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.
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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. |
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4.3.4 Corporate Decision-making and Stock Value