Dead Hand Proxy Puts, Hedge Fund Activism, and the Cost of Capital

Sean J. Griffith is T.J. Maloney Chair and Professor of Law, Fordham Law School; and Natalia Reisel is Professor of Finance and Business Economics, Gabelli School of Business, Fordham University. This post is based on a paper by Professor Griffith and Professor Reisel. Related research from the Program on Corporate Governance includes The Long-Term Effects of Hedge Fund Activism by Lucian Bebchuk, Alon Brav, and Wei Jiang (discussed on the Forum here); The Myth that Insulating Boards Serves Long-Term Value by Lucian Bebchuk (discussed on the Forum here); and The Law and Economics of Blockholder Disclosure by Lucian Bebchuk and Robert J. Jackson Jr. (discussed on the Forum here).

Dead Hand Proxy Puts are a contractual innovation in corporate debt agreements that change the nature of proxy fights. The term triggers default and immediate repayment of corporate indebtedness in the event that a dissident slate wins a majority of the seats on the target company’s board. Unlike the “Change-of-Control” provisions that have become standard in corporate debt agreements, the Dead Hand Proxy Put strips incumbent management of the power to “approve” the dissident slate, thereby threatening a debt default that management is powerless to prevent. As a result, the feature has attracted attention as a defense against hedge fund activists, whose central weapon, the proxy fight, is blunted by the provision. Dead Hand Proxy Puts give shareholders powerful incentives to vote against activist slates in order to avoid triggering default.

In our paper, Dead Hand Proxy Puts, Hedge Fund Activism, and the Cost of Capital, we empirically investigate the effect of the Dead Hand Proxy Put on corporate debt. We first demonstrate that the incidence of Dead Hand Proxy Puts has increased sharply in the era of hedge fund activism, especially for companies that are likely targets of hedge fund activists. We then show that Dead Hand Proxy Puts reduce the cost of debt. In addition, we find evidence that bondholders react positively to the presence of Dead Hand Proxy Puts in loan contracts, suggesting that bondholders free-ride on the protection that the provision offers to bank lenders. These findings suggest that the provision provides a significant firm-level benefit by reducing the cost of capital.

We searched SEC filings from 1994 through 2014 for loan agreements and bond indentures containing the Dead Hand Proxy Put provision and found approximately 2,700 incidents of the provision in loan agreements and only 60 incidents of the provision in bond indentures. Because we found the provision in loan agreements far more often than in bond indentures, we focused our research on loans, constructing large treatment and control samples of loan contracts. The results of our data analysis are summarized below.

Company Characteristics

Companies with Dead Hand Proxy Puts in their loan contracts are significantly smaller than borrowers without Dead Hand Proxy Puts. Firms in our sample adopting the provision have approximately one-quarter the assets of firms in our control group. Moreover, companies with low dividend payouts and lower leverage ratios are significantly more likely to include the Dead Hand feature. These findings are consistent with prior research finding that hedge fund activists tend to target smaller companies with lower dividend payouts and less leverage, perhaps because their plans are to increase leverage in order to increase dividends to shareholders. Our analysis also shows that companies are significantly more likely to adopt Dead Hand Proxy Puts prior to becoming subject to an activist intervention. These findings suggest a relationship between Dead Hand Proxy Puts and activist defense.

Loan Pricing Analysis

Our regression analysis demonstrates that inclusion of a Dead Hand Proxy Put reduces firms’ borrowing costs in a manner that is both statistically and economically significant. When we compare the spreads of loans with and without the provision, we find that the mean loan spread with the provision is 222.86 basis points and 231.96 basis points without it, a difference that is statistically significant at the 1% level. In regressions controlling for debtor and loan characteristics, we find that the presence of a Dead Hand provision is negative and statistically significant across all specifications. In a further treatment effects model to address endogeneity concerns, we continue to find that Dead Hand Proxy Puts reduce the cost of borrowing. These findings are statistically significant at the 1% level across specifications.

The economic magnitude of the reduction in borrowing costs associated with Dead Hand Proxy Puts is also substantial. Our results suggest that the Dead Hand provision may reduce the cost of debt by approximately 45 basis points. This translates into substantial interest savings. Moreover, because most companies keep debt in their capital structure, we can assume this annual savings over the life of the company.

Bondholder Reaction

We also examine bondholder reaction upon public disclosure of the terms of the underlying loan. Because the acceleration of other indebtedness typically triggers a default in bonds as well, bondholders will also benefit from the inclusion of a Dead Hand Proxy Put in corporate loan facilities, at least insofar as the provision deters hedge fund activists from looting creditors. We find some evidence that bondholders view positively the Dead Hand feature included in loan contracts.

Although we find the Dead Hand feature in loan agreements, we also examine bond returns around the public announcement of loan contracts. The presence of the provision in credit agreements may serve to protect bondholders as well because cross-default provisions will trigger a put right for bond holders should the borrower default on other indebtedness. And, indeed, we find evidence of a positive bondholder reaction to the presence of a Dead Hand Proxy Put in loan contracts. Mean bondholder returns at the filling date of loan contracts with Dead Hand Proxy Puts are positive and statistically significant at the 5% level. By contrast, mean bondholder returns to the public announcement of loans without the provision are insignificant. While the difference in means between the two cases is insignificant, the difference in medians is significant at the 10% level. It would appear that cross-default provisions effectively allow bondholders to free-ride on the protection Dead Hand Proxy Puts offer lenders.

Conclusion

In sum, we find strong evidence that Dead Hand Proxy Puts reduce the cost of debt. Although the provisions are agreed between the company and its bank lenders, bondholders also benefit. Lenders are willing to compensate firms for the benefits they receive from the provision, and the compensation firms receive can be economically significant. Companies can save up to 45 basis points when they include the Dead Hand Proxy Put in their loan agreements. Although the precise amount of savings will vary with each firm, we consistently find that Dead Hand Proxy Puts provide a benefit to corporations by reducing the cost of debt.

The complete paper is available for download here.

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