with its strong earnings, stable cash Bow. and improved investment capacity would have greater growth potential after the restructuring because of its improved financial strength. Second, the company proposed that better finan- cial information after the spinoff would enable the capital markets to more accurately assess the true value of the firm. Finally, Marriott executives main- tained that the spinoff would be&t shareholders by providing them with improved in vestment alternatives J.W. Marriott, Jr. stated that it would give investors a clear choioe betwan a management company positioned for growth and a capital-intensive company with strong cash flow and long-term appreci- ation.

Panel A of Tabk 4 presents pro forma balance sheet and income statement figures for Host and International that were released by Marriott after the spinoliannouncement Virtually all of the long-term debt would remain at Host. Internationals exposure to long-term creditors would be limited to a Saoo million line of credit that it would extend to Host. Marriott managers indicated that pro forma I992 interest coverage at Host, excluding capital expenditure

R. Pamno/Jownal of &anciat Economics 43 (IVY?) 241-274 251

and working capital requirements, was expected to be only 1.6 times the projected annual interest expense of S225 million. Based on actual 1991 cash flows, pro forma interest coverage at Host was half of that at Marriott (1.3 versus 2.6).

The stock market response to the announcement was consistent with the benefits proposed by the company. The price of Marriotts common stock increased 11.68% during the three days following the announcement (from $17.125 on October 2. 1992 to S19.125 on October 7). The value of both the Standard and Poors composite index and the hotel index declined during this period. resulting in market- and industry-adjusted returns of 13.79% (S236.3 million) and 13& % ($224.9 million). respectively. These returns are significant at the 1% level.

Whik Mamott managers did not publicly acknowledge the possibility that some of the shareholder gain had been realized at the expense of the bond- holders. it quickly became apparent that the spinoff was expected to redua the value of bondholder claims. Moodys lowered its rating of Marriotts senior debt

Tab& 4 Pro loma bdamx sbaa ad ir- statamnl data lof Marmot Intcmatwnal and tirm Mamott udcr lbc oliginal bpinoll phi Iaaf was a- inOcloturI992araithelinalpheaq*adby majnr boadbolder groups in M8rrh I993 and unplanentcd tn October l994? all numhm cnucpl lhc ratios d EBITDA IO intcre+l cxpc. u arc tn mifbons d dollars ..__- -

Pad A: original lpimgplm

Marriott Corp~ratioll

Marriott Intcmaricmal pro-

Ii054 Mar-riot1 pro hlm.a

hell Curt assets Property and quipmcnt orbcr awes Total assc~s

Liabditics and cqwty Cumnl liabilities Long-~ d&l Other long-term liabilities ?%areboldcrs equity

Immne starmaem~ I I I 92Bb

I.230 I.120 30 3.672 .Mo 3.310 1.431 870 I.060

h.33? xiii Tzii

I.189 1.l.W ?I0 2.891 20 1870 I.500 690 I.310

753 520 230

RCWXllU 8.331 7.426 I.656 Opcnting profit 478 314 I48 Netinwme 82 145 WJI EBITDNintrnxt rxpcnsc 2.6 20.3 I.3 ___.--- - -_.. - . . . . ._._... ..-.. -- . ---.-

252 R. Pam~no/Jownal of Financid Economics 43 (1997) 241- 274

Table 4 (continued) __._. -__--. --.---._-.-.

Panel B: Final spinoflplan

. ._ __ _- - _.__. - ..-

Balanw .shrrr f1/1/93)L

Marriott Corporation

Marriott lntemationai pro forma

Anuts Currcnl asseta Property and equipment ohraswts Total assets

Li8bihties and equity currco1 IiaMtk lmlpkrm debt otkr loag-tmn liabititi shr- spicy

;,r,c*fu rru4r#nenr I : 4 93,

1.4% 3.461 I .453

6.410

I .4% 2.732 I.-7

7R.z

1250 772 995

3.017

I280 394 899 2.313 4ctt-l 794 438 387

Rmnuc 8.722 7.787 oparw v&t 483 331 Netinamc 85 I36 EBllDAhtuest expense 28 6.5

Host Marriott pro forma

301 2689

8%

3.888

from Baa3 to Bat on the day of the ann ouament and. two days later, press reports indicated that prices of some Marriott long-term debt issues had deciined by as much as 30%.

The dealer bid price data reveal that the prices of ail of Marriotts fixed- income =uritics declined during the three days following the spinofl an- nouncement. The aggregate market-adjusted value of the 13 senior notes and debentures f&l1 16.51% ($333.3 million). In addition, daily closing prices from The Wall Srreer Jound reveal that the aggregate values of the LYON and prcknzd stock issues also declined during this period by 7.09% ($16-0 million) and 3.59% (S9.0 million), reqectively. The 3358.3 million decline in the value of the debt and prderred stock -ted 14.35% of their combined value.

The decline in the aggregate value of Marriotts fixed-income securities indicates that there was a wealth transtcr to the shareholders. Furthermore, the

R. Panitto/Jounwl oJ Financial Economies 43 (I W?) 24i- 274 253

fact that the magnitude of the bondholder and preferred shareholder loss exceeds the common shareholder gain suggests that all of the shareholder gain resulted from a wealth transfer and that the spinolI was expected to destroy vaIte4 No evidence of wealth transfm around spinoffs has been reported in other studies Schipper and Smith (19%3) find that prices decline for only I 1 of 26 bonds arouod spinoff annou ocemeots whik Hite ami Owers (1983) report that risk-adjusted bond returns around spinoII annou ncements are not signilkantly diffc!fuIt from zero.

The low pro forma coverage ratio at Host was one reason that the value of Marriotts notes a~ul debentures de&red folIowing the announcement. How- ever, the e&ct of the proposed transaction on the average variability of Host-s cash IIows also contributed to this &dine. The spit&f would increase the average riskiness of the cash flows undetlying boddder daims by distributing the B with the most stabk cash flows to International. An example of this can be seen in the proposed allocation of the cash flows from the unsold hoteI properties between International and Host. Under the manawt con- tracts between he two post-spinoII finm, International would tive a large portion of its cash flows through meaue-based base I&s whik Host would receive only a share of the more vcrhtik operating profits. A presentation by Marriott executives shortly after the spiooIf announcmka t indicated that over 50% of Hosts post-spinoIIc& flows would be provirkd by the volatik hotel operating pro&~ To the exten that the payoff for bondholders is similar to that forthewriterdaputoption.af~adbySmith(1979),aninxcasintht variability of tbe assets underlying bondhokkr daims reduces their vahre.

