Creditor Rights Protection, Ultimate Ownership and the Debt Financing Costs and Ratings: International Evidence

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1 Credtor Rghts Protecton, Ultmate Ownershp and the Debt Fnancng Costs and Ratngs: Internatonal Evdence Narjess Boubakr HEC Montréal Fnance Department 3000, Côte Sante Catherne Montréal, Québec, Canada H3T 2A7 Fax: Hatem Ghouma HEC Montréal Fnance Department, 3000, Côte Sante Catherne Montréal, Québec, Canada H3T 2A7 Phone : # 2838 Fax: Hatem.Ghouma@hec.ca We would lke to thank Mara Boutchkova, Jean-Claude Cosset, Georges Donne, Donald Fraser, Nabl Ghalleb, Omrane Guedham, Douglas Hodgson, Amrta Nan and Chen Zhan for ther valuable comments and suggestons. We also thank semnar partcpants at the 2006 CIRPEE meetngs n Val-Morn (Canada), the 2007 IFC4 n Tunsa and the 2007 EFMA Symposum on Corporate Governance and Shareholder Actvsm n Boccon Unversty (Italy) for ther nput, and Mohamed Jabr for research assstance. Fnancal support s acknowledged from SSRC and the Center of Research n E-Fnance (HEC Montréal). Hatem Ghouma acknowledges fnancal support from the Tunsan Mnstry of Hgher Educaton, Scentfc Research and Technology. 1

2 Credtor Rghts Protecton, Ultmate Ownershp and the Debt Fnancng Costs and Ratngs: Internatonal Evdence Abstract We explore the effect of governance on the costs and ratngs of frms bonds n a mult-natonal sample of frms. We fnd strong evdence that ultmate ownershp (.e., the votng/cash-flow rghts wedge) and famly control have a postve and sgnfcant effect on bond costs, and a negatve and sgnfcant effect on bond ratngs. Moreover, our results suggest that control n the hands of wdely held fnancal frms has a postve effect on bond ratngs only, and that State control has no effect on ether bond costs or ratngs. When we control for the nsttutonal envronment, we fnd that a hgher protecton of debtholders rghts generally reduces bond costs and ncreases corporate bond ratngs. Our results also show that, for both bondholders and ratng agences, the enforcement of debt laws s crucally mportant. Key Words: Debt Cost and Ratng; Ultmate Ownershp; Investor Protecton; Debt Enforcement. JEL Classfcaton: G34; G38; F34 2

3 Credtor Rghts Protecton, Ultmate Ownershp and the Debt Fnancng Costs and Ratngs: Internatonal Evdence I Introducton Shlefer and Vshny (1997) defne corporate governance as the ways through whch supplers of captal to corporatons assure themselves of gettng a return on ther nvestment 1. A large body of emprcal research lnks corporate governance (partcularly ownershp structure) to the managers-shareholders agency problems (Jensen, 1986; Morck et al., 1989; Walsh and Seward, 1990; Fluck, 1999; among others). However, lttle attenton has been devoted to the shareholders-bondholders agency conflct. Indeed, Jensen and Mecklng (1976) show that shareholders may exproprate wealth from bondholders by undertakng rsky new projects that wll allow them to reap most of the gans, whle bondholders bear most of the cost (Klock, Mans and Maxwell, 2005). In ths paper, we focus on the lnk between the ultmate ownershp of the frm and ts debt cost and ratng. We look at ultmate ownershp along two dmensons: (1) the dscrepancy between votng and cash-flow rghts of major shareholders, and (2) ultmate shareholder dentty. The votng/cash-flow rghts wedge measures the extent and the lkelhood of expropraton by majorty shareholders (Claessens et al., 2000; Facco and Lang, 2002). Although bondholders may also face the rsk that managers behave opportunstcally, we choose to focus on the conflct between controllng shareholders and bondholders based on the followng ratonale: The lterature to date shows that, outsde the U.S., ownershp structure s hghly 1 Shlefer and Vshny (1997), p

4 concentrated (Dens and McConnell, 2003). 2 Ths evdence makes expropraton by major shareholders more lkely n an nternatonal settng such as ours. Moreover, managers opportunstc behavour s tackled to a large extent by the fact that controllng shareholders usually appont managers among ther relatves (La Porta et al., 1999; Claessens et al., 2000; Facco and Lang, 2002), thus algnng both partes nterests. Ths stuaton n fact ncreases the lkelhood that expropraton by controllng shareholders occurs. Assumng that bondholders antcpate such behavour, they wll requre a hgher premum, resultng n a hgher debt cost. Prevous studes also suggest that the dentty of the frms (ultmate) owners s mportant to both bondholders and ratng agences. For example, famles usually appont managers among ther relatves (see for example Facco et al., 2001). Ths colluson may be perceved by bondholders as an ncreased rsk of expropraton. Ther ratonal response wll be to requre hgher yelds. In the same ven, ratng agences wll award lower ratngs to famly frms. However, one could also argue that famles are more lkely to adopt value-maxmzng strateges to ensure the frm s survval gven that they ntend to pass t on to subsequent generatons (Anderson et al., 2003). Such behavour may beneft bondholders and other stakeholders, and results n lower debt costs and hgher ratngs. Whch of these two effects wll domnate remans an open emprcal queston that only few studes tred to address (see for example Anderson et al. (2003) on controllng famles and Bhojraj and Sengupta (2003) on the mpact of nsttutonal ownershp, both set n the US context). The common ground of these studes s that they use ownershp-based measures (generally the drect ownershp stake) to assess the power of the man shareholder. In ths paper, we use control-based rather than ownershp-based measures. The data on the dentty of ultmate owners allows us to determne 2 Non-US studes that analyze ownershp structure nclude, among others : Prowse (1992) n Japan, Franks and Mayer (2001) n Germany, Xu and Wang (1997) n Chna, Valadares and Leal (2000) n Brazl, Facco and Lang (2002) n West Europe, and Claessens et al. (2000) n East Asa. Dens and McConnell (2003) offer an excellent lterature revew of ths evdence. 4

