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Abstract:
Recent empirical work has documented the tendency of corporations to reset strike prices on previously-awarded executive stock option grants when declining stock prices have pushed these options out-of-the-money. This practice has been criticized as counter-productive since it weakens incentives present in the original award. This paper sets up a theoretical model for study of this issue. We find that when the menu of compensation contracts is unlimited, resetting cannot increase, and may actually reduce, shareholder value. In more realistic settings, however, when only commonly-observed compensation instruments may be used, we find that allowing for the possibility of resetting can, in fact, result in increased shareholder value; we identify specific conditions on the effort-aversion of the manager under which this is always the case. We also find that the relative importance of resetting may increase as the impact of external (economy- or industry-wide) factors on the firm's performance increases; this offers one possible explanation for why resetting has been far more common in small firms than large ones. Finally, we also analyze the relationship between the relative optimality of resetting and managerial control over returns generation. In summary, our results suggest that current criticism of the practice of resetting may be misguided, and that resetting may be a value-enhancing aspect of corporate compensation contracts.

Abstract:
Prior research has often taken the view that entrenched managers tend to avoid debt. Contrary to this view, we find that firms with entrenched managers, as measured by the Gompers et al. (2003) governance index, actually use more debt finance and have higher leverage ratios. This increased use of debt by entrenched managers is higher with higher ownership by large shareholders. To address the potential endogeneity of the governance index, we use both instrumental variables analysis and the exogenous shock to corporate governance generated by the adoption of state anti-takeover laws. We examine several explanations for this behavior. Our evidence is consistent with entrenched managers receiving better access to debt markets (better credit ratings) and better financing terms (perhaps in response to the conservative investment policy that they pursue). We also document a positive stock price response to the announcement of debt issues by entrenchment managers. Our result on the positive relationship between entrenchment and debt continues to hold even after controlling for the possibility that managers use debt as an entrenchment device.

Financing policy, capital structure, corporate governance, shareholder rights, managerial risk-taking

Abstract:
This paper reviews empirical research on the use of private and court-supervised mechanisms for resolving default and reorganizing companies in financial distress. Starting with a simple framework for financial distress and a quick overview of the theoretical research in this area, we proceed to summarize and synthesize the empirical research in the areas of financial distress, asset and debt restructuring, and features of the formal bankruptcy procedures in the US and around the world. Studies of out-of-court restructurings (workouts and exchange offers), corporate governance issues relating to distressed restructurings, and the magnitude of the costs and the efficiency of bankruptcy reorganizations are among the topics covered.

Bankruptcy, financial distress, bankruptcy costs, fire-sales, bankruptcy auctions, reorganizations, Chapter 11

Abstract:
This paper examines the role of corporate governance for payout policy design from the perspective of pre-commitment. We test the effect of external and internal corporate governance on the design of payout policy and use of pre-commitment, level and structure of cash distributions, and firm dividend and repurchase behavior.

We argue that firms use pre-commitment to dividend payments to mitigate the agency conflict due to poor governance. We argue that there is an important distinction between dividends and repurchases from the perspective of pre-commitment. Managers that deviate from the chosen dividend policy incur a cost due to a strong negative market response, which reinforces the pre-commitment role of dividends. On the other hand, the market treats share repurchases as more flexible, irregular payouts made at the manager's discretion, which makes repurchases less effective at mitigating the agency conflict. Therefore, a standalone repurchase policy is not sufficient to mitigate the governance failure, introducing the need for dividend pre-commitment as part of payout policy. Empirically, we find that weak governance is associated with a greater emphasis on dividend pre-commitment in total payout composition. Firms with weak governance are also significantly less likely to use standalone repurchase policies as opposed to a dividends - only or a mixed dividends - repurchases payout policy. Costly dividend pre-commitment presents few benefits to well-governed managers. Instead, they either store excess cash in the firm or distribute it through repurchases. We find that the type of monitoring mechanism is relevant for predicting discretionary payouts.

Given the generally strong investor protection level in the US, poorly monitored managers are not immune from firing and they will follow a costly dividend policy. Consistent with the proposed explanation, we find that firms with weak corporate governance on average pay higher dividends. The relation between dividends and governance is stronger for firms with high free cash flow.

Managers faced with a high takeover threat (external monitoring) are more likely to repurchase and tend to repurchase more on average. On the other hand, strong internal governance (board, institutional blockholder) allows more accurate following of managerial actions and is associated with fewer cash distributions of any kind, including repurchases.

payout policy design, dividends, repurchases, pre-commitment, corporate governance, agency conflicts

Abstract:
This paper studies how collateral affects bond yields. Using a large dataset of public bonds, we document that collateralized debt has higher yield than general debt, after controlling for credit rating. Our model of agency problems between managers and claimholders explains this puzzling result by recognizing imperfections in the rating process. We test the model's implications. Consistent with our model and in results new to the literature, we find the yield differential between secured and unsecured debt, after controlling for credit rating, is larger for low credit rating, nonmortgage assets, longer maturity and with proxies for lower levels of monitoring.

Abstract:
This paper studies how collateral affects bond yields. Using a large dataset of public bonds, we document that collateralized debt has higher yield than general debt, after controlling for credit rating. Our model of agency problems between managers and claimholders explains this puzzling result by recognizing imperfections in the rating process. We test the model's implications. Consistent with our model and in results new to the literature, we find the yield differential between secured and unsecured debt, after controlling for credit rating, is larger for low credit rating, nonmortgage assets, longer maturity and with proxies for lower levels of monitoring.

Abstract:
This paper studies how collateral affects bond yields. Using a large dataset of public bonds, we document that collateralized debt has higher yield than general debt, after controlling for credit rating. Our model of agency problems between managers and claimholders explains this puzzling result by recognizing imperfections in the rating process. We test the model's implications. Consistent with our model and in results new to the literature, we find the yield differential between secured and unsecured debt, after controlling for credit rating, is larger for low credit rating, nonmortgage assets, longer maturity and with proxies for lower levels of monitoring.

Abstract:
This paper studies how collateral affects bond yields. Using a large dataset of public bonds, we document that collateralized debt has higher yield than general debt, after controlling for credit rating. Our model of agency problems between managers and claimholders explains this puzzling result by recognizing imperfections in the rating process. We test the model's implications. Consistent with our model and in results new to the literature, we find the yield differential between secured and unsecured debt, after controlling for credit rating, is larger for low credit rating, nonmortgage assets, longer maturity and with proxies for lower levels of monitoring.

Abstract:
In this paper we study how collateral and loan characteristics can affect bond yields of debt. Using a large data set of all fixed rate straight debt public issues made in the period January 1, 1993 to March 31, 1995, we document that the yield on collateralized debt is higher than on general debt after controlling for credit rating. An explanation for this puzzling result is proposed that recognizes the effect of agency problems between managers and claimholders, and imperfections in the rating process. We then derive and test implications of the story. Consistent with this explanation, and in results new to empirical literature, the yield differential after controlling for credit rating, between secured and unsecured debt is found to be larger for low credit rating, nonmortgage assets, longer maturity and with proxies for lower levels of monitoring.

