I'd like to propose a financial innovation that I think would actually be good (besides the ATM). It would be a new security that firms could market to investors, just like CDOs and all of that good stuff. But rather than being a means of expanding the supply of credit (the questionable purpose of most "financial innovation"), this investment product would change the character of credit provided by investors to firms. It would provide an alternative to the customary form of corporate debt.
True believers might argue that if what I suggest were a good idea, a free capital market already would have discovered it. I'm not a true believer, but I'll make common cause in part, and point out that securities like those I propose are presently tax disadvantaged, so capital markets have not been free to discover them. In particular, if dividends on preferred equity were tax-deductible to firms like interest, perhaps these securities would already be commonplace. But I'll reveal my cruel, statist heart by hinting that since firm managers may be myopic in their preference for cheap financing, and since distress costs are in part external to firms, an active policy tilt in favor of more robust capital structures might be worth considering. 
I'm suggesting a new financial instrument. Here's its catchy name: "In-arrears convertible cumulative preferred equity", or "IACCPE". ("Yak-pee" for short?) Let's chop that aromatic mouthful into tasty, digestible chunks:
Preferred equity is a form of investment that is like debt, in that the issuing firm promises to pay an agreed dividend level (like an interest rate), rather than a share of a firm's variable profits. However, preferred equity is unlike debt, and like stock, because if a firm for whatever reason does not pay the promised dividend, aggrieved investors cannot sue for bankruptcy. Preferred shareholders' only means of enforcing payment is priority: common equityholders cannot receive dividends if preferred shareholders' dividends have not been paid.
Cumulative means that if the issuing firm has skipped some dividend payments, the firm is said to be "in arrears", and must pay preferred investors all past skipped dividends before it can make any payout to common shareholders. "Cumulativity" ensures that, unless a firm goes bust before ever paying another dividend, preferred investors will eventually get all the payments they were promised, although they may suffer from delay. Cumulative preferred equity is more "debt-like" than noncumulative preferred equity, in that noncumulative investors permanently lose claim to some dividends if a company falls on hard times and suspends payments, while debtors always have claim to interest owed.
In-arrears convertible means that while payments on the preferred shares are "in arrears", when the firm had failed to pay some of the dividends that it had promised and not yet cured the failure, investors would have the option of converting the shares to common stock on favorable terms.
It's the in-arrears contingency that makes this security novel and interesting (I hope). But the feature requires some explanation. Usually, a convertible security has a par value and a conversion price that fix the number of shares of common stock an investor would get for converting a share of the security. This means that investors normally convert only when a firm is doing well. Suppose you have a share of preferred stock that (without the conversion feature) would be worth $100, but that can be converted to 10 shares of common stock. You would never exercise that right when the common stock price is less than $10, since the preferred share is more valuable than the stock you'd get. You would only convert when the common stock is doing well enough so that the value of the stock you would get on conversion exceeds the value of your preferred share. 
An "in-arrears convertible" would be pretty useless unless the conversion price were very low, since firms stop paying their preferred stock dividends in difficult times, when their stock price is depressed. So rather than fixing the conversion price in advance, these securities would be convertible at a discount to the market price of the stock at the time the preferred dividend was not paid.  That is, by going into arrears on the preferred shares, firms would open themselves up to dilutative preferred-to-common-equity conversions, at the option of the preferred shareholders. If a firm does have long-term, going-concern value, but is simply unable to meet the cash flow requirements of its capital structure, preferred shareholders could convert at a bargain rate during the limited in-arrears period. If a firm is not likely to be viable as a going concern, preferred shareholders could choose to hold tight. They'd be paid out in preference to common stock holders at the eventual liqudation.
Firms could issue multiple classes of "IACCPE", like they now offer multiple debt issues, each with a distinct priority in the capital structure of the firm. Ordinarily, these securities would be indistinguishable from debt, both to the firm and to investors. Investors would fork over a set amount of cash, and then expect to be repaid with interest (formally dividends) on a predetermined schedule. But in bad times, firms that fail to meet their obligations would be forced to offer equity, including control rights, to creditors on very favorable terms. (Non-payment of a dividend could also provoke a special shareholders meeting, and holders of the unpaid preferred could be given the right to propose replacement directors, thereby maximizing the value of converters' control rights.)