5 who s perceved by bondholders and ratng agences as representng a potental rsk of expropraton. Usng a multnatonal sample of debt ssung frms from developed and developng countres, we assess how the qualty of the nsttutonal envronment condtons the agency cost of debt and credt ratng across nsttutonally dverse envronments. To our knowledge, our analyss s the frst multnatonal study that addresses ths queston. Our study thus contrbutes to the scarce academc lterature on the lnk between governance mechansms and the cost of debt fnancng, and contrbutes to our understandng of the functonng of fxed ncome securtes markets around the world. As Shlefer and Vshny (1997) note, emprcal research on credtor governance s ndeed an under researched area n the corporate governance lterature. Whle some recent studes analyze the relatonshp between governance mechansms and debt yelds and ratngs, (Sengupta, 1998; Bhojraj and Sengupta, 2003; Anderson et al., 2003; Ashbaugh et al., 2006), ther evdence s drawn from the US, and thus cannot be generalzed to other countres wth less favourable legal envronments. The lack of evdence on ths ssue s puzzlng snce debt consttutes an mportant external source of fnancng for publcly traded frms around the globe. Ths paper also contrbutes to the lterature on nternatonal corporate governance on other grounds: for nstance, the avalable lterature focuses prmarly on drect ownershp. Our analyss reles nstead on ultmate ownershp and allows us to control for the extent and lkelhood of expropraton by controllng shareholders (.e., extent of agency conflcts wthn the frm). Moreover, no other prevous study looked at the potental mpact of nvestor protecton and overall qualty of nsttutons n the country on the frms cost of debt fnancng. A recent study by Ellul et al. (2005) provdes the frst prelmnary evdence of the mpact of these nsttutons by analyzng U.S frms and foregn frms that ssue ADRs n the U.S. However, such 5

6 an approach s lkely to suffer from a selecton bas problem snce ADR frms have to comply wth (nternal) corporate governance standards that are generally mposed by the Amercan legslator and the Securtes Exchange Commsson (SEC). As a consequence, the frms used n Ellul et al (2005) s study are more lkely to exhbt a better governance than ther local counterparts that do not ssue ADRs. Fnally, our framework provdes us wth a valuable opportunty to dentfy the set of nsttutons that the legslator needs to adjust to foster the development and well functonng of fnancal debt markets. Based on a sample of corporate bond ssues n 19 countres from East Asa and Western Europe, we fnd that the wedge between ownershp and control (.e., our proxy for expropraton) affects sgnfcantly both the debt cost and ratng. Wth respect to the controllng shareholder s dentty, we fnd that famly control s perceved as a potental rsk of expropraton by both bondholders and ratng agences as t loads a postve statstcal effect on bond costs and a negatve statstcal effect on bond ratngs. Thus, contrary to Anderson et al. (2003), who show that U.S. famly frms are seen as a protector of bondholders rghts, our fndng suggests nstead that ths type of owner s more lkely to harm bondholders n other markets. By takng advantage from ther controllng poston, famles are able to extract prvate benefts that are costly to all stakeholders, ncludng bondholders. Furthermore, famles often avod ownershp dluton n order to keep a tght control over the frm, whch leads them to prefer debt to equty fnancng, hence the hgher leverage of such frms. Fnally, we fnd that control n the hands of wdely held fnancal frms affects postvely bond ratngs (only), whle State control affects nether bond costs nor ratngs. Next, we analyze the effect of the nsttutonal envronment on corporate bond costs and ratngs. We consder a large set of natonal governance mechansms that encompasses regulatory nsttutons that prevous studes (e.g., La Porta et al., 1998; Dyck and Zngales, 2004; 6

7 Djankov et al., 2006; and Djankov et al., 2007) have shown to play a sgnfcant role n preservng nvestors rghts. Our results show that hgher nvestors (and essentally debt-holders ) protecton generally reduces bond costs (.e., spreads), and ncreases corporate bond ratngs. However, we document that the credtor rghts ndex (.e. restrctons that drectly protect ther rghts) does not matter for bond costs and ratngs, whle most debt enforcement measures load statstcally and economcally sgnfcant coeffcents. Ths suggests that both debtholders and ratng agences value debt enforcement rather than the mere exstence of debt laws. Thus, ceters parbus, authortes who are seekng to develop bond markets should put more emphass on the enforcement of laws protectng credtors (for example, by creatng credt regstres) rather than seek to create and enact new laws for the book. The remander of ths paper s organzed as follows. Secton II presents the theoretcal framework by descrbng the relaton between corporate governance and the debt yelds (costs) and ratngs. In secton III we descrbe our models, the varable measurements, the sample and data sources, and we provde descrptve statstcs. Secton IV dscusses our emprcal evdence and Secton V concludes. II. Corporate Governance and the Agency Cost of Debt: Hypothess Development A. Theoretcal Framework: The Agency Cost of Debt Recent studes show that lenders do not only rely on the frm s past proftablty and on the ssue characterstcs n order to nfer the expected cash flows (and default probablty). In fact, nvestors also prce the frm s corporate governance structure. Ths s essentally due to the fact that the frm s success (and hence ts ablty to pay back ts bondholders) s closely related to the extent of agency conflcts wthn the frm. Specfcally, debtholders face essentally two major problems: ) the managers opportunstc behavour, and ) the controllng shareholders expropraton. 7