A review of the indenture a-t for tbe Marriott senior notes and debentures teveak that it contained 10 provisions that would prohibit tbe type of distribution that Marriott proposed. This raises the question of wbetber the bondbohlers were compensated, ex ante, for the possibility of opportunistic behavior on tbe part of Marriott Compring the ykkls on Marriott debt with the BBB3 Bloomberg indexes reveals that tbe Marriott bond yields were in fact higher than those for other debt with similar ratings. Tbe yields on Marriott

Whik thr musud &dine in cht value d tk hrahxmmc sccuritics cxeds Ibe inause io the value of th minmon stock following tbc spinoff an- mtitisddKcdltosaypecibdybow

lars this difTcmm ir An industry analyst informed the authr tha1 tbac were kty W tmks involving Marriott bonds immcdiatdy hIlowing the spinotT anwunamen I. He nuiaclhrd that ext(lcM umczrtunty cawed 8 lack Cc liquidity. which. in turn. irmMd the number of trades If ibis Is tru. dealers had ks incOruutio0 available to lhan wbm they vet their prim Carscqucatly. the ~oCtbcbidpicawupcubrblylowrd~Ibopaiadthrnei~beCorctbc~ lneatorPCWmO~in~aabwItht~~avaiLMc!o~~aputidpmrr.Thc analysts comments aho suggest that it is unlikely that ding pesw~rc by institutions that ycrc hudtosdlblldsaftcrtludcbt wasdlnmgdd by Moodys contributed to the sharp doclinc in IbcpYicesoflhclKttcsanddebcntu~

254 R. Pam~no/Joumal of Financial Economics 43 (1997) 241-274

notes with two-, five-, and ten-year maturities were 37,80, and 56 basis points higher, respectively, than the yields on BBB3 debt of corresponding maturities in early 1992. These yield differentials are consistent with the expectation that premiums would be required to compensate investors for the lack of protection against such opportunistic distributions to shareholders. However, they could also reflect compensation for higher risks associated with other aspects of the bondholder claims.

If Marriotts bondholders did require yield premiums to compensate for the possibility of a spinoff. then at least part of the decline in bondholder wealth folowing the spinolTannoutuzmen t is not a wealth transfer in the strictest sense. Only the difl&nce between the decline in bondholder wealth and the value of the premiums that bondholders received before the announcemen tdaterepre- sents a net ex post wealth transfer to shareholders The remainder represents a recapture by shareholders of wealth that had been distributed to bondholders through the premiums.

The bondholder reaction to the spinoff plan was both swift and unambiguous Within ten days of the announcemen L, two das+acGon suits were filed against Marriott and several large bondholders had formed a committee to expIore ways of Mocking the spinoIL By the end of December, a total of ten class-ircrion suitsaadoDcsuitbyalgoupol~boad~hsdbeeafikdtoMocirtbc spit~ofLlhecontroversy Prompted Merrill Lynch which had been both a princi- pal underwriter for some of Marriotts senior debt issues and art advisor to Marriott on the spittolL to witMraw as ao advisor. By Iate December, Marriott agreed to hold d&us& ns with repmentatives of the major bondholder groups opposing the distribution. The pressure on Marriott to modify its phn was so severe that the firm agreed to pay the f&s of the advisors to the bondholder groups to bring the bondhokIers to the bargaining table.

An agreement was reached between Marriott, the class-action plaintiffs, and several large bondholders in early March 1993. although the group bf laq~e bondbol&m that had filed suit in the call of I992 did not lind the revisions acceptable and decided to continue its legal action. Major modifications to the initial spinolI plan includedz

I) the transfer of $400 million in additional assets and debt to International; 2) an agreement through which International would provide $125 million in

financing for the unfinished Philadelphia Marriott hotel; 3) an increase in the line of credit provided to Host by International from S&N)

to $630 million; 4) the retirement or defeasance of all of the debt maturing before February 19w

(thre issues with a face value of S350 million);

R. Pamm~Jownal of Financial Economics 43 (1997) 241-274 255

5) the exchange of all remaining notes and debentures (ten issues with a face value of S1,520 million) for new Host debt with stricter covenants;

6) an agreement that Host would use up to 75% of the net proceeds from certain asset sales to repurchase debt issued under tbe exchange agreement.

The coupon payments on the debt issued under the exchange agreement would be loo basis points higher than the corresponding rata on the old notes and the maturities would be extended by four years for nine issues and reduced by five years fbr one. As part of the exchange agctmcat, $174 million of tbe $1,520 miUion of exchanged debt would also be retired with $70 million of Marriott stock and $104 million in cash In addition to the spinoff plan moditicationr Marriott agreed to pay $1 million to the das+act&n plaintiffs for lea and expenses and to issue 7.7 milhon five-year warrants to purchase Host stock to bondbokiers who sold their claims at a loss following the October 1992 an- nouncement

~financlalimpactoTthcmodificdspi~planibapplrtntinpandBol TaMc 4. The ratio of book debt to total capital at Host would be lower than under the initial plan (0.89 versus 0.95) and the interest coverage ratio. based on the pro forma msuhs from the previous year, would be hi&r (1.8 versus 1.3) Furthermore. the mised capital structure and the extension oft& maturities for most of the notes reduced tbe immediate threat oCa Host ddauh ;Oy lowering debt service and principal tepayments during the first few years Mowing the qinoli.

The revised spinoff plan was approved by the Marriott sharebokkrs oo July 23.1993 aud the distribution was completed on October 8 in - with the revised plan. AU but two bondholder groups. the grwp that fikd suit in the fall of 192 and the Florida state pen&n fund which filed suit in late March 1993 to block the revised plan, settled their claims by Lhc distribution date. The suit by the Florida pension fund was ultimately settled in April 1994 and the lall 1992 suit was dism&al in January 1995. The agreement with the Florida pension fund required Marriott to purchase the $7.6 million in bonds owned by the fund at face value.

4.3. Skcmrity rehms hetuven anno6weme nt and diswifwiott

4.3.1. Cwnnum smck Table 5 reports common stock returns during the period between July IO.

1992 and January 4, 1994. Returns are teported for three-day event windows around key events, except that a six-day window is used for the bondholder agreement anno uncement hecause two Wall Smef lmfmtd artida pubhsbed three days apart, reveal nonoverlapping information about that agmement. Cumulative returns are also reported for the period from the announcement on October 5, 1992 through the distribution on October 8. 1993.

