Tag: Corporate debt

Financing Payouts

Joan Farre-Mensa is Assistant Professor of Business Management in the Entrepreneurial Unit at Harvard Business School. This post is based on the article, Financing Payouts, authored by Mr. Farre-Mensa, Roni Michaely, Professor of Finance at Cornell University, and Martin Schmalz, Assistant Professor of Finance at the University of Michigan.

The established conventional wisdom in the finance literature is that firms rely on free cash flow to fund their payouts, whether these payouts are motivated by agency, signaling, or other considerations. In a popular finance textbook, Ross, Westfield, and Jaffe (2013) conclude that “a firm should begin making distributions when it generates sufficient internal cash flow to fund its investment needs now and into the foreseeable future.” Accordingly, they recommend managers to set their level of payouts “low enough to avoid expensive future external financing.” While it is a theoretical possibility that firms could also raise external funds to finance their payouts, such behavior is costly and thus often considered an “extreme payout policy” (DeAngelo, DeAngelo, and Skinner, 2008) that is “uneconomic as well as pointless” (Miller and Rock, 1985)—which likely explains why this possibility has gone unexamined until now.


Impact of the Dodd-Frank Act on Credit Ratings

The following post comes to us from Valentin Dimitrov and Leo Tang, both of the Department of Accounting & Information Systems at Rutgers University; and Darius Palia, Professor of Finance at Rutgers University.

In response to the Global Financial Crisis of 2008-2009, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) in July 2010. Among its various provisions, Dodd-Frank outlines a series of broad reforms to the Credit Rating Agencies (CRA) market. Many observers believe that CRAs’ inflated ratings of structured finance products were partly to blame for the rapid growth and subsequent collapse of the shadow banking system. In response, Dodd-Frank’s CRA provisions significantly increase CRAs’ liability for issuing inaccurate ratings, and make it easier for the SEC to impose sanctions and bring claims against CRAs for material misstatements and fraud.


Bankruptcy Court Holds Secured Creditors Can Be “Crammed Down” With Below-Market Replacement Notes

The following post comes to us from Mark I. Bane, Partner focusing on corporate restructurings at Ropes & Gray LLP, and is based on a Ropes & Gray Alert.

On August 26, 2014, in the case In re MPM Silicones, LLC, Case No. 14-22503 (Bankr. S.D.N.Y.) (“Momentive”), the United States Bankruptcy Court for the Southern District of New York held that secured creditors could be “crammed down” in a chapter 11 plan with replacement notes bearing interest at substantially below market rates. Unless overturned on appeal, this decision will introduce a new level of risk to leveraged lending—secured lenders will face the specter of losing in a bankruptcy restructuring not only their negotiated rates, but any semblance of market treatment. This risk could result in a tightening of availability and increased costs to borrowers in levered transactions.


The Effects of Mandatory Transparency in Financial Market Design

The following post comes to us from Paul Asquith, Professor of Finance at Massachusetts Institute of Technology (MIT); Thomas Covert of the Economics Area at the University of Chicago; and Parag Pathak of the Department of Economics at Massachusetts Institute of Technology (MIT).

Many financial markets have recently become subject to new regulations requiring transparency. In our recent NBER working paper, The Effects of Mandatory Transparency in Financial Market Design: Evidence from the Corporate Bond Market, we study how mandatory transparency affects trading in the corporate bond market. In July 2002, the Trade Reporting and Compliance Engine (TRACE) program began requiring the public dissemination of post-trade price and volume information for corporate bonds. Dissemination took place in four phases over a three-and-a-half year period, with actively traded, investment grade bonds becoming transparent before thinly traded, high-yield bonds.


Do the Securities Laws Matter?

The following post comes to us from Elisabeth de Fontenay of Duke University School of Law.

Since the Great Depression, U.S. securities regulation has been centered on mandatory disclosure: the various rules requiring issuers of securities to make publicly available certain information that regulators deem material to investors. But do the mandatory disclosure rules actually work? The stakes raised by this question are enormous, yet there is precious little consensus in answering it. After more than eighty years of intensive federal securities regulation, empirical testing of its effectiveness has failed to yield a definitive result.


Who Knew that CLOs were Hedge Funds?

Margaret E. Tahyar is a partner in the Financial Institutions Group at Davis Polk & Wardwell LLP. The following post is based on a Davis Polk client memorandum.

U.S. financial regulators found themselves on the receiving end of an outpouring of concern from law makers last Wednesday about the risks to the banking sector and debt markets from the treatment of collateralized loan obligations (“CLOs”) in the Volcker Rule final regulations. Regulators and others have come to realize that treating CLOs as if they were hedge funds is a problem and we now understand from Governor Tarullo’s testimony that the treatment of CLOs is at the top of the list for the new interagency Volcker task force. But what, if any, solutions regulators will offer—and whether they will be enough to allow the banking sector to continue to hold CLOs and reduce the risks facing debt markets—remains to be seen.