8 In fnancal theory, management behavour can exacerbate the default probablty of the frm. The manageral frm defned by Berle and Means (1932) s characterzed by a separaton between ownershp and control, and s later defned by Jensen and Mecklng (1976) as beng a nexus for a set of contractng relatonshps 3 among a number of ndvduals wth conflctng objectves. Wthn ths frm, managers are not a perfect agent for shareholders because they may adopt a non value-maxmzng behavour, and engage n self-servng actvtes such as empre buldng and perquste consumpton at the expense of shareholders. Moreover, snce they nvest ther human captal n the frm, managers are less wllng to engage n rsky actvtes. Ths, n turn, harms shareholders that seek to have a well-dversfed portfolo. Also, because of ther lmted horzon n the frm, managers have ncentves to favour short-run projects rather than projects that ensure a contnuty of the frm n the long run. In order to resolve these conflcts, Jensen and Mecklng (1976) clam that the frm wll support some agency costs that mght reduce ts value. Of course, from the credtors, and partcularly the bondholders, pont of vew, ths results n a hgher lkelhood of default. Thus, ratonalty encourages bondholders to requre larger yelds (.e., hgher costs) for frms wth less dscplned managers. Beyond managers opportunstc behavour, debtholders need also worry about beng exproprated by the frm s owners. Stockholders, especally controllng shareholders, could be nduced to operate wealth transfers from bondholders n ther favour, especally by undertakng rsker projects that are rewardng to shareholders but costly to bondholders. Accordng to the opton theory (Black and Scholes, 1973), shareholders possess a call opton on the assets of the frm. The rsker are these assets, the more valuable s ther opton. Obvously, debt clamants wll bear all the cost, whle shareholders capture most of the gan f the nvestment does well. Jensen and Mecklng (1976) provde an extensve analyss of ths wealth expropraton and rsk 3 Jensen and Mecklng (1976), p

9 shftng conflct. Ther man concluson s that such a stuaton cannot be completely tackled by contract provsons, and gves rse to what we commonly call the agency costs of debt. In some nstances, relatvely straghtforward contractual covenants, such as restrctons on mergers or on addtonal fnancng, can solve these agency costs of debt, but many other contngences, such as overnvestment, are dffcult to solve wth such provsons. Consequently, and by antcpatng ths potental wealth expropraton, debtholders wll requre a hgher premum, thus a hgher cost of debt fnancng to frms. We dscuss n the next two sectons, the emprcal lterature that relates corporate governance to debt costs and credt ratngs. We then derve our man hypotheses. B. Corporate Governance, Ultmate Ownershp, Debt Cost and Credt Ratng Few recent studes nvestgate the relaton between nternal corporate governance mechansms and debt costs and ratngs. All avalable evdence s based on US markets, and the varables related to corporate governance dffer across studes, whch makes general nferences more dffcult. For example, Sengupta (1998) analyzes the assocaton between the frm s corporate dsclosure qualty and the cost of ts debt. Dsclosure qualty s measured by a score that reflects the analysts evaluaton of the tmelness, clarty and detal of the nformaton publshed by the frm. The author shows that the cost of debt s negatvely related to dsclosure qualty, and that ths relaton s more pronounced for frms exhbtng hgher varances n stock returns (as a proxy for market uncertanty). Hence, lenders and underwrters seem to value a hgher dsclosure n annual and quarterly reports because t allows them to better assess the frm s default rsk, especally for those frms that exhbt a hgher market uncertanty. Anderson, Mans, and Reeb (2003) analyze another aspect of the frm s corporate governance, namely ownershp structure. Specfcally, they observe that ownershp concentraton n the hands of the foundng famly s negatvely assocated to the agency cost of 9

10 debt. In fact, famly controlled frms enjoy a lower cost of debt fnancng of about 32 bass ponts than non-famly frms. They argue that ths type of nvestors, wth undversfed holdngs, are concerned, not only wth wealth maxmzaton, but also (and probably more lkely) wth the frm s survval, n order to pass t onto subsequent generatons. Because of ther large undversfed ownershp stakes, they avod rsky projects hence allevatng any ncentve to exproprate bondholders. As a result, debt clamants prce famly ownershp because t protects ther nterests (aganst managers). The authors also examne the mpact of nsttutonal ownershp, but fnd no sgnfcant relaton between nsttutonal nvestors partcpaton and the cost of debt. Another mportant study that also features US frms, by Bhojraj and Sengupta (2003), explores the effect of governance mechansms (n ths case, nsttutonal ownershp and outsde drectors) on bond ratngs and yelds. The authors argue that these governance mechansms could reduce the lkelhood of default of the frm through a reducton of the agency problems and the nformaton asymmetry between the frm and ts lenders. Ths would normally result n a lower cost of debt fnancng and a hgher credt ratng. Ther emprcal results support ths conjecture: frms wth greater nsttutonal ownershp and a large proporton of outsde drectors ndeed enjoy lower bond yelds and hgher credt ratngs. Furthermore, these two mechansms are more effectve n reducng the cost of debt and ncreasng the bond ratng for frms wth poor governance qualty. Fnally, they pont out that concentrated nsttutonal ownershp has an adverse effect on debt costs and bond ratngs. More recently, Ashbaugh et al. (2006) examne, as n Bhojraj and Sengupta (2003), the relatonshp between corporate governance and credt ratngs. They focus on four governance features (.e. ownershp structure and nfluence, fnancal stakeholder rghts and relatons, fnancal transparency and nformaton dsclosure, 10

11 and board structure and process) 4. They document that credt ratngs are postvely affected by the qualty of fnancal transparency and by board ndependence, ownershp and expertse. Moreover, credt ratngs are negatvely related to shareholder rghts, to the CEO beng also Chef of the board, and to ownershp concentraton (as measured by the number of blockholders ownng 5% or more of the frm). Other recent studes that examne the mpact of shareholder control on bondholders are Cremers, Nar, and We (2004) and Klock et al (2005). Usng nsttutonal ownershp to proxy for shareholder control and frms takeover defenses to proxy for takeover vulnerablty, Cremers et al. (2004) document that shareholders control s assocated wth lower yelds for well protected frms (aganst takeovers). Shareholders control s related to hgher yelds for less protected frms. Klock et al. (2005) extend the study of Gompers, Ish and Metrck (2003) to analyze the mpact of ant-takeover provsons on the cost of debt. Ther analyss shows that ant-takeover governance provsons, whle (not) benefcal to (shareholders) managers, are prced by debtholders. They fnd that frms wth strong ant-takeover provsons are assocated wth a lower cost of debt fnancng of about 34 bass ponts relatve to frms wth weak ant-takeover provsons. 5 Overall, the pror lterature suggests that management opportunsm and shareholders expropraton lead debt clamants to requre a hgher premum aganst any opportunstc behavour from management and/or controllng shareholders. In the same perspectve, ratng agences are more lkely to assgn lower ratngs to those frms that face one or both of these problems. Ths lterature revew on the effect of corporate governance on debt yelds and 4 As the authors argue, these components are drawn from S&P Corporate Governance Scorng. For more nformaton on these governance dmensons, see Ashbaugh, Collns, and LaFond (2006). 5 Some other studes analyze the mpact on bondholders wealth around some major corporate events that drectly affect the frm s governance structure such as Leverage Buyouts (eg. Lehn and Poulsen, 1988; Maras, Schpper and Smth, 1989; Warga and Welch, 1993) and Mergers & Acqustons (eg. Denns and McConnell, 1986; Maquera, Meggnson, and Nal, 1998; Bllett et al., 2004). 11