Table

5

Marri

ott

comm

on

stock

ret

urns

born

Ju

ly IO

. I99

2 tda

y -

601

throu

gh

Janu

ary

4. 19

94

(II;IY

31

6t

Even

t;hold

ing

pwiod

Day

relat

iw

to sp

inotT

an

noun

crmcn

t Iln

adjur

tcd

IWJr

ll

? l:lr

kcl-

.ulru

st~d

r Irn

_

Spino

ff an

noun

crmcn

t

Merri

ll Ly

nch

resig

natio

n

Bond

holde

r ne

gotia

tions

an

noun

ced

i3ond

hoMe

r ag

rccmc

nt an

noun

ad

Shar

ehold

ers

appr

ove

spino

lf

Distr

ibutio

n

Anno

unce

tnmt

throu

gh

distri

butio

n

--60

IO

- I

6.64%

1.3

. IY%

0

IO

2 I I

.68%

I3.

?9%

3

IO

.w

10.4

29.

2.6R%

31

IO

33

-- 4.71

%

.- 5.X

7%

34 I

O 57

4.

106?

$ -3

.12%

58

IO

IXJ

- 0

60%

--

0.40%

61

to

IO5

2453

%

I g.23

?/;,

IO6

to I I

I 5.7

7%

3 77

%

.- II2

IO

M

O 0.

96%

2.4

9%

MI

lo 20

3 I 8

0%

0.94%

20

4 to

25

3 13

.26%

5.5

7%

254

to

236

3.90%

4.0

I %

25

7 to

316

15.82

%

9.92

90

0 to

256

93.93

%

41.12

%

I-sta1

.J -.

__.

.-. -._

0.62

3.36

0.3

4 -2

.1s

-0.36

-0

.14 I.48

0.88

-0.09

0.3

4 0.4

7 1.4

4 0.7

5

Indus

tr!.

adjus

led

retur

n f-s

tat.

2.874

, -0

.18

13.06

%

4.35

7.

089.

0.8

0 -6

.17%

-

2.08

- 3.6

3%

-0.41

-

4.24%

-

I.41

I .36

0/J

0.1 I

0.94%

0.2

5 -3

.48%

-0

.17

3.64%

I.1

9 -

5.87%

-0

.44

3.31%

I .

08

3.95%

0.3

7

0.99

4.84%

0.3

3 -

-___

_ -_

__---

.--_-

__--_

__I_

_-..

_-_

_ ._

____

.

All

return

s ar

e ge

ometr

ically

co

mpou

nded

Ja

ily

return

s ov

er the

ind

icate

d pe

rrod.

%lar

riott

anno

unad

tha

t it

uould

sp

in ofT

its

mana

geme

nt

busin

esse

s on

Oc

tober

5. 19

92

Mar

ket-a

djuste

d ret

urns

arc

comp

uted

by

subtr

actin

g Ihe

da

ily

return

s prc

dictcd

by

H

marke

r mo

del.

R,

- z

+ /R

,, +

d.,. f

rom

the

duly

retur

n on

Ma

rnott

s co

mmon

sto

ck.

Tbc

!S&P

50

0 ind

ex

is us

ed

as a

prox

y for

the

mA

tkct

portf

olio.

Two

sets

of ca

flicien

ts arc

es

timate

d to

incor

pora

te po

tent

ial

chan

ges

in the

ma

rket

mode

l pa

rame

ters.

Cocff

&ents

klo

rc the

spin

ofTan

noun

ccme

n~.

I, an

d /f,.

arc

es

timate

d us

ing

daily

ret

urns

over

the

200

tradin

g da

ys

endin

g 61

tra

ding

days

kb

re tha

t an

noun

amm~

. Co

effici

ents

aRcr

tk sp

inofV

anno

unam

cnt.

I) an

d g,.

arc

cs

timaic

d ov

er the

MO

tra

ding

days

be

ginnin

g 61

tru

ding

days

aft

er

the

distri

butio

n an

d en

ding

260

tradm

g da

ys

afler

lhc

dis

trihu

tton.

Markc

l.iidju

sted

Wum

s pr

ior

to the

sp

tnog

4

anno

unam

ent

are

estim

ated

using

I,

and

8,.

whik

all

subrq

ucnc

ret

urns

arc

cstim

alcd

using

x:

and

PI.

;

dThe

r-s

tatist

ics

for

the

markc

t.adjc

Jicd

return

s arc

ca

lculal

cd

using

the

fo

llowi

ng

rclatr

on:

4. 0

wher

e PE

, is

tk pr

edict

ion

error

(mar

ket-a

djuste

d ret

urn)

:n d

ay

r. Sl

ts

the

varia

nce

olth

c re

sidua

ls fro

m the

ma

rket

mode

l rcg

rasio

n. T

is the

nu

mber

d.

of da

ys

in the

cu

muleu

on

perio

d. N

is the

nu

mkr

*\f d

ays

used

to

ntim;

ste

the

marke

t mo

del.

and

R,

is the

re

turn

on

the

marke

t. ;; 3

Indu

stry-a

djuste

d ret

urns

arc

c.,mp

utcd

hy

vuhlr

aclin

g the

da

ily

return

s on

an

equ

al-wc

lghted

ho

tel

index

fro

m the

da

ily

mtum

s on

Ma

rriott

co

mmon

$

stock

. 6 w

The

I-stat

istics

for

lhc

ind

ustr:

-adlu

stcd

rclurn

r. RI

M *c

l). ur

e ca

lculam

d fro

m CA

Rq

with

n,

=I [?

~rnr

t

2*(l

- 1)

*r*or

] 1,

when

CA

R is

the

sum

of 2

dally

va

lues

of

A1.d

4d,

ow

the c

umula

tion

pnod

. r

is the

nu

mkr

nfday

s In

lk cu

mulat

ion

perro

d. rar

1s

the

varia

nrr

of Ih

e da

ily

value

s of

&,&&

d)

over

2 the

pe

riod

begiu

nirg

60 d

ays

kfurc

the

spino

fl an

noun

ceme

nt thr

ough

0

days

fo

llowi

ng

the

distrr

butio

n (3

76

tradin

g da

ys).

and

COI

is the

firs

t-orde

r % y

aumc

ovar

irnti

of tk

daily

RI

, *,,

.sc

rics

I 2 5ip

nilica

nl at

the

5%

Icvcl.

** p

258 R. Pamno! Journal o/Financial Economics 43 (I 997) 241-274

The market- and industry-adjusted returns arc only significant around the spinoff announcement and the Merrill Lynch resignation. The negative reaction to the Merrill Lynch resignation indicates that the market interpreted this event as a signal that shareholder gains from the distribution would be smaller than previously expected and/or that the distribution was less likely to take place. Merrills etTort to distance itself from the spinoff may have been interpreted as a signal that bondholder opposition to the spinofT plan was stronger than expected and/or that legal chalknges to the plan were likely to succeed.

