Creditor Rights, Claims Enforcement, and Bond Returns in Mergers and Acquisitions

Luc Renneboog is Professor of Corporate Finance at Tilburg University. This post is based on a recent paper authored by Mr. Renneboog; Peter Szilagyi, Associate Professor of Finance at CEU Business School, Central European University, and Judge Business School, Cambridge University; and Cara Vansteenkiste of Tilburg University.

The market for corporate control has become increasingly global over the past decades, with cross-border mergers and acquisitions (M&As) now accounting for more than a third of M&A activity worldwide. To date, empirical studies that have investigated the potential cross-country spillovers in governance and legal standards mainly focused on the economic implications for shareholder wealth, relating the governance regimes in the countries of bidder and target to shareholder returns, to the takeover premium demanded by target shareholders in deals involving equity offers, to changes in the valuation of non-targeted rival firms and even of entire industries in which cross-border deals occur.

As country-level differences have such large effects on shareholder returns, they may also affect the returns to creditors and, specifically, to bondholders around M&A announcements. In our paper Creditor Rights, Claims Enforcement, and Bond Returns in Mergers and Acquisitions, which was recently made publicly available on SSRN, we examine how cross-country differences in governance and legal standards affect bond performance, concentrating on how differences in creditor protection and claims enforcement affect bond returns in international Eurobond-issuing firms around M&A announcements. There is substantial variation in the way how and the extent to which countries adhere to the interests of creditors. From the perspective of bondholders, an important aspect of cross-border M&As is that they combine firms from jurisdictions with varying degrees of quality of creditor protection provided by the legal systems and with variation in the efficiency of claims enforcement. Our empirical results confirm that cross-country differences in governance and legal standards related to creditor protection and claims enforcement are strong predictors of bidder and target bond performance in M&As. Bidding firms’ bondholders obtain higher abnormal returns of up to 15 basis points when their firm becomes exposed to a jurisdiction with better quality of creditor rights or better enforcement of claims in court. These findings are both statistically and economically significant.

Our findings suggest that cross-border M&A deals provide much greater scope for functional spillovers in creditor protection than was previously assumed.  The existing literature on corporate governance attributes only limited relevance to cross-border spillovers in the legal protection of creditors, arguing that spillovers in creditor rights are limited because corporate assets remain under the jurisdiction of the country where they are physically located (La Porta et al., 2000). However, exposure to a more creditor-friendly regime can exacerbate the threat and implications of insolvency proceedings against the firm if it becomes financially distressed, even more so if the firm is already present in that jurisdiction—the more assets are up for grabs, the more incentives creditors have to pursue them. Moreover, it is not clear that assets remain under the jurisdiction of the country where they are physically located. A worldwide wave of bankruptcy law reforms, aimed at enhancing co-operation among national authorities, increased creditors’ abilities to arbitrage their firm’s exposure across legal systems. A key template for these reforms was the Model Law on Cross-Border Insolvency issued by the United Nations Commission for International Trade Law (UNCITRAL) in 1997, which puts one jurisdiction in charge of insolvency proceedings on a worldwide basis. Creditors can thus race against management and each other to identify a jurisdiction that is the most beneficial given their legal position, and ensure that their claims are optimally satisfied. Consequently, the ability of creditors to arbitrage across legal systems further intensifies spillovers in creditor protection.

Whether or not creditors can engage in insolvency arbitrage themselves, the ensuing reduction in the agency cost of debt should affect all of the firm’s creditor classes. That we find significant results for a sample of Eurobond holders is remarkable, because they are prevented from doing insolvency arbitrage themselves given that English law applies in case of insolvency. Eurobond holders should nonetheless be highly sensitive to improvements in the position and bargaining power of diligent creditors in relation to the firm, which deter management from excessive risk-taking. Eurobond holders thus only indirectly benefit from spillovers in creditor protection, which are triggered by other creditor types not constrained by the covenant restriction on the choice of jurisdiction. This implies that the effects for other classes of creditors are potentially much stronger. Unfortunately, the secondary market for those types of securities is not liquid enough to test these effects directly.

Overall, we document that bidder and target bondholder returns respond to differences in specific creditor protection regulations  and enforcement and not to cross-country differences in broader corporate governance measures such as the rule of law, anti-directors’ rights indices, or legal origin. This suggests that bondholders welcome both the quality and enforcement of creditor rights. The resulting reduction in the agency cost of debt following takeovers involving firms subject to different levels of creditor protection generates beneficial effects for all creditor classes, regardless of their seniority or their ability to engage in insolvency arbitrage. Moreover, we confirm our conclusions by investigating Eurobondholders of firms that are more likely to default and that are thus more risky to creditors: longer maturity bonds, bonds by firms with high asset risk, and bonds by firms with a higher likelihood of financial distress are most sensitive to improvements in the quality and enforcement of creditor protection following a takeover.

The full paper is available for download here.

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