12 ratngs s, however, country specfc snce all studes analyze U.S. data. Furthermore, these studes restrct ther analyss to a varable number of corporate governance mechansms. Some of them (e.g. Bllett, Kng, and Mauer (2004)) use an event-study analyss to compute abnormal returns (yelds) bearng the rsk that the man conclusons may be contamnated by other events. All these factors make the generalzaton of the avalable evdence to other countres outsde the Unted States, unft. Our study tres to tackle ths ssue and provdes a cross-country evdence for a sample of 19 countres. Our proxy for the qualty of corporate governance s the lkelhood of expropraton by controllng shareholders (.e., extent of agency conflct wthn the frm). The above arguments lead to the formulaton of the followng hypothess: H1: The extent of expropraton s postvely (negatvely) related to debt costs (ratngs) Also, as suggested by the prevous studes, we use data on the dentty of the ultmate owner to dentfy whch type of controllng shareholder represents a potental rsk of expropraton to bondholders and ratng agences. Specfcally, we analyze the effect of dfferent types of controllng shareholders (not only famles) on bond costs and ratngs, usng controlbased rather than ownershp-based measures (unlke Anderson et al. (2003) and Bhojraj and Sengupta (2003)). C. Credtor Rghts Protecton, Debt Cost and Credt Ratng Debtholders rghts are remarkably heterogeneous around the world, partcularly between developng and developed countres. In some countres (such as Greece), laws that prevent automatc lqudaton and encourage the reorganzaton of the defaultng company actually protect non-senor debt clamants aganst senor debt clamants, whle n some other countres, senor debt clamants have the prerogatve to hold up the collateral even n the case of reorganzaton. Further, the role of managers n defaultng companes vares from one country 12

13 to another. For nstance, under Chapter 11 n the US, managers may ask law enforcers to protect them from credtors whle n other countres, such protecton s condtoned by the consent of credtors. Also, n some countres such as Malaysa, laws requre that the management team s replaced before any reorganzaton plan of the frm s approved. In some other countres, management turnover s not necessary (e.g. U.S., Canada, and France). However, n these cases, the exstng management must be supervsed by an admnstrator durng the reorganzaton process. In some countres (e.g. France), laws favour reorganzaton plans n order to preserve jobs, whle n others, lke the U.K. for nstance, laws focus prmarly on the enforcement of fnancal contracts between management and credtors, and allow these latter to choose between lqudaton and reorganzaton. The frst formal work that examnes nvestors protecton n an nternatonal framework s by La Porta et al. (1998). In addton to shareholders rghts, the authors explore the extent to whch debtholders (and more generally credtors) are protected n 49 developed and emergng countres. Based on two strateges avalable to deal wth a defaultng frm, namely reorganzaton and lqudaton, the authors produce cross-country scores of credtor rghts, and show that the legal orgn of the country determnes the extent of these rghts: The authors observe that Common-law countres offer a stronger legal protecton for debtholders compared to French-cvl-law countres. More recently, Djankov et al. (2007) document a sgnfcant relaton between the development of prvate credt (clams on the prvate sector by banks) and legal credtor rghts. In ther study, legal credtor rghts are measured by the credtor rghts ndex (n the sprt of La Porta et al. (1998)), and by the exstence of publc and prvate regstres (as proxes for the level of nformaton sharng). Well protected debt clamants would normally requre lower nterest rates. Fnally, the unque study, that we are aware of, that consders an nternatonal sample s by Ellul et al. (2005). The authors report that famly frms beneft from 13

14 lower debt costs n countres where nvestor protecton s better (measured by the legal envronment, the judcal effcency, the rule of law and the credtor rghts ndex). Ths evdence s drawn from a sample of frms that ssued ADRs n the US market, whch could eventually lead, as dscussed prevously, to a selecton bas snce these frms must normally comply wth corporate governance standards mposed by the SEC. Based on ths lterature, we expect that cross-country dfferences n the level of debtholders protecton wll lead (1) debtholders to requre hgher (rsk) prema (. e. hgher yelds), and (2) ratng agences to assgn lower credt ratngs to frms from countres where debtholders are the least protected. Thus, we can formulate our second testable hypothess as follows: H2: A better credtor rghts protecton s negatvely (postvely) related to debt costs (ratngs) To establsh the relaton between nvestor protecton and the debt cost and ratng, we consder two aspects: laws on the books and the extent of ts enforcement. Ths ssue s related to recent evdence on law exstence and enforcement. For nstance, La Porta et al. (2006) fnd that the exstence of laws that facltate prvate contractng s a stronger determnant of fnancal markets development than the publc regulatory enforcement. Bhattacharya and Daouk (2002) study nsder tradng laws around the world, and fnd that the ntal enactment of laws that prohbt nsder tradng does not affect the cost of equty, whle the frst tme these laws are enforced reduces t by about 5%. Another study, more related to ours, by Esty and Meggnson (2003) analyzes the mpact of credtor rghts and legal enforcement on the debt ownershp structure for a sample of global syndcated loans. Ther results suggest that n countres wth hgh nvestor protecton level and a strong legal enforcement, banks tend to be organzed n smaller and more concentrated syndcates n order to assure montorng and low cost contractng. On the contrary, they prefer larger and more dffuse syndcates structures to deter 14