While none of the adjusted returns around other events in Table 5 an significant, the -4.24% industry-adjusted return for the bondholder nego:i- ation annou ncement suggests that these negotiations were expezted to reduce shareholder gains. In fact, the -4.24% value does not reflect the entire price decline associated with this event. During the five trading days leading up to the December 29. 1992 anaou ncement, the industry-adjusted return was -6.69% (r-statistic of 1.80). suggesting thar information concerning the negotiations began lo be reflected iv prices ar earl; as December 22.

Fig. 1 illustrates cumulative re: ms on Marriotts cornwon stock for the +iioU ctiver& AI, 1a1~ 3. the industry-adjusted plot shows that the positive return following the announcemen t was largely offset by the negative returns around the Merrill Lynch resignation and the bondho&r negotiations an- nouncement. Marriotts stock returns were similar to those of the industry from January 1993 through the distribution in October, except for one increase around an eariy-January positive earnings announcement.

The stock returns during the period from announcement through distribution provide little evidence that the spin& increased shareholder value. Whik the unadjusted tetum on Marriotts common stock during this period was 93.93%. much of this return is explained by changes in the industry index. Tbe industry- adjusted cumulative rptum is a statistically insignificant 4.84%.s Tbe industry- adjusted change in the value of Marriotts common equity from ~be announcement through the distribution was only 580.6 million. computed by multiplying each daily return by the dividend-adjusted dollar value of the companys equity at the end of the previous day and tben summing these daily value changes.

iI is possible that the sharcholder gain cxcccded SO.6 million but rhat poor performance relative to other industry firms offset much of the increase.

The period beman the an nounammt and distribution coinckkd with a strong raxwcry in the hod industry fdiowing the 1990 -91 ramsionTlwraurastoshrrcholdmalaUOCthefinnsin~ hod index cxacdcd the 1114% mum on I& S&P 500 index during &is period. Tbc total returns bchvccnthea ~~wmccmc~t and distribution for the individual hold firms are 38.39% br La Quinta Motor Inns L.P.. 136.46% for La Quinta Motor Inm Inc. 127.68% lor ShoLod~ Inc.. 143.33% for Hospitality Franchise Systems. Inc. 55.79% for Marcus Corpomtion and 36.76% for Red Lion inns L.P.

R. PamnolJoumal of Financial El wwntics 43 II V97) 241.-274 259

260 R. Pomno/Jownal of Financial Economics 43 (1997) 241.-274

However. the evidence is not consistent with this explanation. Press reports between the announcement and the distribution reveal no evidence of poor relative performance at Marriott. Furthermore, the industry-adjusted plot in Fig. 1 is inconsistent with poor relative petformance between January and mid-October 1993. This curve would most likely have been downward-sloping had the market received signals of poor petformance during that period. Instead. it is flat.

4.3.2. Fmjid stock The unadjusted cumulative return for Marriotts convertibte preferred stock

and its daily trading volume are illustrated in Fig. 2.a. The negative 3.59% return following the spinoff announcement indicates that preierred shareholders ini- tially expected the spinolf to reduce the value oi their claims However, this loss was more than offset by gains during the following month as the unadjusted value of Marriotts co~mott eqr!ity increased beyond its post-announcement level.

XL p.cterre;i sturare~, -me couvertible only into shares of Host stock after the distribution. Therefort, the change in the value of these securities between the annou ntzment and distribution dates was agected by the adjustment of the conversion ratio from shares of Marriott stock into shams d Host stock. Apparently. most @erred shareholders believed that this adjustment would not favor them because approximately 92% of prdemd shares outstanding were cortvcrtcd into Marriott common stock before the adjustment was an- nounced. This was a costly error for those who converted because Marriott overestimated the value dtbe distributed shares when it set the new conversion ratio. The ratio was adjusted from 2874 shares of Marriott common to 19.160 shares 0; Host common based on the assumption that the distributed shares represented 85% of the value of Marriotts equity. The actual percentage, based on the initial trading prices Ot the Host and International shares, was 79%. Consequently, p&&red shareholders who did not convert their hotdings prior to the conversion ratio adjustment realized a pm-tax windfall gain of 40% on the day that the new ratio was annotmced.6 This gain, which is a wealth tran&r from the common sharchokkrs, is illustrated in Fig 2a by the sharp increase in the cumulative return on October I, 1993.

Fig. 2b shows that the p&rred share price premium over its conversion value dropped sharply after the spinoff announcement from approximately 514

R. PamnolJoumaI of hanciat Economics 43 (1997) 241 274 261

Fig 2b. Marriott p&nuJ rtoc& price io exas d its amtwxion value from Julj IO. 1992 rhr,.,gh Jaonuuy 4. WM.

to $5, where it remained through the end of 1992 in 1993, the premium-to- conversion value gradually declined to a level of approrimately $3 at the end of June and then dropped to are during the T.ra week of July. The July drop Mowed the denial by a Deiawar c court of a request from a p&&red share- holder group to postpone the meeting at which the common shareholders were scheduled to vote on the spinoff.

4.3.3. L YONs The Chkugo Trihw reported on October 27.1992 that the language in the

LYON indenture was u&r with respect to how those claims would be a&ted by the spinoff and that the Marriott board had not yet decided how to treat those obligations. Uncertainty concemmg how the LYON claims would be

262 R. Pom~no.lJoumal of financial Economics 43 11997) 24/- 274

Fig. 3a. Marriott liquid yield option IWIC cumulatlvc wadjustcd returns and trading volume Iram July IO, 1992 through January 4 1994.

b-~g. 3b. Marriott liquid yidd optLo note pncc In caocu; ul~ts u~wsion value frum July IO. I992 through January 4. I994

treated in the spinoff appears to have contributed to the 7.09% decline in the aggregate market value of those securities during the three days following the announcement (Fig. 3a). After the initial decline, however. the cumulative LYON return exhibits a pattern similar to that of the preferred share price, gradually increa&ng with the unadjusted common stock price. The LYON price in excess of the conversion value also dropped sharp!y at the time of the announcement and then gradually declined to zero (Fig. 3b).

Unlike the p&erred shares, the value dthe 1 YON claims was altered little by the spinofi. Tbe LYONS became an obligation of both Host (IO%) and Intema- tional(90%) and remained convertible into an equal number of shares of each company. Tbe lo/90 split is consistent with early estimates d the relative values of the two post-spinoff companies. suggesting that an effort was made to

R. Pawiiwihmd of Financial h-momics 43 (1997) 241-274 263

structure the LYON claims so that they retained proportionate rights to the cash flows after the distribution.

