Creditor Rights, Implicit Covenants, and the Quality of Accounting Information
While creditor protection is essential for the development of private credit markets, providing lenders with control rights might have adverse effects, such as too little risk taking or a creditor-induced ‘liquidation bias’. Moreover, different rules of creditor protection, such as access to collateral or the degree of creditor control over bankruptcy procedures, may vary in their effect on creditors and debtors.
In our paper, ‘Creditor Rights, Implicit Covenants, and the Quality of Accounting Information’, we focus on a change to the conditions under which bondholders can force distressed borrowers into bankruptcy. We find that strengthening control rights was perceived by markets as beneficial for bondholders (but not for shareholders) and that some distressed firms seem to have responded to it by raising new equity capital. We also find that, apparently in order to avoid triggering bondholders’ control rights, distressed borrowers have used accounting tactics to increase their reported net worth, thereby detracting from the informativeness of financial statements and potentially undermining bond market efficiency.
We focus on a legal change in Israel that provided some bondholders (but not others) with more control rights. In 2013, bondholders of one of the largest holding companies in Israel asked the court to force the company into bankruptcy. Although the company was current on its payments and did not breach any bond covenant, the court held that, when a debtor’s liabilities exceeded its assets (‘balance sheet insolvency’), bondholders could force into bankruptcy even companies that were not in default. This decision, therefore, is an exogenous legal change to bankruptcy law that significantly expanded creditor rights vis-à-vis distressed companies. We examine the effect of the court decision on distressed firms that had no covenants as of the end of 2012: for these companies, the decision essentially introduced an implicit financial covenant (negative net worth) where none had existed before. We compare these firms to those with pre-existing financial covenants (regardless of their net worth), which were not affected by the court ruling (as their existing covenants were typically more stringent than the implicit covenant granted by the court) and no-covenant firms with high net worth (that are unlikely to become insolvent) along three dimensions—market reaction, effect on real-world conduct and accounting.
Our focus on companies with publicly traded debt allows us to measure the expected effect of the change in creditor control rights on bondholders and shareholders by analysing the market reaction to the court’s decision. Not surprisingly, we find that the decision was perceived by the market as beneficial to bondholders, but detrimental to shareholders: on the date of the court ruling, bonds issued by no-covenant and low-net-worth firms (ie firms close to default) exhibited positive excess returns (relative to a portfolio of corporate bonds of similar rating and maturity), while the shares of these firms exhibited negative excess returns (relative to those predicted by the market model). In addition, the positive difference in yield spreads (relative to similar government bonds) between treated firms and other firms seem to have declined after the court decision.
As the new rule provided bondholders with control rights when firms’ liabilities exceeded their assets, it provided distressed, no-covenant firms with new incentives to increase their net worth so as to alleviate the threat of creditor action. Consistent with this prediction, we find that, in comparison with the control group, there was a pronounced increase in the treated firms’ (reported) net worth following the 2013 court ruling. Firms most likely to be affected by the legal change — no-covenant firms with low net worth — were especially likely to experience an increase in their net worth following the court decision.
What explains this surge in net worth? We observe some increase in equity issuances among treated firms. Treated firms in the lowest decile of the net worth distribution prior to the court decision were especially likely to raise new equity following the ruling, primarily through private placements and warrant issues, perhaps due to the threat of creditor control. This effect is presumably beneficial for creditors. However, equity issuances are not the only change we observe among treated firms in the post-2013 period. We also document a consistent link between the court decision and various changes in the treated firms’ reporting practices. Using statistical as well as anecdotal evidence, we establish that distressed borrowers responded to the increase in creditor power not only by effecting some real changes in their financial condition (raising new equity capital), but also by making changes to the way their financial condition was reported to investors, using overly-optimistic accounting practices: we document an increase in the use of long-term discretionary accruals and a decrease in adherence to the principle of accounting conservatism. The effects of these accounting changes were, however, transitory – the earnings of treated firms declined a few years after the court ruling.
To the extent that it induced the distressed firms in our sample to change their financial reporting, the legal change underlying our study might have affected the informativeness of financial statements. In line with this conjecture, we find that bondholders seem to have attributed less informational content to the treated firms’ reported earnings in the post-court-ruling period, as manifest in a reduced bond price reaction to the publication of new earnings (relative to the pre-ruling period, in comparison with the control group of firms).
We conclude that the benefits from empowering creditors may be mitigated by unintended consequences — incentives for borrowing firms to use overly-optimistic accounting practices to prevent creditors from exercising control rights.
Assaf Hamdani is Professor of Law at the Tel Aviv University, The Buchmann Faculty of Law
Yevgeny Mugerman is Lecturer of Finance at Bar-Ilan University, School of Business Administration
Ruth Rooz is Researcher at the Hebrew University of Jerusalem, School of Business Administration
Nadav Steinberg is Economist at the Bank of Israel, Research Department
Yishay Yafeh is Professor of Finance at the Hebrew University of Jerusalem, School of Business Administration
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