15 voluntary default n countres wth poor legal enforcement mechansms. In another context, Mans et al. (2007), analyze the mpact of some Amercan States laws (partcularly dvdend payout restrcton) on bonds characterstcs, and fnds that bond ratngs and yelds are sgnfcantly assocated to the exstence of State payout restrctons. Based on ths evdence, we control for varables that reflect both the qualty of debt laws and the extent of ther enforcement n the country. III. Methodology and Descrptve Statstcs A. Specfcatons To test the relaton between governance mechansms and bond yelds and ratngs, we use the two followng general specfcatons: (1) Bond costs = f (ultmate ownershp varables, credtor protecton varables, control varables) (2) Bond ratngs = f ((ultmate ownershp varables, credtor protecton varables, control varables) The frst model (bond costs) s estmated usng the OLS method. The second model (bond ratngs) s estmated usng an ordered probt model, snce the dependent varable s ordnal (S&P ratngs are classfed n seven orderng categores). (See Appendx I). Our models nclude three major potental groups of determnants of bond yelds and ratngs (. e., ultmate ownershp varables, credtor rghts protecton varables, and control varables). In the subsequent sectons, we wll examne the effect (on bond costs and ratngs) of the ultmate ownershp structure and the legal envronment varables separately, and then we wll run a general model (for each dependent varable) that regroups both of them as specfed n equatons (1) and (2) 6. 6 In order to tackle the presence of multcollnearty between our varables, we proceed as follows. Frst, we test for multcollnearty n each regresson we run. To do so, we use the regresson collnearty dagnostc procedures of Belsley, Kuh, and Welsch (1980) that examne the condtonng of the matrx of explanatory varables. Ths procedure conssts n the computaton of the condton number (the largest sngular value of the matrx). Belsley et al. (1980) suggest that a value of 30 (or hgher) mples collnearty problems. Second, and for each regresson wth a condton number of 30 or more, we use the Gram-Schmdt orthogonalzaton technque, whch produces a set of new orthogonal varables from the orgnal ones. Each new varable s 15

16 B. Varables B.1. Debt Costs and Ratngs We measure corporate bond costs (COST) by subtractng the yeld to maturty on a US treasury bond from the yeld to maturty on the corporate debt ssue. Both the US treasury and corporate bonds should (deally) have smlar maturtes. 7 As credt ratng measures, we use the S&P credt ratngs (RATING). These ratngs assess the credtworthness of the oblgor wth respect to ts debt oblgatons. There are 22 ratngs rangng from hghest (AAA) to lowest (D). To facltate the analyss, and followng Ashbaugh et al. (2006), we transform these ratngs nto seven orderng numercal categores as presented n Appendx I. B.2. Ultmate Ownershp and the Lkelhood of Expropraton Many recent studes analyze the conflcts between mnorty and controllng shareholders. In such a stuaton, expropraton could take place, and conflcts between mnorty and controllng shareholders (and afflated managers) could arse. For nstance, these latter can stop payng dvdends, pursue a non-proft-maxmzng strateges, transfer cash to other frms n whch they have nterests, etc. As n Claessens et al. (2000), we frst measure the lkelhood of expropraton by the dfference between the votng and cash-flow rghts of the largest shareholders (C_O). Ths measure captures the level (extent) of the wedge, and hence the lkelhood of expropraton, n the frm. created n such a way that the effects of the other varables are removed. By usng these orthogonal varables n our regresson, we ensure that we are measurng the rght effect of each varable. 7 An alternatve measure could be the use of a domestc treasury bond for each country nstead of US Treasury Bonds. We prefer usng the US Treasury Bonds for essentally two reasons. Frstly, the computaton of spreads and rsk premum s usually done wth reference to a rsk free securty. Snce the U.S. government s unlkely to go bankrupt, we use ts bonds as a rsk free securty. Secondly and most mportantly, the use of the US treasury bonds makes the comparson across countres easer snce t provdes a common bass (or reference) to compare to. In spte of ths, we conduct our analyses usng the avalable data on domestc treasury bonds for each country. As dscussed later n the text, our man results reman overall unchanged. 16

17 Prevous studes suggest that the dentty of the frms (ultmate) owners s of nterest for both bondholders and ratng agences. In fact, control concentraton n the hands of few shareholders could enhance (or reduce) expropraton. To test whether the controllng shareholder s dentty affects debt costs and ratngs, we ntroduce the followng dummy varables, FAMILY, STATE, and WHELDFIN, to capture the type of the ultmate owner (respectvely for famly, State, and wdely held fnancal frms). Fnally, we add another dummy varable, MANAGER, to determne whether the appontment of a manager among the famly relatves has an mpact on the bondholders/ratng agences percepton of rsk factors. B.3. Credtor rghts Protecton Several recent studes emphasze the role of regulatory nsttutons n preservng nvestor rghts. The qualty of ths protecton depends on two factors: the exstence of the rghts per se and the qualty of ther legal enforcement. Accordng to Esty and Meggnson ((2003), p. 41): In addton to ensurng they have legal rghts, credtors must also ensure ther rghts are enforceable n the host country. Followng La Porta et al., (1998), Dyck and Zngales (2004), Djankov et al., (2006), and Djankov et al., (2007), we choose the followng ndcators to assess the qualty of nvestor (partcularly credtors) protecton n a gven country: ) Credtor rghts (CREDRIGHTS); Ths ndex assesses the extent of credtor rghts n the country. It ranges from zero (poor credtor protecton) to four (strong credtor protecton). We expect ths ndex to be negatvely (postvely) assocated wth bond costs (ratngs). ) Publc regstry (PUBREGIS); Publc credt regstres are databases managed by governments (e.g. through Central Banks or any other publc agency). Ther man functon s to provde lenders wth nformaton (that they have already collected) on borrowers. The exstence of a publc credt regstry should negatvely (postvely) affect debt costs (ratngs). 17