Abstract:
Debtor-in-Possession (DIP) financing is a unique form of financing that is allowed to firms filing under Chapter 11 of the US Bankruptcy Code. The legal provisions confer enhanced seniority on this financing. It is argued that such financing leads to excessive investment in risky, (even negative NPV) projects. Defenders of DIP financing, on the other hand, argue that it allows funding for positive NPV projects. We examine this issue empirically. Using a large sample of bankruptcy filings, we find little evidence of systematic overinvestment by firms that obtain DIP financing. The firms receiving DIP financing are more likely to emerge successfully and, on average, spend a shorter time in bankruptcy reorganization than the firms that do not receive such financing. Further, we find that relationships are important. In particular, when a lender with a prior lending relationship with the borrower is also the DIP lender, it is more likely to finance smaller firms. These firms also have a significantly shorter reorganization period than firms that secure DIP financing from a new lender. Our results suggest a positive role for DIP financing, which is strengthened when it is combined with a prior lending relationship with the firm.

Chapter 11, Bankruptcy, Debtor-in-Possession Financing

Abstract:
Debtor-in-Possession (DIP) financing is a unique form of financing that is allowed to firms filing under Chapter 11 of the US Bankruptcy Code. The legal provisions confer enhanced seniority on this financing. It is argued that such financing leads to excessive investment in risky, (even negative NPV) projects. Defenders of DIP financing, on the other hand, argue that it allows funding for positive NPV projects. We examine this issue empirically. Using a large sample of bankruptcy filings, we find little evidence of systematic overinvestment by firms that obtain DIP financing. The firms receiving DIP financing are more likely to emerge successfully and, on average, spend a shorter time in bankruptcy reorganization than the firms that do not receive such financing. Further, we find that relationships are important. In particular, when a lender with a prior lending relationship with the borrower is also the DIP lender, it is more likely to finance smaller firms. These firms also have a significantly shorter reorganization period than firms that secure DIP financing from a new lender. Our results suggest a positive role for DIP financing, which is strengthened when it is combined with a prior lending relationship with the firm.

Chapter 11, Bankruptcy, Debtor-In-Possession Financing

Abstract:
This paper considers the impact of takeover (or acquisition) likelihood on firm valuation. If firms are more likely to acquire during times when they have free cash and/or when the required rate of return is low, takeover targets become more sensitive to shocks to aggregate cash flows and/or to the price of risk. Thus, ceteris paribus, firms that are exposed to takeovers will have a different rate of return from firms that are protected from takeovers. Using estimates of the likelihood that a firm will be acquired, we create a takeover-spread portfolio that buys firms with a high likelihood of being acquired and shorts firms with low likelihood of being acquired. Relative to the Fama-French model, the takeover-spread portfolio generates annualized abnormal returns of up to 12% between 1980 and 2004. Further, the takeover-spread portfolio is shown to be important in explaining cross-sectional differences in equity returns. Additionally, using a two-beta model that distinguishes cash flow shocks from discount rate shocks, we show that firms more likely to be taken over have higher betas on the aggregate cash factor. Finally, we provide an explanation for the existence of abnormal returns associated with governancespread portfolios (Gompers, Ishii and Metrick, 2003 and Cremers and Nair, 2005), and relate the takeover-spread portfolio returns to takeover activity in the economy.

Governance, equity prices, risk, time-varying risk premia, takeovers

Abstract:
We investigate the impact of bankruptcy codes on firms' capital-structure choices. We develop a theoretical model to identify how firm characteristics may interact with the bankruptcy code in determining optimal capital structures. A novel and sharp empirical implication emerges from this model: that the difference in leverage choices under a relatively equity-friendly bankruptcy code (such as the US's) and one that is relatively more debt-friendly (such as the UK's) should be a decreasing function of the anticipated liquidation value of the firm's assets.

Using a large database of firms from the US and the UK over the period 1990 to 2002, we subject this prediction to extensive empirical testing, both parametric and non-parametric, using different proxies for liquidation values and different measures of leverage. We find strong support for the theory; that is, we find that our proxies for liquidation value are both statistically and economically significant in explaining leverage differences across the two countries. On the other hand, many of the other factors that are known to affect within-country leverage (e.g., size) cannot explain across-countries differences in leverage.

Capital structure, bankruptcy, financial distress, asset specificity, bankruptcy code, bankruptcy costs

Abstract:
This paper shows that illiquid growth opportunities crucially impact the agency costs of risky debt. If the value of these growth opportunities is sufficiently high, they reverse risk-shifting incentives into risk-avoidance incentives, creating a new agency cost of debt. They can also eliminate Myers's underinvestment problem. It is widely accepted in Corporate Finance that risky debt induces incentives for risk-shifting by the residual equityholder. This paper shows that this result is subject to important qualifications: risky debt does not necessarily create risk-shifting incentives. For a relevant subset of firms it creates instead the opposite effect: it induces risk-avoidance behavior. With risky debt outstanding, the shareholders of a firm with illiquid growth opportunities may optimally prefer safer, less valuable projects to riskier projects with higher net present values. These shareholders present risk-avoidance behavior to preserve control of the firm and to appropriate the firm's future economic rents. The paper models the firm's risk choices in a framework that shows the ex-post optimality of both risk-avoidance and risk-shifting behavior. The presence of illiquid growth opportunities extends the maturity of the equity contract beyond the maturity of the debt contract, explicitly accounting for the nature of the firm as a going concern. The paper constitutes a contribution towards a multiperiod perspective in Corporate Finance, while retaining the parsimony and elegance of finite-period settings.

Abstract:
This paper examines the relationship between investor protection and corporate insiders' incentive to take value-enhancing risks. In a poor investor protection environment corporations are often run by entrenched insiders who appropriate considerable corporate resources as personal benefits. When these private benefits are large, insiders may undertake sub-optimally conservative investment decisions to preserve them. Better investor protection reduces these private benefits and may therefore induce riskier but value enhancing investment policy. Such a relationship can also result from risk-averse behavior on the part of dominant shareholders with undiversified exposure in their own firms, which is again more prevalent in countries with poorer investor protection. If prominent non-equity stakeholders such as banks, labor unions or the government can influence corporate investment, and their influence is decreasing in investor protection, that can also give rise to a positive relationship between investor protection and investment risk. We test these predictions using a large cross-country panel. We find empirical confirmation that corporate risk-taking and firm growth rates are positively related to the quality of investor protection. On the other hand, the data do not lead to consistent evidence for the alternative channels.