4.3.4. Notes and dehentures Fig. 4 illustrates the cumulative unadjusted and market-adjusted returns on

Marriotls senior notes and debentures. The cumulative market- and industry- adjusted common stock returns are also presented for comparison. The initial decline in the aggregate value of the notes and debentures was followed by modest increases ir. mid-October 1992 and between mid-December and mid- January. lhesc incteases correspond to events that ate likely to have been interpre:ed as r~&cing the expected bondholder loss from the spinoff. Tbe October increase coincided with the filing of the class-action suits and the formation of the bondholder committee directed at Mocking the initial spinoff plan. The increase at the end of 1992 occurred around the initiation of the negotiations between Marriott and the bondholders

lhe wealth loss ultrrllately incurred by holders of the senior notes and debentures was less than the 5333 t million decline that followed the spinoff announcement. By the end of January. the market-adjusted value of the notes and detzntures was only SI 51.0 million below their value on tbe day hefore the spinoH annou ncement. The aggregate senior bondholder loss remained at roughly this level through A.*gust and then increased gradually to 5194.6 million (9.98%) on the distribution date.

The dif5zretu.z between the 5194.6 mGon market-adjusted bondholder loss and the 580.6 million industry-adjustea shareholder gain suggests that the spinogcaused a $I 14.0 million decline in the total value of these securities The wealth transfer to preferred shanholders that resulted from the error in the conversion ratio adjustment accounts for approximately $12 5 million of this decline. If the LYON claims were unatTected by the spinotT. the di&rence between the S114.0 million and S12.5 million figctres indicates that tbecost ofthe spinofi was expected to exceed the value it created by S131.5 million. This section considers why the value or Marriotts securities declined.

Tbm were 326..366 prckmzd shares outstanding when the con-on ratio was adjusted. If Marriott had cortrctly cstimakd the value of the disttihution. the convcvion ratio would have been 13.666n1hcrthan 19.160. ThcSI2.5milkn Egurris theproducl ufthcdilicrenabctw&n these two ratios the 57.000 price at which the Host shares bepn trading and the number of pcrcmed shares outstanding.

R. PawinoiJoumd of Finmcial Economics 43 i!H7) 241 274

I

I

/

if Y :

i

R. PomnofJoumal oJ Financial Economics 43 (1997) 241- 274 265

5. I. Sources of t;alue

Comments by Marriott officials as well as arguments in the literature suggest several ways in which the spinoff could have been expected to increase firm value. As .I. W. Marriott, Jr., suggested, the spinoff might enable tbe company to more fully exploit value-creating growth opportunities in tbe management businesses by reducing capital constraints. However, it is not clear how large this benefit would be. The capital constraints were largely &f-imposed since Marriott could bcve financed attractive investments through equity s&s when ite %tancial position deteriorated It is also worth noting tbat Marriott was able to s:ll $400 million in lO- and 20-year debentures at 9.50% and lO.OO%, respectively, during April 1992. Tbe magnitude of tbe value reabxed from improved access to debt capital depends on the extent to which tbe Marriott family was willing :o turn down valuable investments in order to avoid equity Saks.

As Marriott of?iciais also suggested. tbe spinoff might enable the capital markets to more accurately assess the true value of tbe firm by improving tbe quality of financial infombation available to investors. However, a spinofi is not necessarily tbe least costly way to provide the markets witb such infotmrtion. nor will tbe benefits from the availability of better information -rily outweigh tbe costs of pro&ii 9 it. The incremen talcostofmaintainingasecond setoffinancia I records and maiaging a separate stock is5ue can be substantial. In addition, tbe diiure of more detailed information concerning Marriotts businesses might beip its competrtors.

Fig 4. Cumulatiw returns on Marriott senior ocbt and qutty bewun July 10.1992 and Januaty 4. WM.

Tbcunadj~sfflior~rcturosarr~~drom~priotriortbci3prMidycrd+dpawsd notes and ckbcnlurtx 0uIstandiq on hc dale dthc spinolfanncunm.mt (oT,cbtr 5. I992l. Bad ~llnrs~Qctobcr8,1993rrtlcdchm~inthr\~ucoTquityrmivcd~ancrcslng c!k The nurkc:-adjusted senior tkbl tclwm am ahhal from dunp m rhc ydds 04 2-. 5-. ad IO-)ru8B83bondindicesnporttdbyBbom~wairrcuNrrrSmiEccmrtLcwnplt~ TbevIh*oCadraocc~~urrIcriaLiadividur~vldjugodunn8lht~~isdcxthc

mm4 dmdy rnatdwx its matunty. The market-adjustfd coamwn stcdimumsquallbccom- prmdal daily p~~Ji&on erron from a market model The&y prcdikm erron fmm July IO. I992 throu#h the tradh day paccd& the spina(l lnnounaCmen t @rmbcr Z 1992) arc obtained uxing tk pramctcrs from a market & estimated over the 200 tr,.hng days ending 61 trading days bdorcthcan llouncXmcnt Daily prsdiclioa cmns hm the Jllmnmccma 1 day foctobcr J. 1992) through January 4.1994 YE obtained ting pammetax hnnamixrkctmoddttuci5cstianatiovcr tb 200 trading days bCgiIlllifl~ 6i ~twlhg days d&r the distribution on Cktobcr 8 1993. The sdr P 500 index is used to estimate the market models The indwtry-a&ted rrturnx CqupI tbc corn- pcmdd dilfcmna bctwcm the daily mum 00 Marriotts common stoc+ and the daily return on an quai-weighted index amstructsd usi08 ruumx kw six hotel lirw. The timlx used to amstmct the hctd index include Hospitality Franchise Systems (aticr &amber IO. l99Zk Ins.. La Quinta Motor Inns Inc., La Quinta Motor Inns L.P.. Marcux Corporation. Ral Lion inns 1 P., and Sholodgc Inc.

266 R. Pam~no/Joumal of Financial Economics 43 (1997) 241- 274

The Marriott argument that the spinoff would benefit shareholders by providing them with improved investment opportunities is consistent with Hakanssons (1982) conclusion that a spinoff can increase the set of investments available to investors in an incomplete market. However, this benefit is unlikely to be large, as a wide variety of real estate investment trusts and hotel firms were already publicly traded in 1992.