18 ) Estmated cost of nsolvency proceedngs (COST_INSLV); t conssts on all knds of costs borne by all partes as a percentage of the value of the nsolvency estate. Costs nclude court and attorney fees, bankruptcy admnstrator fees, accountant fees, and publcaton fees. The cost of nsolvency should have a postve effect on debt yelds and a negatve effect on debt ratngs. v) Effcency of the bankruptcy process (EFFDBTENFORC) 8 ; It s measured by the present value of the termnal value of the frm after bankruptcy costs. It reflects the value preserved n debt enforcement proceedngs. Hgher values ndcate hgher effcency of debt enforcement. Thus, we expect ths varable to be negatvely (postvely) related to debt costs (ratngs). v) Contract enforcement days (ENFORCDYS); It s the number of days needed to resolve a payment dspute (through courts) that emerges from a smple debt contract, as a measure of the qualty of law enforcement. Ths varable should normally be postvely (negatvely) related to debt costs (ratngs). v) Newspaper crculaton (NEWS); It s the rato of daly newspapers dvded by populaton. It reflects the publc pressure on domnant shareholders. Snce t s expected to reduce expropraton, t should also be negatvely (postvely) related to bond yelds (ratngs). v) Corrupton (CORRUPTION); It s an assessment of corrupton n government. Snce lower scores are for hgher levels of corrupton, we expect ths varable to have a negatve (postve) effect on debt costs (ratngs). Note that the frst varable, credtor rghts ndex, ndcates the qualty of the laws that exst n the country, whle the other varables (specfcally, Publc regstry, Estmated cost of the 8 For more detals on the computaton of ths varable, see Djankov et al. (2006). 18

19 nsolvency proceedng, Effcency of the bankruptcy process, and Contract enforcement days) measure the qualty of debt laws enforcement. B.4. Control Varables Typcally, the cost of debt fnancng and credt ratngs can be explaned by three factors: ) The ssuer characterstcs that allow lenders and underwrters to perceve the lkelhood of default of the frm. These characterstcs nclude leverage, the sze of the frm, ts proftablty, ts ndustry, ts market rsk, ) The ssue characterstcs that nclude the maturty of the debt, the sze of the amount rased, and some other specal features such as the exstence of call or converson provson. ) The country macroeconomc condtons such as the busness cycle of the economy. We nclude the followng control varables: At the frm level, we control for the ssue characterstcs (maturty, and the sze of the ssue) 9, and for the ssuer characterstcs (the sze of the frm, the leverage, the performance, the ndustry, and the rsk). At the country level, we control essentally for the country nflaton rate, and the level of economc and fnancal development (debt market sze, and GDP growth). A detaled descrpton of the varables appears n Table 1. [INSERT TABLE 1 ABOUT HERE] The Cost model can thus be wrtten as follows: COST = α 0 + α.lmat + α.lisize + α. ASSET + α.stdinc + α.roi + α. LEVERAGE + α. INFLATION δ. CORRUPTION δ. CREDRIGHTS + δ.pubregis + δ.cost_inslv + δ. EFFDBTENFORC α.gdpgroth + α. DEBTMKTSIZE + β.c_o + β.family + β.manager + β.state + β.wheldfin + Country Dummes + Industry Dummes + Year Dummes + ε δ.enforcdys + δ.news 5 6 And the Ratng model as follows: 9 In our sample, the absolute majorty (more than 98%) of ssues are not convertble and don t have any other specal characterstc that could affect ther yelds or ratngs. 19

20 Pr( RATING = r) = Φ ( α + α.gdpgroth 8 + δ. CREDRIGH TS 1 + δ. CORRUPTI ON 7 1. LMAT + α. LISIZE + α. DEBTMKTS IZE + δ.pubregis C. Sample and Data Sources α 3. ASSET + β.c_o + α.stdinc + α + β.family + δ.cost_insl V + δ. EFFDBTEN FORC 3 + Country Dummes + Industry Dummes ROI + α + β.manager 3 Year Dummes 6. LEVERAGE + α. INFLATIO N + ε ) + β.state 4 + δ.enforcdys β.wheldfin 5 + δ.news 6 where r { 1, 2, 3, 4, 5, 6, 7} We frst start by mergng the samples of Facco et al. (2002) for Western European corporatons, and Claessens et al. (2000) for East Asan corporatons for whch the authors dentfy ultmate ownershp. Our analyss s cross sectonal n nature snce ultmate ownershp for European frms s for ether one year between 1996 and 1999, and as of December 1996 for Asan frms. We consder all frms that have complete nformaton on votng and cash-flow dvergence, and on the dentty of the ultmate owner. We obtan an ntal database of more than 8,000 frms from 22 countres (Austra, Belgum, Fnland, France, Germany, Ireland, Italy, Norway, Portugal, Span, Sweden, Swtzerland, UK, Hong Kong, Indonesa, South Korea, Japan, Malaysa, the Phlppnes, Sngapore, Tawan, and Thaland). We then match ths database wth bond data from The Fxed Investment Securtes Database. We keep only ssues between 1994 and 2002 that offer fxed nterest rates. Snce ultmate ownershp does not change substantally over tme (Facco et al. (2002) and Claessens et al. (2000)), we beleve that they remaned relatvely steady around the years they were collected at. So, we expect bond ssues between 1994 and 2002 to exhbt the ownershp data collected by Facco et al. (2002) and Claessens et al. (2000). Only 568 ssues survve the matchng procedure between these samples and the Fxed Investment Securtes Database. Data on ssuer characterstcs (performance, rsk, sze, and leverage) are from Worldscope. Regulatory nsttutons are from La Porta et al. (1998) (Credtor rghts and Corrupton), Djankov et al. (2006) (Estmated cost of the nsolvency proceedng, Effcency of the bankruptcy process), Djankov et al. (2007) (Publc regstres and Contract enforcement days), and Dyck and Zngales (2004)) (Newspaper crculaton). Hand matchng the data on bonds and ultmate ownershp 20