Corporate Governance, Investor Protection, Managerial Incentives

Abstract:
This paper examines the incentive features of top-management compensation in the banking industry. Economic theory suggests that the compensation structures for bank management should have low pay-performance sensitivity because of the high leverage of banks and the fact that banks are regulated institutions. In accordance with this school of thought, the authors find that the pay-performance sensitivity for bank CEOs is lower than it is for CEOs of manufacturing firms. This difference is attributable largely to the difference in debt ratios. The authors also find that banks' pay-performance sensitivity declines with bank size.

bank management compensation, corporate governance, pay-performance sensitivity, rish shifting

Abstract:
We hypothesize that CEO compensation is optimally designed to trade off two types of agency problems: the standard managerial agency problem as well as the risk-shifting problem between shareholders and debtholders. Analyses in this setup produces two predictions: (1) the pay-for-performance sensitivity of CEO compensation decreases with the total leverage ratio; and (2) the pay-for-performance sensitivity of CEO compensation increases with the intensity of outside monitoring on the firm's risk choice. We test these two hypotheses for the banking industry where regulators and nondepository (subordinated) debtholders provide outside monitoring on the risk choice. We construct an index of the intensity of outside monitoring based on four variables: subordinated debt ratio, subordinated debt rating, non performing loan ratio and examination rating assigned by regulators. We find supporting evidence for both hypotheses. Our results hold after controlling for the endogeneity among compensation, leverage and monitoring. They are robust to various regression specifications and sample criteria.

corporate governance, CEO compensation, pay-for-performance sensitivity, risk-shifting, agency problems, banking, regulation, subordinated debt

Abstract:
This paper examines the relationship between investor protection and corporate insiders' incentive to take value-enhancing risks. In a poor investor protection environment corporations are often run by entrenched insiders who appropriate considerable corporate resources as personal benefits. When these private benefits are large, insiders may undertake sub-optimally conservative investment decisions to preserve them. Better investor protection reduces these private benefits and may therefore induce riskier but value enhancing investment policy. Such a relationship can also result from risk-averse behavior on the part of dominant shareholders with undiversified exposure in their own firms, which is again more prevalent in countries with poorer investor protection. If prominent non-equity stakeholders such as banks, labor unions or the government can influence corporate investment, and their influence is decreasing in investor protection, that can also give rise to a positive relationship between investor protection and investment risk. We test these predictions using a large cross-country panel. We find strong empirical confirmation that corporate risk-taking and firm growth rates are positively related to the quality of investor protection. On the other hand, the data do not lead to consistent evidence for the alternative channels.

Corporate Governance, Investor Protection, Managerial Incentives

Abstract:
We analyze the impact of option trading and margin rules on the behavior of informed traders and on the microstructure of stock and option markets. In the absence of binding margin requirements, the introduction of an options market causes informed traders to exhibit a relative trading bias towards the stock because of its greater information sensitivity. In turn, this widens the stock's bid-ask spread. But when informed traders are subject to margin requirements, their bias towards the stock is enhanced or mitigated depending on the leverage provided by the option relative to the stock, leading to wider or narrower stock bid-ask spreads. The introduction of option trading, with or without margin requirements, unambiguously improves the informational efficiency of stock prices. Margin rules improve market efficiency when stock and option margins are sufficiently large or small but not when they are of moderate size.

Abstract:
We study how the investor protection environment affects corporate managers' incentives to take value-enhancing risks. In our model, the manager chooses higher perk consumption when investor protection is low. Since perks represent a priority claim held by the manager, lower investor protection leads the manager to implement a sub-optimally conservative investment policy, effectively aligning her risk-taking incentives with those of the debt holders. By the same token, higher investor protection is associated with riskier investment policy and faster firm growth. We test these predictions in a large Global Vantage panel. We find strong empirical confirmation that corporate risk-taking and firm growth rates are positively related to the quality of investor protection.

Corporate Governance, Investor Protection, Managerial Incentives

Abstract:
We model the vulnerability of an economy to a financial crisis as arising from the interaction of the degree of economic specialization and the intermediated financing of the investment opportunities. The probability of a financial crisis is shown to increase in the degree of economic specialization. Bank debt financing (the most common source of intermediated financing in emerging economies) has the beneficial effect of lowering the degree of economic specialization by increasing access to financing of investment opportunities that would not have been financed due to wealth constraints of entrepreneurs (financial access effect). However, bank debt financing induces risk-shifting incentives (leverage effect). The net effect on the probability of a financial crisis depends on which of these two effects dominates. We show that commonly employed mechanisms in managing financial crises, particularly bailouts, induce an additional agency cost on the part of banks. Since the bailout is focused only on the financial crisis state, it distorts bank incentives to concentrate its loans in specific sectors (bank debt concentration effect). We propose a solution mechanism that consists of two tax structures: (1) a corporate tax that changes the ex ante incentives of the residual claimants in the right direction by concavifying the pay-off structure of the after-tax cash flows, and (2) a tax on bank cash flows that eliminates the bank debt concentration effect. Our proposed solution mechanism is targeted towards prevention rather than an ex post resolution of a financial crisis. The foundation for our main results linking financial crisis with the degree of economic specialization is supported by the available data (presented in the form of a couple of empirical tests) - a full-fledged empirical analysis of the predictions of this theory paper is left for future research. Implementation issues and empirical/policy implications are also discussed.

Access, Bailouts, Banks, Conflicts of interest, Financial crisis, Incentives, Leverage, Taxes

Abstract:
This paper investigates the question of whether bond ratings serve as a basis for market prices of bonds or whether investors use their own research and view the ratings only as rough guidelines. Unlike previous work, which focused on rating changes, this paper uses a new data base to consider bond ratings at issue. Agencies such as Moody's or S&P rate subordinated bonds by notching them down from senior bonds. We consider the pricing of both senior and subordinated issue. If notching policies were done properly, then we should find that all equally rated bonds should be priced equally (same yield). However, we find that the market systematically prices differently bonds of identical ratings but different seniority. Specifically, we find that yields of speculative senior bonds are higher than the yields of similarly rated subordinated bonds. The sign reverses in most cases for investment grade issues. We provide a possible explanation for the direction of the bias. We also control for issue and company characteristics.

Debt ratings, senior and subordinated issues, notching, bond yields

Abstract:
We examine how state antitakeover laws affect bondholders and the cost of debt, and report four findings. First, bonds issued by firms incorporated in takeover friendly states have significantly higher at-issue yield spreads than bonds issued by firms in states with restrictive antitakeover laws. Second, firms in takeover friendly states have significantly higher leverage than their counterparts in restrictive law states. Third, bond issues are associated with negative average stock price reactions among firms in takeover friendly states, but positive stock price reactions among firms in restrictive law states. And fourth, existing bond values increase, on average, upon the introduction of Business Combination antitakeover law. These results indicate that state antitakeover laws tend to decrease bond yields and increase bond values – the opposite of their effect on equity values. This, in turn, implies that state laws help mitigate the agency cost of debt by shielding bondholders from expropriation in takeovers. Overall, the empirical evidence suggests that the effect of antitakeover provisions on firm value must take into account the impacts of both bondholders and stockholders.

State antitakeover laws, cost of debt capital, agency cost

Abstract:
We study how the investor protection environment affects corporate managers incentives to take value-enhancing risks. In our model, the manager chooses higher perk consumption when investor protection is low. Since perks represent a priority claim held by the manager, lower investor protection leads the manager to implement a sub-optimally conservative investmentpolicy, effectively aligning her risk-taking incentives with those of the debt holders. By the same token, higher investor protection is associated with riskier investment policy and faster firm growth. We test these predictions in a large Global Vantage panel. We find strong empirical confirmation that corporate risk-taking and firm growth rates are positively related to the quality of investor protection.

Corporate Governance, Investor Protection, Managerial Incentives

Abstract:
We study how the investor protection environment affects corporate managers' incentives to take value-enhancing risks. In our model, the manager chooses higher perk consumption when investor protection is low. Since perks represent a priority claim held by the manager, lower investor protection leads the manager to implement a sub-optimally conservative investment policy, effectively aligning her risk-taking incentives with those of the debt holders. By the same token, higher investor protection is associated with riskier investment policy and faster firm growth. We test these predictions in a large Global Vantage panel. We find strong empirical confirmation that corporate risk-taking and firm growth rates are positively related to the quality of investor protection.