To the extent that accounting and market performance measures would better refect managerial performance in the post-spinoff companies+ as sugges- ted by Aron (1991), the spinoff might also enabk Marriott to write more efbcknt contracts with managers owning modest equity stakes. However, the potential gain from improved contracts with managers is likely to be limited by the active participation of the Marriott family in the management of the company. The family has strong incentives to closely monitor senior managers and access to proprietary information that would be useful in evaluating their performance

The spinotT is alio uuhkely (0 substantially increase tbe value of tk firm :hr oug!, .4xr m&s Ii< TS lh?! Za\c .xen examined in the literature. A review of the spinoff pian indicates that there are no meaningful tax or regulatory benefits of the sort identified by Schipper and Smith (1983). Furthermore, since separation of the ownership of the hotel and senior living properties from the management of those facilities is largely a financial transaction, it is unlikely that the spinoff would improve operating e&ienc& by streamlining Marriotts organizational structure (Glassnuq 1988) or better position the firm for tnerm or takeover activity (Hite and Owers, 1983; Cttsatis, Miks and Woolridge, 1993). In fact, Marriott executives conceded that the major reason the Host/ Travel Plazas business was separated from the management busincsscs was to ensure that Hosts cash flow would be sutlicient to meet its debt service obligations.

5.2. S@inofl carts

Whik the potential for the spinoff to create value is unclear, the direct costs and ine&kncies appear relatively large. Table 6 lists some costs associated with the spinotT. International and Host recognized spinoff-related pre-tax charges of $39 million in 1992 and 1993. These charges, which are for expendi- tures on items such as legal, accounting, and investment banking activities, cost securityholders approximately 523.4 million on an after-tax basis, based on a tax rate of 40% (similar to the marginal rate at International in 1992 and 1993).

The spinotfako reduced the after-tax cash flows to securityholders by accder- ating some tax payments. After the spinoff, the firm was no longer able to immediately use tax shields generated by Hosts businesses The magnitude of this cost can be estimated by considering that Host reported $12 million in loss carryforwards at the end of 1993 (after th,ee months of independent operation)

R. Porrim/JowaaI ofhancia~ Economics 4J (1997) 241-274

Tabk 6 Cat8 dtk Marriott spittoP

267

!soora COSt -. ---- ______ ---_.-_---. .---.-.-----..--^_

cOustharMbequulbtkd Dimctdm~taqnizdiafttuthJstatcttunts S23.4 LooO((brability(oodidHo4bPawilbMlrrio(tlntanrtioarlpoh~ S3.1 Akr-t8xlo88fraoboad~ S5.0 V8htcdw8tTaot8i88dulMkl-~t s29.3 Total Giiii

otkrco8ts . . Dt+amod8aYoootiog8od~8y8tao8 IN Higkrsawity inamaacortr Id

and a S19 million pretax Ios in 1994. If the spinoff had not been compktai, these cartyfotwards and losses could have o&et profits from tbc vt busincosff Assuming that Host is unabk to use tbe associated tax shields for ~)~aadusinsamarsi~tarratcof40%andadisoouotratcdl~~, thepnscatvalutoftbecostoldeCerriogthtuscdthcsetaxshiddsisS3.1 million. Additional losses at Host ord&rraJ of the use of the tax shidds for more than three yeas will add to this cost.

268 R. PawinnlJoumal of Financial Economics 43 lIW7) 241. ?i4

Marriotts tax payments could also be accelerated for another reason. By isolating the hotel properties from most of the firms cash flows, Marriott is no longer able to immediately use tax shields arising from the sale of hotel properties for less than their book values. With many hotel property values still below their 1989 kvels, there was a real possibility of such sales at the time dtbe distribution.

The March 1993 bondholder agreement also proved very costly. In addition to the $1 million cash settkment with the class-action plaintiffs (&kc&d in the spinoff-related charges discussed above), Host recognized a $5 million after-tax loss on the exchange of the notes and debentures. Furthermore, the 7.7 million warrants that Marriott agreed to distribute to former bondholders were already in the money when they were distributed. The value of these warrants, estimated using a binomial option pricing model. was $29.3 million on the day that the o&ring prospectus was filed.

The spinoff could ako result in o?erating i&ii&&s and incmased costs tF: I ala: zn1 tail, AUdf. I!% ujmg guMic info,mation. For instance, the dupli- cation dadministrative f&as at Hart and International could increase total operating costs. Each firm maintains separate accounting and finance stafis. as well as systems ror lmnqing &uebokkr rdations and tracking share owner- ship. Fur&rmom, as rudegted by Hite and Owers (1983), the spinofl could limit ecoom&s d sak in future eii0rt.s to raise capital.

Finally. the rpinoIT is likely to mise the cost d future debt issues and/or force Marriott to accept more restrictive covenants. The etkct of the spinotTon the cost d future debt issues was mentioned frequently in press reports following tbe announameot. Comments attributed to financial profeAo!rak indicated that the spinog would make it more difbcult for Marriott to raise capital because it would cause investors to revise their estimates of the likelihuod that Marriott would behave opportunistically in the future.

ICmarkacstimatcsdtbecosts associated with the spin& were similar to those reported in Tabk 6, the diRerena between the 360.8 million in quantifi- l bk costs and the $101.5 net securityholder loss suggests a lower bound ofS40.7 million for the expected cost of ir&cien& and higher debt issuance costs ~tingfromtbtspinoll:Thir~.fmilliondiRrrtaocw~equabI.l%o(tbe market vahre dtbe Marriott-s public securities on the distribution date, is a lower bound because it is net of any value that was created by the restructuring.

If the shareholder gain following the announcement was largely o&t by price declines in November and December 1992, and the stock price performance in 1993 was no different than it would have been haJ the spin& not been proposed, the question arises as to why Marriott completed the distribution.

R. Pamno/Jownal of Financial Economics 43 (1997) 241-274 269

One explanation is that the Marriott family feared that backing down in tbe face of strong bondholder opposition might harm its reputation and the reputations of other senior managers. As long as the public shareholders were not harmed, the family may have seen no reason to alter its plans. While this explanation is plausible, the Marriott family could have expected to beadit from the spinotT in other ways

First, the spinoff reduced the likelihood that the family would lose control of tbe entire firm. The deterioration of Marriotts financial condition had left it in a precarious position and prospects for improved performance were uncertain. Continned poor performance might have pushed the firm into financial distress and caused the lamily to lose control. By legally -rating the profitable management businesses from the real estate and much of the pubhc debt, the family was able to redtnx the likelihood of losing control.

ThespiaoAalso~tedthcpotca~losscstothcMarriottlPmilyinthetvent of a default With Marriott stock comp&ngahighproportiooofitstotalnet worth, the Marriott tily is likely to have been more conarnod than other rvdldiversified investors &out the unsystematic risk ofits po&lio. To theextent tbPttbcCamilyval~thend~dthioristt&lamifyhadaninocntiveto compkrcthcspiooacreailitJidwta&aaIbemuirctpriadlhtfim?ssbans.