21 wth data on ssuer characterstcs and regulatory nsttutons results n a fnal sample of 256 ssues for bond costs and 307 ssues for bond ratngs. 10 Table 2 reports the dstrbuton of both samples across countres. 11 [INSERT TABLE 2 ABOUT HERE] D. Descrptve statstcs Table 3 reports descrptve statstcs of the varables used n the analyss. In our sample, the average spread s about bps, whle the average ratng s 4.63, whch falls between A- and BBB+ n our transformaton scale. Moreover, the mean for the varable C_O s 3.6%. Around 28% of the frms are controlled by famles. Ths proporton s about 19 and 20% for State and wdely held fnancal frms, respectvely. Table 3 also presents Pearson correlatons between our two key varables (COST and RATING), and all the other potental explanatory varables. In general (except for some varables), COST s postvely and sgnfcantly correlated whle RATING s negatvely and sgnfcantly correlated wth ultmate ownershp varables. Furthermore, both varables are sgnfcantly correlated wth most country varables, and generally n the expected drectons. We can note at ths stage the hgh and sgnfcant correlaton between RATING and most other varables. Snce these varables wll be ntroduced n our COST regressons, we choose (as n Sengupta (1998) and Bhojraj and Sengupta (2003)) to exclude the RATING varable from those models. [INSERT TABLE 3 ABOUT HERE] 10 We do not have the same number of ssues for both varables because, for some ssues, we have only nformaton on bond ratng (and we lack nformaton on the spread). 11 Note that three countres are dropped from the analyss (Belgum, Span and Tawan) because of mssng values. 21

22 IV. Emprcal Results A. The Impact of the Ultmate Ownershp Structure on Bond Costs and Ratngs A.1. Ultmate Ownershp Structure and Debt Costs We frst examne the effect of ultmate ownershp structure on debt costs. Partcularly, we use the wedge between cash-flow and control rghts that reflects the level of expropraton (as measured by C_O) and the dentty of the ultmate owner (FAMILY, STATE or WHELDFIN). Table 4 reports the regresson results. The statstcal sgnfcances of the reported coeffcents are calculated usng robust standard errors (Huber-Whte-Sandwch estmator of varance). In the second column of Table 4, we report the basc model n whch we do not control for corporate governance. All the ssuer and ssue characterstcs varables are sgnfcant (at 6% or better) wth ther expected sgn. As expected, debt yelds are negatvely affected by the sze of the debt market (DEBTMKTSIZE) and the level of economc growth (GDPGROWTH). Ths fndng suggests that nvestors are senstve to the sze of secondary markets (where they could lqudate ther assets), and to the economc stuaton of the country as a whole snce t reflects, to some extent, the future potental of ther nvestments. Fnally, the coeffcent of nflaton s not sgnfcant although t has a postve sgn. In columns (2) to (6) of the same table, we add the ultmate ownershp measures, each one n a separate model. These regressons show that the level of expropraton and famly control are postvely and sgnfcantly related to bond costs. On the contrary, State control and wdely held fnancal frms control have the opposte effect. Appontng managers from the famly relatves seems not to affect bond costs. In model (7), we nclude all the governance varables as well as an nteracton term between C_O and the dentty of the ultmate owner (FAMILY, STATE, or WHELDFIN). Results show that the expropraton measure remans sgnfcant and postve. That s, an ncrease of 1% n the level of expropraton leads to an ncrease n the cost of debt by approxmately bass ponts beyond the Treasury 22

23 bond spread. Among the three types of ultmate owners, only FAMILY s consdered as a potental rsk of expropraton by bondholders. Ths result goes aganst evdence n Anderson et al. (2003) who fnd that US famly frms have lower debt costs than non-famly US frms. Ths could be due to the fact that, n ther study, the authors use an ownershp-based measure rather than a control-based measure of the famly holdngs. Fnally, as shown by the coeffcents of the nteracton terms, when the ultmate owner s a famly or a wdely held fnancal frm whose control stake exceeds ts ownershp stake, the effect on debt costs s more pronounced. Furthermore, bondholders do not seem to consder State control as a rsk factor, even f the State has votng rghts n excess of ts cash-flow rghts (the coeffcent of STATExC_O beng nsgnfcant). Facco et al. (2001) argue that dvdends can be used by controllng shareholders to exproprate outsde shareholders wealth. The authors suggest that f nvestors are aware of the rsk of expropraton, they wll use dvdends to protect themselves. Usng West European countres as a benchmark, the authors show that nvestors n East Asa are less alert to expropraton. Investors n West European countres, n contrast to ther counterparts n East Asa, antcpate more strongly the rsk of expropraton and, to offset ther concerns, requre hgher dvdends n frms where expropraton s more lkely. If ths s ndeed the case, we should expect bondholders n Western Europe to requre hgher nterest rates (.e., bond spreads), compared to bondholders n East Asa, whenever there s a sgnfcant separaton between the ownershp and control stakes held by controllng shareholders. Put dfferently, we expect the (postve) effect of the cash-flow/votng rghts dvergence on spreads to be more prevalent n the West European sample. To test ths hypothess, we estmate model (7) for both West European and East Asan sub-samples. The last two columns of Table 4 dsplay the results. As expected, bondholders n East Asan countres do not seem to antcpate expropraton by 23

24 controllng shareholders (C_O s nsgnfcant at any conventonal level). In contrast, bondholders n countres from Western Europe countres requre a sgnfcantly hgher nterest rate from ssung frms wth a wder observed dscrepancy. Moreover, t seems that both Asan and European bondholders fear famly control, snce the coeffcent of FAMILY s postve and hghly sgnfcant n both models. On the contrary, bond costs are negatvely affected by STATE for the Asan sample and by WHELDFIN for the Western European sample. Ths shows, to some extent, the type of nvestor that Asan and European bondholders have most confdence n (snce the presence of that partcular type of nvestor reduces the cost of bonds). [INSERT TABLE 4 ABOUT HERE] A.2. Ultmate Ownershp Structure and Debt Ratngs Table 5 reports the results of ordered probt models for the effect of expropraton measures on bond ratngs. We keep all the control varables prevously dscussed. The unque dfference s that nstead of ntroducng dummes for the years, countres and ndustres, we choose to nclude dummes to control for three partcular ndustres more lkely to affect ratngs (Fnance, Utlty and Hgh-Tech), for three perods (before, durng and after the 1997 Asan fnancal crss), and for two regons (Asa or Europe). We do so because cross-tabulatng the ordered dependent varable (RATING) wth many dummy varables creates too many empty cells that prevent an ordered probt estmaton. So, our soluton for ths techncal problem conssts n reducng the dummes nstead of mergng some categores of the dependent varable. The frst column presents the man model wthout ncludng any proxes for governance. In columns (2) to (6), we test separately for the effect of each measure of ultmate ownershp on bond ratngs. At 10% level (or better), all the governance measures affect sgnfcantly bond ratngs. The level of the cash-flow and votng rghts dscrepancy as well as the exstence of 24