Corporate Governance, Investor Protection, Managerial Incentives.

Abstract:
Using a unique data set that covers the entire career path of film directors (managers) and contains project-specific measures of performance, we examine intertemporal patterns in managerial performance and turnover, and test the implications of job matching theories. We show that turnover is initially high but declines in the number of films (projects) completed. Further, we show that a performance metric constructed from the entire career history is the appropriate measure of re-hiring decisions, superior to a measure based on only the most recent performance. We estimate the marginal contribution of directors to the economic success of their films, and we find that this ability measure is increasing in the number of films made. Similarly, the budget or scale of the project is increasing in directors' experience. Overall, our evidence supports job matching based on continuously updated ability measures. Our findings also extend a larger literature on managerial turnover.

Abstract:
We study CEO compensation in the banking industry by considering banks' unique claim structure in the presence of two types of agency problems: the standard managerial agency problem and the risk-shifting problem between shareholders and debt holders. We empirically test two hypotheses derived from this framework: that the pay-for-performance sensitivity of bank CEO compensation (1) decreases with the total leverage ratio and (2) increases with the intensity of monitoring provided by regulators and non-depository (subordinated) debt holders. We construct an index of the intensity of outsider monitoring based on four variables: the subordinated debt ratio, subordinated debt rating, nonperforming loan ratio, and BOPEC rating (regulators' assessment of a bank's overall health and financial condition). We find supporting evidence for both hypotheses. Our results hold after controlling for the endogeneity among compensation, leverage, and monitoring; they are robust to various regression specifications and sample criteria.

banking, regulation, subordinated debt, CEO compensation, pay-for-performance sensitivity, risk shifting

Abstract:
This paper attempts to link the agency literature (concerned with the fact that tensions between bondholders and shareholders may trigger suboptimal investment decisions) with the one dealing with temporal resolution of uncertainty (TRU). We consider here how the speed of resolution of the uncertainty characterizing the firm's operations affects the risk-shifting behavior of a shareholder-aligned manager. It is assumed that investors are risk neutral and that the return on the risky technology is normally distributed. It is shown that the speed of TRU affects monotonically the extent of risk shifting as well as bond yields, even after optimal contracts mitigating deviations from the first-best investment policy have been written. In particular, the optimal investment-restricting covenant is endogenously characterized. Empirical implications are derived and discussed.

Abstract:
This paper attempts to link the agency literature (concerned with the fact that tensions between bondholders and shareholders may trigger suboptimal investment decisions) with the one dealing with temporal resolution of uncertainty (TRU). We consider here how the speed of resolution of the uncertainty characterizing the firm's operations affects the risk-shifting behavior of a shareholder-aligned manager. It is assumed that investors are risk neutral and that the return on the risky technology is normally distributed. It is shown that the speed of TRU affects monotonically the extent of risk shifting as well as bond yields, even after optimal contracts mitigating deviations from the first-best investment policy have been written. In particular, the optimal investment-restricting covenant is endogenously characterized. Empirical implications are derived and discussed.

Abstract:
This paper attempts to link the agency literature (concerned with the fact that tensions between bondholders and shareholders may trigger suboptimal investment decisions) with the one dealing with temporal resolution of uncertainty (TRU). We consider here how the speed of resolution of the uncertainty characterizing the firm's operations affects the risk-shifting behavior of a shareholder-aligned manager. It is assumed that investors are risk neutral and that the return on the risky technology is normally distributed. It is shown that the speed of TRU affects monotonically the extent of risk shifting as well as bond yields, even after optimal contracts mitigating deviations from the first-best investment policy have been written. In particular, the optimal investment-restricting covenant is endogenously characterized. Empirical implications are derived and discussed.

Agency costs, temporal resolution of uncertainty, corporate debt yields, optimal contracts

Abstract:
In a setting where corporate investment imposes positive externalties, the social impact of corporations depends on the sharing rule between the owners of the corporation and non-financial claimants. We examine the role of law and organizational form in altering the sharing rule. Since the legal regime affects the extent to which corporate owners are held responsible for the negative externalties they impose, unlimited liability may discourage investment in strong legal regimes. Limited liability, however, might be accompanied by excessive investment. We highlight the role of the government in altering the sharing rule due its claim through corporate taxation and investigate the relation between law and corporate taxation. We find that corporate tax rates are are a decreasing function of legal strength. Finally, we document supporting evidence using cross-country data.

Corporate Taxation, Corporate Liability, Organizational Design, Law

Abstract:
This paper examines the incentive structure underlying the current features of bank regulation, particularly the role of prompt corrective action, capital requirements and mandatory restrictions on asset choice as primary tools to control risk-shifting incentives of depository institutions. We propose instead a more direct and effective mechanism of influencing incentives through the role of top-management compensation, whereby a fair and revenue-neutral FDIC premium incorporates incentive features top-management compensation as well as the level of bank capitalization. With this pricing scheme (for FDIC insurance) we show that bank owners choose an optimal management compensation structure which induces first-best value-maximizing investment choices by a bank s management. We also characterize the parameters of the optimal managerial compensation structure and the FDIC premium schedule explicitly.

Abstract:
This paper examines the incentive structure underlying the current features of bank regulation, particularly the role of prompt corrective action, capital requirements and mandatory restrictions on asset choice as primary tools to control risk-shifting incentives of depository institutions. We show that capital regulation has limited effectiveness, given the observed high leverage ratios of banks. We propose instead a more direct and effective mechanism of influencing incentives through the role of top-management compensation, whereby a fair and revenue-neutral FDIC premium incorporates incentive features of top-management compensation as well as the level of bank capitalization. With this pricing scheme (for FDIC insurance) we show that bank owners choose an optimal management compensation structure which induces first-best value-maximizing investment choices by a bank s management. We also characterize the parameters of the optimal managerial compensation structure and the FDIC premium schedule explicitly.

Abstract:
This paper examines the incentive structure underlying the current features of bank regulation. We show that capital regulation has limited effectiveness, given the observed high leverage ratios of banks. We propose instead a more direct and effective mechanism of influencing incentives through the role of top-management compensation, whereby a fair and revenue-neutral FDIC premium incorporates incentive features of top-management compensation. With this pricing scheme (for FDIC insurance), we show that bank owners choose an optimal management compensation structure which induces first-best value-maximizing investment choices by a bank's management. We also characterize the parameters of the optimal managerial compensation structure and the FDIC premium schedule explicitly.

Abstract:
We show that concentrating bank regulation on bank capital
ratios may be ineffective in controlling risk-taking. We
propose, instead, a more direct mechanism of influencing
bank risk-taking incentives, in which the FDIC insurance
premium scheme incorporates incentive features of
top-management compensation. With this scheme, we show
that bank owners choose an optimal management compensation
structure that induces first-best value-maximizing investment
choices by a bank's management. We explicitly characterize
the parameters of the optimal management compensation
structure and the fairly priced FDIC insurance premium, in
the presence of a single or multiple sources of agency
problems.

Bank regulation, Capital regulation, FDIC insurance, Management compensation, Agency problems

Abstract:
This paper surveys the empirical and theoretical literature on the mechanisms of corporate governance. We focus on the internat mechanisms of corporate governance (e.g., arising from conflicts of interests between managers and equityholders, equityholders and creditors, and capital contributors and other stakeholders to the corporate firm. We also examine the substitution effect between internal mechanisms of corporate governance and external mechanisms, particularly markets for corporate control. Directors for future research are provided.