Acquisition Financing 2014: the Year Behind and the Year Ahead

The following post comes to us from Eric M. Rosof, partner focusing on financing for corporate transactions at Wachtell, Lipton, Rosen & Katz, and is based on a Wachtell Lipton memorandum by Mr. Rosof, Joshua A. Feltman, and Gregory E. Pessin.

Following a robust 2012, the financing markets in 2013 continued their hot streak. Syndicated loan issuances topped $2.1 trillion, a new record in the United States. However, as in 2012, financing transactions in the early part of 2013 were devoted mostly to refinancings and debt maturity extensions rather than acquisitions. In fact, new money debt issuances were at record lows during the first half of 2013. The second half of 2013, though, saw an increase in M&A activity generally, and acquisition financing in the fourth quarter and early 2014 increased as a result.


Corporate Funding: Who Finances Externally?

The following post comes to us from B. Espen Eckbo, Professor of Finance at Dartmouth College, and Michael Kisser of the Department of Finance at the Norwegian School of Economics.

In our paper, Corporate Funding: Who Finances Externally?, which was recently made publicly available on SSRN, we provide new information on security issues and external financing ratios derived from annual cash flow statements of publicly traded industrial companies over the past quarter-century. Our use of cash flow statements permits us to differentiate between competing forms of internal financing, including operating profits, cash draw-downs, reductions in net working capital, and sale of physical assets. Unlike leverage ratios which dominate the focus of the extant capital structure literature, our cash-flow-based financing ratios are measured using market values (cash) and are unaffected by the firm’s underlying asset growth rate.

The empirical analysis centers around three main issues, the first of which is to establish the importance of external finance in the overall funding equation. In our pool of nearly 11,000 (Compustat) non-financial firms, the net contribution of external cash raised (security issues net of repurchases and dividends) was negative over the sample period. Moreover, the average (median) firm raised merely 12% of all sources of funds externally. Also, annual funds from total asset sales contributed more to the overall funding equation than net proceeds from issuing debt.


The New Market in Debt Governance

The following post comes to us from Yesha Yadav of Vanderbilt Law School.

Scholars have traditionally assumed that lenders that protect themselves using credit derivatives like credit default swaps (CDS) have limited interest in debt governance. The rationale behind this proposition seems straight-forward. Lenders that have bought credit protection should have little incentive to invest in monitoring and disciplining a borrower where they know they will be repaid under the CDS. Indeed, scholars argue, lenders that have purchased CDS protection have considerable interest in seeing a borrower fail. When this happens, they can easily and cheaply exit their investment by triggering repayment on the CDS.

This paper, the New Market in Debt Governance, recently made available on SSRN, challenges this consensus and proposes a new theory of governance in the context of credit derivatives trading. While scholars have traditionally focused on lenders that protect themselves using CDS, they overlook the role of financial firms that sell this credit protection and thereby assume economic risk on the underlying borrower. These protection sellers take on the risk of a borrower defaulting, but possess no legal tools with which they can discipline the borrower to stave off default. As a result, unlike ordinary lenders, protection sellers have no direct means to control a borrower’s risk-taking. They possess no legal powers to influence how much leverage a borrower takes on, its use of collateral, cash reserves or its acquisitions and enterprise strategy. Given this precarious position, it follows that protection sellers possess powerful incentives to seek out ways to influence how a borrower company is run to better control how risky it is allowed to become.


Corporate Tax Reform

Editor’s Note: Robert Pozen is a senior lecturer at Harvard Business School and a senior fellow at the Brookings Institution. This post is based on a Tax Notes article written by Mr. Pozen and Lucas W. Goodman, titled “Capping the Deductibility of Corporate Interest Expense,” available here.

Amid the current debate over tax policy in Washington, there is a bipartisan consensus on one issue: the corporate tax rate, which is currently 35 percent, should be reduced to roughly 25 percent. At the same time, budgetary pressures preclude any significant increase in the deficit to accomplish corporate tax reform.

In light of these competing demands, most corporate tax reformers advocate broadening the corporate tax base to pay for any rate reduction. Unfortunately, few politicians have put forth base-broadening measures that would generate revenue sufficient to significantly lower the corporate tax rate on a revenue-neutral basis.

In fact, revenue-neutral corporate income tax reform is likely to be very difficult, because corporate tax expenditures represent a relatively small portion of total corporate tax revenues. A preliminary analysis by the Joint Committee on Taxation suggested that the elimination of all corporate tax expenditures—except for the deferral of tax on foreign source profits, a provision whose repeal would be politically and economically infeasible—would allow for the corporate tax rate to be reduced to only 28 percent.

Therefore, if policymakers want to reduce the corporate tax rate on a revenue-neutral basis, they will likely have to adopt other types of reforms to broaden the corporate tax base. Ideally, those reforms should offer the potential for significant revenue gains and reduce economic distortions.