Finally, the family benefited from the spiaotT because it improvod the maaage- mat businesses* access to A-51 capital By using the spinoff to separate tbe maoagcmcnt businesses from he asociata4 teal estate, tbe family was once again in a position to aggressively pursue growth opportunities without risking dilution of its ownership position.

7. c-

Marriott spun off its management businesses in reaction to changes in economic conditions that made its operating strategy meft&tive. The spinoff accomplished what the practice of selling hotel properties had done for the 6rm ia the l9tlOs. It enabled Marriott to separate its management businesses from mucbofthe associated real estate. However. tbc e&t of the spiooff on tbe firms securityholders was quite difTercnt from that of hotel sales 1 Mike hotd sales, the spinoff reduced the value of the assets underlying bondholder claims. The dedine in interest coverage at Host was not accompanied by a commensurate increase in bondholder returns.

Nonetheless, this case illustrates how bondholders can inguenaz corporate policy even in the absence of explicit covenant protection. The bondholders were able to force the company to modify the spinotT plan in ways that eliminated most of the initial shareholder gain. The value created by the spinoff was more than offset by its cost and the remaining bondholder loss was largely consumed by transaction costs and inefficiencies

Chronology oJer!ents in the Marriott spinofl

Ocroher 5. 1992 Marriott announces the spinoff plan. Shares in the companys management busi- nesses are to be distributed, on a pro rata basis, to the shareholders. The new firm will becalled Marriott International(Inrernurionul) and the parent will be renamed Host Marriott (Host). Moodys lowers its rating of the Marriott senior debt from Baa3 to Ba2 and subordinated debt from Bal to BI. Standard and Poors places Marriott on its CreditWatch list for possible downgrade.

oclokr 9.1992 Two class-action suits arc filed on behalf of Marriott bondholders

oclokr 15.1992 News reports indicate that a bondholder steering committee. consisting of repre- sentatives frcjrn 1 I !d~gc institut8onal investors. has been formed to explore alterna- :iq rnurSer of Rr*ion aimed 11 bls, cmg the proposed transac :ion.

Ub.dw ~9. iW,

A third lawsuit is filed by a group of investon coikctively hording approximately SIZO million of senior Marriott debt. The suit alleges that Marriott improperly failed to disclost the restructuring plan wben it issued S400 million worth of Series Land!kriesMSeniorNotesinAprili!?Q. The bondholder steering committee is reduced IO seven members with the defec- tion of three members to the group filing the suit and tbe departure danother for otber feasons

Norm&r 9.1992 First Na*ional Bank d Chicago resigns as trusta for the 13 note and debenture issues that Marriott has outstanding.

Normher II. 1992 Bane One af6liate First Chicago Corporation is named as the new trustee for the Marriott debt. Duff and Phe!ps downgrades Marriott nom and debcnturrs from BBB to B. Liquid Yield Option Notes (LYONS) from BBB- to B-. and convertibk prefer& stock from BE LO CCC.

Norember It. 1992 %andard and Poors announces tbat it will downgrade Marriotts senior un- secured &%t from BBB to B. its LYONS from BBB- IO B. and its convertible pderred stock from BBB to CCC when it becomes clear that the spinoff will occur as currently planned.

Normber 17. 1992 Merrill Lynch & Co. w&draws as an advisor to Marriott on the spir& plan. Merrill. an underwriter d several Marriott debt issws. has been criticized for its association with tbe restructuring plan.

Nowder 20.1992 A Federal judtqz combines the bondholder suits against Marriott and delays interviews with potential witnesses until January 8 1993 so that Fe-trial paper work can be annpkted.

R. Pamno. Journal of Financial Economics 43 (I 997) 241-2 74 271

December 29. I992 Marriott announces that it has begun discussions with bondholders in an sfiort to address their concerns with the spinoff- Ten class-action suits have been tiled against Marriott by this date.

Janwwy 8, 1993 Marriott and the bondholder groups suing to block the reorganization agree to postpone the next court hearing, scheduled for January 8. until January 28.

Jammy If, 1993 J. W. Marrioa. Jr.. announus that Marriott had strong pro forma eamiog in 1992 Operatint- profits are expefzted to be between 1490 and SSOO million. 1991 operating profits were S478.

Jammy IL 1993 Marriott provides details of its bond exchange proposal to the bondholder groups with which it is negotiating. The proposal inch&s lcq+cniog the matunty of the bonds by four years and a sweetener consisting off50 million of Marriott common stock.

Janwl~ 25.lW3 Each of the three bo:tiho&r groups countcr~ the Marriott proposzt The rernarn- ing members d the bondholder staring committee propose keeping tbe company as a singk entity while distributing separate shares Tar each of the two segments. The group that filed suit on October 29.1992 (the suing boodbolder group) agrus with the steering commit- proposal but adds that if Marriott insixts on spinning oIV Inrrrmariad that tk latter should cross-guaraalcr the Host &bt. Reprrunta- Iives of the class-action plair.tilts propose an initial public of&q of Irrtminnal stoctwithtk~uscdtopay&wasomedHoztsdebc Marriott rejects these propos& but o&s to change the s~ucturr d the transac- tion so that fnrrrnarionol will take land valued at 5265 rnillioo and asxume the associated debt.

Febnwy 2. 1993 The suing bondholder group annd>unces that discussions have substantially- broken down. A Marriott spokesman says that disunions are continuing with major bond-.

h4aJz-h 8. toy3 Thr Wall Strref Journal reports that Marriott is o&ring to almond tk restructur- ing proposal. Marriott says that it expects to rCMh an agreement with the bondholders within the next few days.

Marc-h 9, lW3 Marriott reaches an apreemen t in principle with the c&s-action plaintiffs.

Mach IO. 1993 Marriott reaches an agrecmcnt in primzip& with the bondholder steering mm- mittee.

Man-h II. I993 Marriott announces that the spinoff is b&g moo&A in accordance with an agreement between Marriott. the class-action pIaim% and the steering corn- mittee.

March 2.5. iW3 floridas state pension fund files suit to block the revised spinoff plan. The suing bondholder group sa)b that it may expand its sllit against Marriott.

272 R. PomnolJournal of Financial Economrcs 43 (1997) 241.-274

April I. I993 Tke Wall Street Journal reports that holders of Marriotts convertibk preferred stock have formed a group to oppose the spinoff. Thos shares, which are currently convertible into 2.874 shams of Marriott common, will be convertibk into only Host shares after the spinotT. The conversion price will be based on the relative values of Host and /n~mtati~~nal at the time that the latter is spun off.

April 2. lW3 The prckrrcd shareholder group files suit to block the spinoff. The suit claims that the reorganiwtion will result in common stockholders recetving dividends before preferred shanbolders. Under the spinog plan holders of lntemurioaol common shares are likely to receive dividends while holders of Host prhmd sham are unlikely to rtive any.