Abstract:
We examine how different economies would design an optimal corporate governancesystem structured from three of the main mechanisms of corporate governance (managerial ownership, monitoring by banks, and disciplining by the takeover market). We allow for interactions among the mechanisms. The first set of results characterizes the combination of governance mechanisms that can appear in any optimally designed structure: 1) when monitored debt appears in an optimal system it is accompanied by concentrated ownership, and 2) when takeovers appear in an optimal system they are accompanied by diffuse ownership. We show that out of the numerous governance structures that could arise from combinations of the governancemechanisms, only three are candidates for an optimal system. These three endogenously derived governance structures match the prevalent systems (family based, bank based and market based) in the world. The optimal system for a given economy is characterized as a function of the degrees of development of its financial institutions and markets. Our analysis yields several testableimplications.

Abstract:
Corporations seem to issue much more senior than subordinated debt and ratings agencies seem to treat these two types of bonds very differently. We document and explore these differences between senior and subordinated debt. Unlike previous work which focused on rating changes, this paper considers bond ratings at issue. Agencies such as Moody's or S&P rate subordinated bonds by notching them down from senior bonds. We document the market pricing of both senior and subordinated issues. If notching policies were done properly, then we should find that all equally rated bonds should be priced equally (same yield). However, we find that the market systematically prices differently bonds of identical ratings but different seniority. Specifically, we find that yields of speculative senior bonds are higher than the yields of similarly rated subordinated bonds. The sign reverses in most cases for investment grade issues. We provide a conceptual model based upon market frictions which incorporates all our empirical findings.

Notching, debt rating, subordinated debt

Abstract:
In this paper, we develop and test five hypotheses relating the takeover premium paid for a target to the investors' divergence of opinion on the target's equity value. For a sample of acquisitions of publicly traded targets, we show that the total takeover premium is higher when investors have higher divergence of opinion on the target's value. Second, we decompose total takeover premium into a stock price runup for the target prior to the takeover announcement and a post-announcement markup. We show that both the target's stock price runup and the post-announcement markup increase with an increase in the divergence of opinion on the target's value. Third, we show that the post-announcement markup and the pre-announcement runup could be positively correlated since both are positively related to the divergence of opinion on the target's value. Fourth, we show that the post-announcement markup decreases with an increase in bidder toehold. Finally, we show that a positive sentiment shock at the market level increases the divergence of opinion on the target's equity value, thereby increasing the total takeover premium, the target runup, and the post-announcement markup. Our results highlight the importance of the divergence of investor opinion in explaining the takeover premium, the pre-announcement runup and the post-announcement markup in mergers and acquisitions.

Takeover Premium, Divergence of Opinion

Abstract:
This paper shows that illiquid growth opportunities crucially impact the agency costs of risky debt. If the value of these growth opportunities is sufficiently high, they reverse riskshifting incentives into risk-avoidance incentives, creating a new agency cost of debt. They can also eliminate Myers s underinvestment problem. It is widely accepted in Corporate Finance that risky debt induces incentives for risk-shifting by the residual equityholder. This paper shows that this result is subject to important qualifications: risky debt does not necessarily create risk-shifting incentives. For a relevant subset of firms it creates instead the opposite effect: it induces risk-avoidance behavior. With risky debt outstanding, the shareholders of a firm with illiquid growth opportunities may optimally prefer safer, less valuable projects to riskier projects with higher net present values. These shareholders present risk-avoidance behavior to preserve control of the firm and to appropriate the firm s future economic rents. The paper models the firm s risk choices in a framework that shows the ex-post optimality of both risk-avoidance and risk-shifting behavior. The presence of illiquid growth opportunities extends the maturity of the equity contract beyond the maturity of the debt contract, explicitly accounting for the nature of the firm as a going concern. The paper constitutes a contribution towards a multiperiod perspective in Corporate Finance, while retaining the parsimony and elegance of finite-period settings.

Abstract:
This paper shows that illiquid growth opportunities crucially impact the agency costs of risky debt. If the value of these growth opportunities is sufficiently high, they reverse risk shifting incentives into risk-avoidance incentives, creating a new agency cost of debt. They can also eliminate Myers s underinvestment problem. It is widely accepted in Corporate Finance that risky debt induces incentives for risk-shifting by the residual equity holder. This paper shows that this result is subject to important qualifications: risky debt does not necessarily create risk-shifting incentives. For a relevant subset of firms it creates instead the opposite effect: it induces risk-avoidance behavior. Withrisky debt outstanding, the shareholders of a firm with illiquid growth opportunities mayoptimally prefer safer, less valuable projects to riskier projects with higher net present values. These shareholders present risk-avoidance behavior to preserve control of the firm and to appropriate the firm s future economic rents. The paper models the firm s risk choices in a framework that shows the ex-post optimality of both risk-avoidance and risk-shifting behavior. The presence of illiquid growth opportunities extends the maturity of the equity contract beyond the maturity of the debt contract, explicitly accounting for the nature of the firm as a going concern. The paper constitutes a contribution towards a multi period perspective in Corporate Finance, while retaining the parsimony and elegance of finite period settings.

Abstract:
We study a model where economic agents must exert costly effort to develop entrepreneurial projects, and agents benefit from the entrepreneurial efforts of other agents. Agents rationally anticipate each other's actions but cannot coordinate them. The equilibrium of the resultant "global game" is characterized by a "tipping point." Only when an economic state variable is above this point does a functioning economy arise. We then show that if the banking system is not competitive or is subject to other frictions, the tipping point is higher, potentially severely retarding economic development. An implication is that small economic shocks and subtle changes in the structure of the financial system may have a large systemic impact on the economy, even in the absence of direct contagion among financial intermediaries. Our results include a prescription for an organizational form of the financial intermediary that ameliorates the effects associated with bank market power, namely that of the cooperative financial institution ("CFI"), which is owned by its borrowers and savers instead of a third party. In an extension of our basic model, we also study "redlining" and show that it can arise as an equilibrium phenomenon.

Abstract:
We study CEO compensation in the banking industry by taking into account banks unique claim structure in the presence of two types of agency problems: the standard managerial agency problem as well as the risk-shifting problem between shareholders and debtholders. We empirically test two hypotheses derived from this framework: (1) the pay-for-performance sensitivity of bank CEO compensation decreases with the total leverage ratio; and (2) the pay-for-performance sensitivity of bank CEO compensation increases with the intensity of monitoring provided by regulators and nondepository (subordinated) debtholders. We construct an index of the intensity of outsider monitoring based on four variables: subordinated debt ratio, subordinated debt rating, non performing loan ratio and BOPEC rating assigned by regulators. We findsupporting evidence for both hypotheses. Our results hold after controlling for the endogeneity among compensation, leverage and monitoring. They are robust to various regression specifications and sample criteria.