Substituting this kind of security for debt in firms' capital structure would enable a kind of bankruptcy in increments, an automatic and self-enforcing reorganization. I think this would improve value for all stakeholders compared to our present system. Chapter 11 bankruptcy was itself a great innovation, but it exposes even viable firms to large, indirect distress costs when capital structure and cash flows become misaligned. To the degree that a firm has widespread or important stakeholders outside its capital structure (customers, employees, financial counterparties, local governments, etc), Chapter 11 even at its best produces costly externalities, as stakeholders must provision for abrupt and unpredictable changes even when a firm is likely to survive and even thrive once arguments over who gets what are resolved. Because Chapter 11 bankruptcies (and receiverships for financial firms) are disruptive, governments sometimes intervene to prevent them or to the process with subsidies. The expectation of intervention causes investors in "systemically important" firms to over-lend and under-monitor. For large firms, the threat that contractually prescribed, preferred-to-common conversions might be triggered would be more credible than the threat of an uncontrolled bankruptcy without government subsidy. Investors would be forced to actually price the "lower tail", rather than hoping it will be truncated by the state. Common stockholders would face a steep penalty for missing "debt" payments, but the extent of their dilution would be predictably related to the scale of the obligations they fail to meet.
IACCPEs wouldn't replace or eliminate traditional bankruptcy, of course. Regardless of capital structure, firms that are not viable businesses will need to be liquidated. Sometimes firms have contractual arrangements other than straight debt that need to be modified if a firm is to become viable. Moreover, even if all "financial" debt were eliminated from firm capital structures (I think that would be a good thing), firms would still have transactional business creditors, for whom traditional "hard" debt makes sense.  This proposal does not directly address off-balance-sheet contingent liabilities or pension and health obligations, which are increasingly sources of firm distress. I think pension and health issues will have to be addressed on a national basis, that our employer-centric system of managing health and retirement issues will ultimately have to be, um, retired. But some contingent liabilities (uncollateralized derivative exposures) could and probably should be replaced by contracts that can be paid off in some form of equity (at punitive valuations) when they cannot be paid in cash.
Highly leveraged capital structures make individual firms, and networks of interdependent firms and communities, brittle. Replacing debt in firm capital structures with some form of preferred equity would serve as a shock absorber, allowing viable firms to survive transient cash flow shocks without affecting outside parties. It might be enough to simply level the playing field between debt and preferred equity by making preferred stock dividends tax-deductible for firms. But debt investors take some comfort in the fact that they have power, via the bankruptcy process, to enforce payment. That threat may reduce the cost to firms of debt finance. The sense of the present proposal is to define an instrument that gives fixed-income investors as much of the power they would have in a bankruptcy as is possible while reducing the likelihood of a "singularity" that creates far-reaching costs and uncertainties.
 The proposed "IACCPEs" would not necessarily be a more expensive form of financing than traditional debt: On the one hand, they take a weapon away from creditors, so creditors would want to be compensated for the additional vulnerability. On the other hand, by reducing the likelihood that a transient shock provokes an unnecessary bankruptcy, replacing debt with IACCPEs might reduce expected distress costs, and thereby increase overall firm value relative to a firm financed with traditional debt, which would be reflected in a lower cost of financing across the capital structure. Which of the two offsetting factors dominates would have to be an empirical question.
 Usually you would wait quite a bit longer than that, because the option of converting at any time makes the convertible security as valuable as the shares, but the agreed-in-advance payments of the unconverted security provides protection should the stock price tank. Exactly when it's worthwhile to exercise the conversion option on convertible shares is complicated, and in real life depends on the level of dividends paid by common shares and the relative liquidity of the market for common and preferred shares. In frictionless markets for a firm that issues no common dividend, it would only be worthwhile to convert an instant prior to maturity of the convertible security (if it is not perpetual). For our purposes, however, all that matters is that investors usually convert preferred stock only when the common shares are doing well.
 Getting the conversion option trigger right would be an important technical issue in defining these securities. Managers might try to manipulate their stock price around the time of the triggering nonpayment, in order to minimize the cost of dilution to existing shareholders (and themselves). The conversion price might be based on an average stock price over 30 days prior. Managers would not have very much scope to time the nonpayments, because they would be required to skip dividends on the most junior class of preferred shares, whose dividend schedule would have been set in advance.
 Broadly, "financial" investors should be expected to research and take some responsibility for the firms in which they invest, while customers and suppliers should be able to do business with a firm without worrying very much about its balance sheet. There is no bright line between transactional credit and financial debt, but it is nevertheless a distinction worth making, and even policing, in firms' capital structure. The "cash efficiency" movement, which encourages firms to maximize their use of transactional credit as a source of cheap financing, is in my view pernicious. But that's a rant for another day.
- 2-May-2009, 3:50 p.m. EDT: Reorganized a bit, changing the name "In-arrears contingent convertible cumulative preferred equity" to the more svelte "In-arrears convertible cumulative preferred equity".
|Steve Randy Waldman — Saturday May 2, 2009 at 3:21pm||permalink|