Is it Worthwhile to Augment the Legal Protection of Public Debt Placed by Privately Held Companies?
A considerable proportion of publicly traded corporate bonds comprises bonds of privately held firms (ie, firms whose equity is non-listed and does not trade over the counter). In our paper 'Is it Worthwhile to Augment the Legal Protection of Public Debt Placed by Privately Held Companies?' we address the issue of what corporate governance regulation is appropriate for private firms that only issue debt. Should these firms be required to adopt the same corporate governance standards as publicly-traded firms, or should they be given some exemptions?
The proponents of strict regulation argue that public supervision and information about private firms is rather limited, and that private firm owners possess too much power and can easily expropriate public bondholders. Opponents of strict regulation point out the existence of more protective covenants in private bonds and their slightly higher yields, concluding that markets adjust for risk and can cope with private bonds without additional regulation.
We approach this issue empirically by examining the effects of an amendment to the Israeli Corporate Law in 2011 that imposed on private bond-issuing firms virtually the same set of corporate governance standards as on public firms. The amendment was the regulatory response to public pressure. During the Great Recession of 2007-2009, many corporate bonds defaulted or needed restructuring, inflicting ‘haircuts’ and heavy losses on their investors and raising questions about necessary regulatory reforms.
The amendment required that: 1) the firm must appoint to its board at least two outside independent directors; 2) an audit committee must be established, and most of its members and the Chairman must be independent directors; 3) every firm should employ an internal controller reporting to the audit committee; 4) firm directors must have some minimal qualifications; and 5) the firm's CEO or her relative cannot also serve as Chairman. The most innovative requirement was that the audit committee and Board must examine every related-party transaction and disapprove the transaction if it will impair the company’s ability to settle its public debt.
Our empirical work employs data on all 71 private bonds traded on the Tel-Aviv Stock Exchange in 2005-2015. Two main results emerge. First, consistent with existing evidence, the improved bondholder protection offered by the amendment boosts the immediate market valuation of already-trading private firms' bonds. This is a clear indication that corporate governance standards affect corporate bond values. In an even more direct test, we show that the bond price response to the amendment is more positive the higher the number of related party transactions in the firm.
Second, we find that the amendment suppresses the private bond market. After the amendment enactment the number of private bond IPOs decreases sharply – the share of private firms among all firms offering bonds for the first time decreases from 33.3% before the amendment proposal to 12.5% after it. Cutting off private firms from a potential financing source hurts economic efficiency. Further, trading volumes in the private bonds market declined, and an extraordinary proportion of private firms redeem their existing public bonds early – the proportion of private bonds amongst all early-redeemed bonds leaps from 11.8% in 2008-2011 to 40% in the post-amendment (2012-2015) period. The impairment of the private bond market is intriguing, and is perhaps the less-intended result of the amendment.
Other tests we conduct allow us to highlight a potential benefit of Israel’s strong pro-bondholders amendment experiment. In a cross-sectional test we find that private bond firms with the highest rate of related party transactions show a markedly higher tendency of leaving the market (early-redemptions) following the amendment. To the extent that related party transactions are sometimes used for tunneling of resources away from public bondholders and shareholders, it may be argued that the amendment purged the bond market of firms with potentially severe agency problems, and blocked entrance to the market of firms with ‘improper incentives’.
The amendment was proposed at a time of great regulatory pressure, in the midst of the Great Recession. Such times are susceptible to popular legislation, the effects of which might be unintended, as Murphy and Jensen suggest. The overall costs of the amendment appear to us excessive. Perhaps a less bold version could have produced better overall results.
Beni Lauterbach is a Professor of Finance and the Raymond Ackerman Family Chair in Corporate Governance at the Graduate School of Business Administration, Bar Ilan University, Israel
Keren Bar Hava is a Senior Lecturer and the Accounting Department Head at the School of Business Administration, Hebrew University, Israel
Roi Katz is a Ph.D. student at the Faculty of Business and Management, Ben-Gurion University, Israel
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