CEO compensation, pay-for-performance sensitivity, risk-shifting, agency problems, banking, regulation, subordinated debt

Abstract:
This paper examines the effect of governance on firm investment in industry downturns. Existing work offers a variety of theories of governance and investment. We consider the governance-investment relation in a new and important setting. Large exogenous industry shocks increase the risk to managerial human capital. Self-interested managers can preemptively cut back on risky investments during negative industry shocks in an attempt to conserve the firm's cash flow and lower the chances of liquidation, thus preserving their human capital and stream of private benefits. Since poorly monitored managers have more discretion in investment policy, they exhibit greater conservatism in bad times. Empirically, we test our conservatism hypothesis against competing predictions of overinvestment, shirking and quiet life. We find strong evidence in support of conservatism. Poorly monitored managers make greater cutbacks in risky investment in bad times. Internal mechanisms of monitoring, including institutions and boards, are more effective than the takeover market at mitigating conservatism. We do not observe significant governance-related differences in investment around positive industry cash flow shocks. The results are robust to a battery of sensitivity tests, including controls for other determinants of firm investment and potential endogeneity.

corporate governance, investment, shocks, institutional ownership, anti-takeover protections

Abstract:
CEOs and top management team members have incentives to influence their own pay. Asymmetric benchmarking of pay for CEOs has been linked to the CEO's control over the pay-setting process in previous research. This paper examines whether asymmetric benchmarking of pay exists for top management team members. The presence of asymmetric benchmarking of pay could on one hand suggest that managers are involved in skimming and on the other hand it could mean that firms insulate managers to prevent them from accessing outside opportunities. Using ExecuComp firms from 1992-2007, we find that top management team members are rewarded for good luck but they are not penalized bad luck. Unlike CEOs, asymmetric benchmarking of pay for top management team members is consistent with the retention hypothesis rather than skimming. In particular, we find that asymmetric benchmarking of pay for top management team members has a positive relationship with firm value.

CEO compensation,TMT Compensation,Benchmarking, Pay for luck

Abstract:
Two different financial systems with some opposing features have evolved in the advanced economies, namely the insider system and the outsider system. In this paper, we provide a theoretical framework where the features of the optimal governance systemare derived as a function of economy-wide parameters, such as the degree of development of markets and the quality of the institutions, and firm-specific parameters,such as the productivity of its technology. Our results include the following: (1) For adegree of relative development of markets below a threshold, internal governance systems dominate for all firms in the economy independent of productivity, (2) When thedevelopment of markets in an economy is above that threshold, either system may emerge as optimal depending on the productivity of the technology. There are marked differences in the residual agency costs under the two systems when the scale of investment is large. It is shown that insider systems constitute the optimal governance system for technologies that are optimally implemented at a small scale while outsider systems dominate for technologies that are optimally implemented at large scales. These results provide a new argument for the potential convergence towards outsider systems based on technological growth.

Abstract:
We analyze the impact of option trading and margin rules on the behavior of informed traders and on the microstructure of stock and option markets. In the absence of binding margin requirements, the introduction of an options market causes informed traders to exhibit a relative trading bias towards the stock because of its greater information sensitivity. In turn, this widens the stock'sbid-ask spread. But when informed traders are subject to margin requirements, their bias towards the stock is enhanced or mitigated depending on the leverage provided by the option relative to the stock, leading to wider or narrower stock bid-ask spreads. The introduction of option trading, with or without margin requirements, unambiguously improves the informational efficiency of stock prices. Margin rules improve market efficiency when stock and option margins are sufficiently large or small but not when they are of moderate size.

Abstract:
We analyze the impact of option trading and margin rules on the behavior of informed traders and on the micro structure of stock and option markets. In the absence of binding margin requirements, the introduction of an options market causes informed traders to exhibit a relative trading bias towards the stock because of its greater information sensitivity. In turn, this widens the stock's bid-ask spread. But when informed traders are subject to margin requirements, their bias towards the stock is enhanced or mitigated depending on the leverage provided by the option relative to the stock, leading to wider or narrower stock bid-ask spreads. The introduction of option trading, with or without margin requirements, unambiguously improves the informational efficiency of stock prices. Margin rules improve market efficiency when stock and option margins are sufficiently large or small but not when they are of moderate size.

Abstract:
We characterize conditions under which a large institutional shareholder and the manager of a firm will establish relationship investing, wherein the manager actively cooperates with the institution in the monitoring process, to resolve agency problems. The setting of our model is that of a privately informed manager choosing between a project that has a faster resolution of uncertainty and a project that has a delayed resolution of uncertainty. The agency problem arises because the manager has incentives to focus on the firm's perceived market value, rather than its true long-term value, through his compensation contract and leads to investment distortions. We show that relationship investing solves the agency problem and reduces the free-riding problem associated with large shareholder monitoring. We also show that under some conditions it is optimal for shareholders to make the manager's compensation more distortionary by increasing the manger's incentives to focus on the firm's perceived market value, in order to induce him to cooperate in the monitoring process.

Abstract:
We conduct a theoretical and empirical investigation of the impact of bankruptcy codes on firms' capital-structure choices. In our theoretical framework, costs of financial distress are endogenously determined as a function of the bankruptcy code. Anticipated liquidation values emerge as the key variable in the capital structure-bankruptcy code link: among other things, the theory predicts that the difference in leverage between a debt-friendly bankruptcy code (such as the UK's) and a more equity-friendly code (such as the US's) should be a monotone function of liquidation values. We examine empirical support for the theory by comparing leverages in the US and the UK for the period 1990 to 2002. Our tests use two (inverse) proxies of liquidation values: asset-specificity of the firm, and the fraction of the firm's assets that are intangibles. We find the theory is strongly backed by the data. The results are robust to considerations such as employing net leverage (debt net of cash holdings) and controlling for other firm characteristics that affect leverage.

Leverage, bankruptcy costs, asset-specificity, intangibles, financial distress

Abstract:
This paper considers the impact of the takeover channel on firm valuation. We usethe idea that takeover activity responds to investor expectations of future rate of return and hence to state variable(s) related to the time variation in risk premia. Thus firms with higher exposure to takeovers, due to higher expectations of receiving a takeover premium, have a higher exposure to the state variable that dictates time variation in risk premia. Consequently, the difference in the returns between firms that differ in their takeover vulnerabilities can be used to used to proxy these state variables. To do so, we create a takeover-spread portfolio that buys firms with low cash-adjusted-leverage(cheaper targets) and shorts firms with high cash-adjusted-leverage and show that sucha portfolio generates annualized abnormal returns of up to 11.20% between 1980 and2003. Also, abnormal returns associated with governance-spread portfolios (Gompers,Ishii and Metrick, 2003 and Cremers and Nair, 2004) decrease significantly once the assetpricing model includes this cash-adjusted-leverage factor. Finally, we propose a new takeover factor to proxy for the risk due to changes in these risk-premia related state variables, which is shown to be important in explaining cross-sectional differences in equity returns. The paper shows why investors require a higher rate of return on firms exposed to takeovers and yet value them higher than firms protected from takeovers.

Abstract:
In this paper we examine a model of the optimal financial claim for a bank in a world where a borrowing firm s uninformed stakeholders depend upon the bank for truthful information about the firm s evolving financial condition. In particular, stakeholders rely upon the bank to reveal whether the borrowing firm is truly financially distressed and whether concession by stakeholders are necessary. The bank s financial claim is designed to ensure that it cannot form a coalition with the firm s owners either to seek unnecessary concession when the firm is actually healthy, or to claim that the firm is healthy when it is actually in distress. We show that the optimal chain has the following characteristics. To ensure that a healthy firm/bank coalition will not form to seek unnecessary concessions from stakeholders, the bank must keep its equity stake in a distressed firm below a ceiling level. To ensure that a distressed firm/bank coalition will not falsely claim that the firm is healthy, a sufficiently large portion of the bank s financial claim on the healthy firm must be subordinated to stakeholders claims. Since banks may have difficulty in credibly subordinating their debt claims, a bank equity stake in the healthy firm may be necessary. Thus, our analysis offers limited support for the argument that bank equity stakes in borrowing firms may enhance banks ability to reduce the costs of financial distress for borrowing firms.