April. 4. 1993 Tk Wail Sweer Journal reports that Marriott has rejected demands by the preferred shareholder group that the spinoff plan be modified.

April II. 1993 Marriott announces that. adjusting for an accounting change. firstquarter net income is 513 r;iilliou. Ihis compares with net income of Sl 1 million in the first qu: ierof 1992

M&I.,, ., IYY., Marriott Bks a SICK3 million countersuit against the suing bondholder group. On May 21. I993 Tk fhd Eqrr reports that a Marriott spokesman described tbe suit as alkging lhat [the suing bondhddtf group] sought to intcrfem both in our deals with our fina&al advisors. . . and also that it conspi~~I to organize a group boycott Ot Marriott hotels and other serv&s.

hi* 9.1993 The Marriott !kries H notes mature. The local fact value of Marriotts pubhc notes and debentures is nxluccd from 51.87 to Sl.77 billion.

May IO. 1093 Marriott fiks its bond exchange ollix with the SEC.

May 25. 1993 Marriott ammmwxa that the June 22 sha~cholder meeting will be res&dukd for July. Tbe SEC has not completed its mvkw of the prosy mate&Is.

May 26. 1993 Standard & Poors announces that it plans to assign an A- debt fatirg to Inter- rsariotsat and that it has lowered its rating on Marriotts senior notes from BBB to B.

Jwte 9. 1993 A Delaware wurt dismisses the claim by the p&erred sharrhoider group that rbe spitmU constitutes a breach of fiduciary duty. Other claims remain unresolved in this suit.

Jk+ I. loo3 The Ddaware court denies a request by the prekrred shareholder group to delay the July 23 shareholder meeting.

July 19. 1993 Marriott begins the debt exchange o&u.

J& 23. I993 The spinoff plan is approved by 85% of the votes cast at the annual shamholder dng Marriott announces that it has reached an agreement with the prdemd &arc- holder soup that had sued to Mock the reorganization. The agreement calls for the preferred shareholders to dismiss the litigation, retease Marriott from all

R. Pam~nolJawd o/Financial Ecnnomics 43 (1997) 24/- 274 213

claims, and convert their shares into Marriott common stock before the distribu- tion date. In exchange. Maniott agrees to pay the plaintiffs SXtO.000.

August 18, I993 Marriott extends the expiration dale for the bond exchange ofkf to August 20 due to a lower than expected response as of the previous August 17 deadline.

August 24.1993

7% Wd/ Street lovnal reports that MatliOlt has l uuilalcraJly dtangai tk swap ruks, by announcing that it MI Jongcr nucds 51% of each of two bond issuu. for which it has faikd to ICC&C that amount in order to proceed with tk exchange Ok.

August 31.1993 Marxiotl sets a new faord date of September 30 and distribution date of October 8.

ssTptcnltxe 1.1993 The Mamiolt &rim J noles mature. lk tocz face value of Marriotts public notes and dekntures IS reduced from Sl.77 to Sl.62 billion.

sepmrbrr 28. 1993 Tk IRS informs Marriott that tk spinotT will be tax-free.

septtuher.9.1993 Mamoll annouuccs lhat ah cond~knts necessary to proceed wxtJi tk spnoft have bcm met Tk annpanv abo seports thal. adjusting For uoncash income tax changes and tk e!Tects &lodging dispositiom operating pro& net income. and earnings per share am up 7%. 20%. rad 15%. mspaztivdy. over lk third quarter in 1992.

cklok 1.1993 Marsiott anuounm that 92% 4 tk fimr adlioo convertible preened shares have been amvested into 10.6 million sham of Marriott common stock. Tk nmainiug 326.366 shams d prefemd stock will beoa&mb each k coovertibk into 19.16 shares d Host stock. htemationrrl begins trading on lk Yew Yorh Stmk Exckngc wi (whm issuait and Host begins trading both with &idend and ui (wbm issued witbout tbe divideod rights). Qandard & Po.A aunoukas lhat Intenuujollol will replaa Marriott in tk SBtP MO imkx aftex the dose d lrading on Octoher 8.

alober8.1993 Marriott issues lk special divida~J. dWiveJy compiling tk spim5. fntematiold amounces au inilial quarteriy cash dividcad d SO.07 per share. This dividend equals the quarterly dividend previously paid by Marriott. TbeSericsGnotathatmatureonFebnrar) 1,1994arcd&ascdandmnovbd from tk Hmr baJame sheet. Tk total hsce value d Hmrs public uotes and debmlures is fuduczd lo SI.35 Wioa. The fl.ol billion on Szplmber 1 hat he-u reducaJbySO.1 biJlionasarcsuJtdtkdelksmm and SO. Ii hibiom through stock and cash payments ma& as part of tk exchange o&r.

ocrober 12.1993 The Host shares trade exdividend.

April 28. I994 Thch~tfiledbytkFkwidasca(epcnsionfundisstrled.HosragmtonPudYgc approximately 57.6 million of oki notes held by Rorida fund at tkir par value.

octo&r I,: 1994 Host fiks a Prospectus for tk issu.mce of 7.7 million wan-acts lo acquire shares of common stock at a price of Sg per share for three years and SIO per share during the following two years. Host shares close at SlO.750.

214 R. Parrho/Joumol ojFinmcial Economics 43 (1997) 241-274

October 19. I994 The trial involving the suing bondholder group ends with the jury hop&sly deadlocked. The judge declares a rcistrial. The plaintifT is seeking damages of approximately S18 million.

Jamuty 25. I995 A U.S. District Court juds dismisses the suit filed by the suing bondholder group. The jw ruks that Marriott did not violate federal security laws in failing to ~theporriMspiaoRwhrnitsoldtheScriesLandMSclliorNotuiaApri1

Aron, Ikbra J, 1991. Using I& apiur nmkd as a monitor: Corporate spind% in an agncy framework. Rand Journal of Eamoak 2f 505-518.

Cuutis, Pat&k J, Jama A. Mila. ami J. Randall Woolride. 1993. ltcstneuring tbrougb spkdk Thesto&multctevideaat.JomulofFimncialE.umcmb33.293-311.

citamu& David M, 1988 spin4s and spir+Juts using suutitizatioa to beat the bu~uaacy. kxund of Applial Cotpomte Finance I. 82 (19.

Hvh~-vn. :.:Ts j4, ;Yb, ;ha,,-; JllklitWLd~rtCl:\i&Rmdpicrcllatr~thCbuic cbsacaadvaluc eoammh, Jamal d Fi- 37.977-ltXJ4.

H&e, G&n L and Jama E