WFU Law School
Law & Valuation
4.3.4 Corporate Decision-making and Stock Value

4.3.5 Relationship Between Stockholders and Bondholders

A tension exists between the stockholders and bondholders of a company. For example, if stockholders use their control to pay themselves high dividends, thus weakening the company's ability to pay its debts as they come due, the value of bonds falls. Likewise, if a company takes on a heavy debt burden, swamping it with interest obligations, stockholders may not be paid dividends.

This tension is particularly visible in a leveraged buyout (LBO), where an acquirer pays a premium to stockholders to buy their shares and acquire control, and then uses that control to have the company take on new debt to finance the payments made to the shareholders. As a result on the new debt, bondholders of the company find themselves with a much riskier investment - and falling prices for their bonds.

Thus, in an LBO a company acquires its common stock by taking on new high-risk debt. From the perspective of existing debt holders, an LBO represents a fundamental shift of the company's capital structure from one of low leverage (debt/equity ratio) to high leverage. The effect of an LBO is that the existing debt falls in value as the company's risk profile changes overnight. Do existing debt holders, particularly as long-term bondholders, have any rights to prevent this change or to seek compensation for the revaluation of their interests? Put another way, does the company board of directors owe fiduciary duties to existing debt holders not to transform and undermine their investment?

Klock, Mansi & Maxwell, "Corporate Governance and the Agency Cost of Debt"SSRN 527663 (2004)


We examine the relation between the cost of debt financing and a governance index that contains various antitakeover and shareholder protection provisions. Using firm-level data from the Investors Research Responsibility Center for the period 1990
through 2000, we find that antitakeover governance provisions lower the cost of debt financing. Segmenting the data into firms with strongest management rights (strongest antitakeover provisions) and firms with strongest shareholder rights (weakest antitakeover provisions), we find that strong antitakeover provisions are associated with a lower cost of debt financing while weak antitakeover provisions are associated with a higher cost of debt financing, with a difference of about thirty-four basis points between the two groups. Overall, the results suggest that antitakeover governance provisions, although not beneficial to stockholders, are viewed favorably in the bond market.

 

 

Example

The takeover of RJR-Nabisco in the late 1980s illustrates the reallocation of value in an LBO. In the fall of 1988 the CEO of RJR Nabisco, Ross Johnson, led a management group that made a $75 bid for the company, about $20 over the trading price. Six days later, the takover firm of Kohlberg, Kravis & Roberts( KKR) made a competing offer of $90/share.

A bidding contest developed. When Johnson's group bid $100/share, the board called for final bids. Despite a higher bid of $112/share from Johnson's group, the board under wilting media attention accepted KKR's final bid of $108/share.

Johnson, although stung by the defeat, claimed victory for the shareholders -- the winning offer was double the trading price. But bondholders were left holding the bag. KKR's use of $19 billion in debt to finance the takeover brought high (and unexpected) leverage to RJR. As a result of the company's post-LBO debt burden, pre-LBO bondholders saw their investment grade bonds fall to junk status.

In 1989 two RJR-Nabisco bondholders, Met Life and Jefferson-Pilot Insurance, sued the company and its CEO Johnson for the loss in the value of their bonds resulting from the LBO. They argued the company had breached an implied covenant of good faith and fair dealing. They also argued the board had violated its fiduciary duties to the bond holders. (More>>)

LOCAL NOTE

The impact of the RJR-Nabisco buyout was especially felt in Winston-Salem as some long-time RJR employees, who were also stockholders, suddenly became Wall Street jackpot winners. Most recipients tucked away their windfalls in other investment plans, and retailers in town didn't report any spike in sales, with one exception--the Cadillac dealer. Ironically, even though he secured the financial security of many Winston-Salem citizens, Johnson, who soon after his arrival had moved the company's headquarters to Atlanta, remained an "unbelievable demon" to many residents unwilling to forget how he uprooted the company from its birthplace and 100-year home.

4.3.4 Corporate Decision-making and Stock Value

©2003 Professor Alan R. Palmiter

This page was last updated on: April 27, 2004