Abstract:
Recent empirical work has documented the tendency of corporations to reset strike prices on previously-awarded executive stock option grants when declining stock prices have pushed these options out-of-the-money. This practice has been criticized as counter-productive since it weakens incentives present in the original award.We find that although the anticipation of resetting will typically result in a negative effect on initial incentives, resetting can still be an important, value-enhancing aspect of compensation contracts, even from an ex-ante standpoint. Indeed, we find a precise sense that some resetting is almost always optimal. We also characterize the conditions that affect the relative optimality resetting. We find, for example, that the relative advantages of resetting decrease as managerial ability to influence the resetting process increases, as the relative importance of external (industry-or economy-wide) factors in return generation increase, and as the direct or indirect cost of replacing the incumbent manager decrease. Our analysis, in summary, that the case against resetting is quite weak.

Abstract:
This paper investigates the design of privatization mechanisms in emerging market economies. We identify an emerging market economy by the political constraints that limit the set of viable privatization mechanisms. Our objective is to explain the striking diversity of privatization mechanisms observed in practice and the frequent use of an apparantly suboptimal privatization mechanism: private negotiation. We develop a simple model wherein privatization is to be carried out by a government agent who plays favorites among bidders and is potentially disciplined by forthcoming elections. We find that it is the degree of political constraints that determines which mechanism is more successful in raising funds. If the political environment is such that the privatization agent himself aims at raising the fair value for the company, the privatization auctions and private negotiations are equally successful in raising public revenues. If, however, political constraints distort the agent's incentives, then one mechanism outperforms the other. In particular, if the distortion is moderate, then private negotiations can raise more value for a successful enterprise than privatization auctions. In this case the agent may play favorites among bidders, but to the extent he cares about price, he will use his bargaining power to negotiate his target price. If, however, the distortion is severe so that the agent lacks sufficient motivation to raise a fair price for the company, then privatization auctions will outperform private negotiations. Even though the agent may play favorites among the bidders, he would not put pressure on the bidders to raise the price during negotiations. In a privatization auction, in contrast, the presence of other bidders, regardless how informed they are, induces competition and places a lower bound on the equilibrium winning bid. We further find that information disclosure laws may have negative welfare implications: they may help the privatization agent to collude with some of the bidders to the disadvantage of noncolluding bidders. Our theory provides further regulatory implications for privatization procedures in emerging market economies.

Abstract:
Recent empirical work has documented the tendency of corporations to reset strike prices on previously-awarded executive stock option grants when declining stock prices have pushed these options out-of-the-money. This practice has been criticized as counter-productive since it weakens incentives present in the original award.

Abstract:
This paper investigates the design of privatization mechanisms in emerging marketeconomies characterized by political constraints that limit the set of viable privatization mechanisms. Our objective is to explain the striking diversity of privatization mechanisms observed in practice and the frequent use of an apparently suboptimal privatization mechanism: private negotiations. We develop a simple model wherein privatization is to be carried out by a government agent who plays favorites among bidders and is potentially disciplined by forthcoming elections. We find that it is the degree of political constraints that determines which mechanism is more successful in raising funds. If the political environment is such that the privatization agent himself aims at raising the fair value for the company, then privatization auctions and privatenegotiations are equally successful in raising public revenues. If, however, political constraints distort the agent s incentives, then one mechanism outperforms the other. In particular, if the distortion is moderate, then private negotiations can raise more value for a successful enterprisethan privatization auctions. In this case the agent may play favorites among the bidders, but to the extent he cares about the price, he will use his bargaining power to negotiate his target price. If, however, the distortion is severe so that the agent lacks sufficient motivation to raise a fairprice for the company, then privatization auctions will outperform private egotiations. Even though the agent may play favorites among the bidders, he would not put pressure on the bidders to raise the price during negotiations. In an auction, in contrast, the presence of other bidders,regardless how informed they are, induces competition and places a lower bound on theequilibrium winning bid. We also show that information disclosure laws may have negative welfare implications: they may help the privatization agent to collude with some of the bidders to the disadvantage of non-colluding bidders. Our theory provides further regulatory implications for privatization procedures in emerging market economies.

Abstract:
We analyze the impact of option trading and margin rules on the behavior of informed traders and on the microstructure of stock and option markets. In the absence of binding margin requirements, the introduction of an options market causes informed traders to exhibit a relative trading bias towards the stock because of its greater information sensitivity. In turn, this widens the stock's bid-ask spread. But when informed traders are subject to margin requirements, their bias towards the stock is enhanced or mitigated depending on the leverage provided by the option relative to the stock, leading to wider or narrower stock bid-ask spreads. The introduction of option trading, with or without margin requirements, unambiguously improves the informational efficiency of stock prices. Margin rules improve market efficiency when stock margins and options margins (relative to stock margins) are sufficiently large or small but not when they are of moderate size.

Abstract:
This paper considers the impact of the takeover likelihood on firm valuation. If firms are more likely to acquire when there is more free cash or lower required rates of return, the targets become more sensitive to shocks to cash flows or the price of risk. Ceteris paribus, firms exposed to takeovers have different rates of return than protected firms. Using takeover likelihood estimates, we create a “takeover factor,” buying (selling) firms with a high (low) takeover likelihood, which generates “abnormal” returns. Several tests confirm that the takeover factor helps explaining cross-sectional differences in equity returns and is related to takeover activity.

Abstract:
Geography has been shown to affect the behavior of investors and analysts. We investigate the impact of geography on firm dividend policies. We argue that location influences a firm's information environment. If distance increases information asymmetries about managerial investment decisions, investors of remotely located firms will demand higher dividends. Our empirical results support the first prediction. Centrally located firms pay lower dividends and replace regular dividends with share repurchases or special dividends. Similar results are obtained for changes in dividends. Centrally located firms make more dividend cuts, raise dividends more often, and exhibit less dividend variability. Market reaction to dividend announcements is negatively related to urban location. The effect of geography on dividends is most pronounced when growth opportunities are limited.

geography, firm location, dividends, payout

Abstract:
Debtor-in-Possession (DIP) financing is a unique form of enhanced secured financing that is granted to firms filing for reorganization under Chapter 11 of the US Bankruptcy Code. Opponents of DIP financing argue that such financing can lead to overinvestment, i.e., excessive investment in risky, (even negative NPV) projects. Alternatively, DIP financing can allow funding for positive NPV projects. Related to this is the question of whether DIP financing is related to a quicker resolution of the bankruptcy process. We examine these issues empirically. Using a large sample of bankruptcy filings, we find little evidence of systematic overinvestment. DIP financed firms are more likely to emerge from the Chapter 11 process than non-DIP financed firms. Interestingly, DIP financed firms have a shorter reorganization period; they are quicker to emerge and also quicker to liquidate. The time spent in bankruptcy is even shorter when the DIP lender also has a prior lending relationship with the firm.