25 famly control n the frm and the appontment of managers among the owner s famly members lead ratng agences to assgn lower ratngs for these frms (the coeffcents for C_O, FAMILY and MANAGER are negatve). In contrast, State control or control by wdely held fnancal frms do not seem to be consdered by ratng agences as addtonal potental rsk factors of expropraton (because ther presence as controllng shareholders ncreases bond ratngs as shown by the coeffcents of STATE and WHELDFIN). When we consder all the governance proxes n the same model (column (7)), we stll obtan the same results, except that STATE becomes nsgnfcant whle stll keepng ts postve sgn. The nteracton coeffcents between C_O and both FAMILY and WHELDFIN are negatve and hghly sgnfcant, suggestng that ratng agences have a negatve percepton of the cash-flow/votng rghts dscrepancy. Overall, these fndngs shed some lght on the effect of ultmate owner dentty on credt ratngs. Prevous studes have argued that the concentraton of ownershp n the hands of nsttutons (Bhojraj and Sengupta (2003)) or n the hands of blockholders (Ashbaugh et al. (2006)) could enhance the prvate benefts hypothess, leadng ratng agences to downgrade ther score for the frms that exhbt these features. Evdence from Table 5 goes beyond ths evdence and shows that controllng owners do not all have the same mpact on debt credt ratngs. At ths stage, we can compare the perceptons of bondholders and ratng agences regardng the frms ownershp features. By takng a glance at column (7) of tables 4 and 5, we can easly note that bondholders as well as ratng agences are able to assess the potental rsk of expropraton (the cash flow and votng rghts dscrepancy). Both seem to consder the potental costs of famly control (both FAMILY and C_OxFAMILY beng economcally and statstcally sgnfcant n both models). Ths rsk can materalze n two ways: Frst, famles can take full advantage from ther controllng poston, and seek to extract (drect) prvate benefts that harm all stakeholders (especally mnorty shareholders and debtholders). Second, famles often want 25

26 to keep control by avodng the dluton of ther ownershp. Thus, famly frms wll normally prefer debt fnancng to equty to fnance ther projects, whch translates n relatvely hgher leverage ratos. [INSERT TABLE 5 ABOUT HERE] B. The Impact of Regulatory Insttutons on Bond Costs and Ratngs B.1. Regulatory Insttutons and Bond Costs We now turn to the effect of regulatory nsttutons on bond spreads. To proxy for the legal protecton of nvestors rghts, we use, as dscussed above, the followng measures of regulatory nsttutons: credtor rghts, publc regstry, estmated cost of nsolvency proceedngs, effcency of the bankruptcy process, contract enforcement days, newspapers crculaton, and corrupton. Models (1) to (7) n Table 6 llustrate the effect of each factor on bond spreads. As one can see, among our set of nsttutons, only credtor rghts and the effcency of the bankruptcy process are nsgnfcant at the 10% level. All the other nsttutons are sgnfcant wth ther expected sgns. In the last column of the same table, we regress bond costs on all factors. The conclusons reman the same except that the effcency of the bankruptcy process becomes sgnfcant, whle corrupton loses ts sgnfcance once we take nto account the effect of all other nsttutons. The exstence of a credt publc regstry, the effcency of the bankruptcy procedure, and the extent of newspapers crculaton affect, as expected, negatvely and sgnfcantly, corporate bond costs. In contrast, hgher nsolvency costs and longer contract enforcement perods lead to sgnfcantly hgher bond costs. These results lead us to a frst concluson: the legal envronment s mportant to bondholders. Ths concluson corroborates, to some extent, the fndng of Ellul et al. (2005) that the presence of a foundng famly n less protectve legal systems exacerbates the cost of debt (and vce versa). Ther result ndrectly 26

27 ponts to the role of the legal envronment n encouragng (or forcng) foundng famles to preserve mnorty nterests. Our fndngs suggest that, regardless of who s controllng the frm, legal regmes could protect debtholders and guarantee ther rghts. We also note from Table 6 that, contrary to the evdence on debt laws enforcement measures dscussed above, the exstence of restrctons amed at protectng credtor rghts has no mpact on debt cost. In fact, whle varables related to the qualty of debt laws enforcement (.e., PUBREGIS, COST_INSLV, EFFDBTENFORC, and ENFORCDYS) are sgnfcant, the credtor rghts ndex (CREDRIGHTS) that captures the exstence of these laws, s not sgnfcant at any conventonal level. That s, to bondholders, debt laws enforcement s more mportant than the exstence of these laws. [INSERT TABLE 6 ABOUT HERE] B.2. Regulatory Insttutons and Bond Ratngs Table 7 reports evdence on the effects of the regulatory nsttutons on bond ratngs. As prevously, we start by testng the mpact of each solated factor, and then we test the effect of all factors taken together n the same regresson model. From columns (1) to (7), we can see that the exstence of a credt publc regstry as well as an extensve newspapers crculaton lead to hgher bond ratngs, whle a longer perod to enforce a debt contract through courts reduces t. When we run our regresson wth all the nsttutonal governance factors n the same model, we fnd that CREDRIGHTS, COST_INSLV, and CORRUPTION have no statstcal effect on bond ratngs. PUBREGIS, EFFDBTENFORC, ENFORCDYS, and NEWS are, n contrast, hghly sgnfcant (at less that 1% level) and havng ther expected sgns. Here also, we can conclude that, to ratng agences, debt laws enforcement s more mportant than the exstence of laws (CREDRIGHTS beng nsgnfcant). The fnal model leads to a presudo-r 2 of 23.19%. 27

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