Collateral, Yields, Credit Rating

Abstract:
Recent empirical work has documented the tendency of corporations to reset strike prices on previously-awarded executive stock option grants when declining stock prices have pushed these options out-of-the-money. This practice has been criticised as counter-productive since it weakens incentives present in the original award.

This paper presents a theoretical analysis of the optimality of resetting executive stock options based on a dynamic agency framework. The firm's shareholders (the "principal") provide an effort-averse manager (the "agent") with long-term incentives in the form of call options on the firm's equity. Given an initial compensation contract for the manager, suppose interim information becomes available on the state of the world. From the standpoint of ex-ante value maximization, can it be optimal for the principal to agree to amend the terms of the original option award to reflect this additional information?

We show that although the anticipation of resetting can have a substantial negative effect on initial incentives, resetting provides superior incentives for continuation. Resetting can thus be an important, value-enhancing aspect of corporate compensation contracts, even from an ex-ante standpoint. We find in a precise sense that some resetting is almost always ex-ante optimal. By allowing dependence on interim information, resetting allows the manager's final payoffs to incorporate a greater degree of sensitivity to the realized path; this flexibility is lost if the principal commits not to reset the contract.

We also characterize the conditions that affect the relative optimality of resetting. We find, for example, that resetting becomes relatively less optimal (i) as managerial ability to manipulate contractual resetting increases; (ii) as direct or indirect costs of replacing the incumbent manager decrease; and (iii) as external (economy- or industry-wide) factors increase in importance relative to managerial input in return generation. The last feature offers one possible explanation for why resetting has been far more common in small firms than large ones. We find that our results are robust to expanding the menu of compensation contracts to allow for equity, cash, bonuses, etc.

In summary, our results suggest that much of the criticism of the practice of resetting may be misguided.

Abstract:
We find that asset sales lead to an improvement in the operating performance of the seller's remaining assets in each of the three years following the asset sale. The improvement in performance occurs primarily in firms that increase their focus; this change in operating performance is positively related to the seller's stock return at the divestiture announcement. The announcement stock returns are also greater for focus-increasing divestitures. Further, we find evidence that some of the seller's gains result from a better fit between the divested asset and the buyer.

Abstract:
Corporate limited liability can create agency conflicts between the public and private sectors. The resulting distortion may induce overinvestment in risky technologies relative to the social optimum. This paper examines the role of a well-designed corporate tax structure in aligning private investment choices with socially optimal levels. An appropriate constant tax rate imposed on the positive cash flows provides sufficient investment disincentives to offset the overinvestment incentives of limited liability. However, the optimal tax rate is specific to the technology of individual firms. It is shown that a tax structure designed with an economy-side single tax rate when combined with other features such as an initial zero tax bracket, investment-based deductions, tax credits and tax deductibility of debt can replicate the same incentives as that of an economy with multiple technology-specific tax rates. Institutional features observed in many advanced economies are consistent with such a design of taxation.

Abstract:
This paper investigates the design of privatization mechanisms in emerging market economies. We identify an emerging market economy by the political constraints that limit the set of viable privatization mechanisms. Our objective is to explain the striking diversity of privatization mechanisms observed in practice and the frequent use of an apparently suboptimal privatization mechanism: private negotiation.

We develop a simple model wherein privatization is to be carried out by a government agent who plays favorites among bidders and is potentially disciplined by forthcoming elections. We find that it is the degree of political constraints that determines which mechanism is more successful in raising funds. If the political environment is such that the privatization agent himself aims at raising the fair value for the company, then privatization auctions and private negotiations are equally successful in raising public revenues. If, however, political constraints distort the agent's incentives, then one mechanism outperforms the other. In particular, if the distortion is moderate, then private negotiations can raise more value for a successful enterprise than privatization auctions. In this case the agent may play favorites among the bidders, but to the extent he cares about the price, he will use his bargaining power to negotiate his target price. If, however, the distortion is severe so that the agent lacks sufficient motivation to raise a fair price for the company, then privatization auctions will outperform private negotiations. Even though the agent may play favorites among the bidders, he would not put pressure on the bidders to raise the price during negotiations. In a privatization auction, in contrast, the presence of other bidders, regardless of how informed they are, induces competition and places a lower bound on the equilibrium winning bid. We further find that information disclosure laws may have negative welfare implications: they may help the privatization agent to collude with some of the bidders to the disadvantage of noncolluding bidders. Our theory provides further regulatory implications for privatization procedures in emerging market economies.

Abstract:
We derive the optimal financial claim for a bank when the borrowing firm's uninformed stakeholders depend on the bank to establish whether the firm is distressed and whether concessions by stakeholders are necessary. The bank's financial claim is designed to ensure that it cannot collude with a healthy firm's owners to seek unnecessary concessions or to collude with a distressed firm's owners to claim that the firm is healthy. To prove that a request for concessions has not come from a healthy firm/bank coalition, the bank must hold either a very small or a very large equity stake when the firm enters distress. To prove that a distressed firm and the bank have not colluded to claim that the firm is healthy, the bank may need to hold equity under routine financial conditions. The views expressed here are those of the authors and do not necessarily represent the views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System.

Abstract:
We derive the optimal financial claim for a bank when the borrowing firm's uninformed stakeholders depend upon the bank to establish whether the firm is distressed and whether concessions by stakeholders are necessary. The bank's financial claim is designed to ensure that it cannot collude with a healthy firm's owners to seek unnecessary concessions or to collude with a distressed firm owner's to claim that the firm is healthy. To prove that a request for concessions has not come from a healthy firm/bank coalition, the bank must hold either a very small or very large equity stake when the firm enters distress. To prove that a distressed firm and the bank have not colluded to claim that the firm is healthy, the bank may need to hold equity under routine financial conditions.

Abstract:
We model the impact of insider trading regulations on the dynamic trading strategies of corporate insiders. We focus our attention on Section 16(a) of the Securities and Exchange Act -- the trade disclosure rule. In a rational expectations equilibrium, we show that when an informed insider has to disclose her trades after they are made, she has an incentive to manipulate the market by sometimes trading in the "wrong" direction, i.e., buying with bad news or selling with good news. This strategy reduces the informativeness of her subsequent trade disclosure since a buy (sell) no longer unambiguously conveys good (bad) news and allows her to reap large profits in later periods by trading in the right direction. Such manipulation lowers initial bid-ask spreads and market efficiency and it can be curtailed by enforcing the short swing profit rule (Section 16(b) of the Act). The manipulation is more likely to occur when the market is liquid and when the insider's information advantage over the market is small. But it is less likely to occur when we allow for (i) the possibility of the insider being uninformed, (ii) the possibility of early arrival of public information, (iii) multiple insiders, and (iv) multiple trade sizes for the insider to choose from.

Abstract:
We show that the regulation requiring corporate insiders to disclose their trades ex post creates incentives for informed insiders to manipulate the market by sometimes trading against their information. This allows them to increase their trading profits by maintaining their information advantage over the market for a longer period of time. Such manipulation lowers initial bid-ask spreads. We show how the insider's likelihood of manipulation is affected by her information advantage, the number of other insiders, market liquidity, the early arrival of public information, and the choice of trade size. The short swing profit rule curtails this manipulation.