I am continually amazed at the quality of comments that Interfluidity attracts. But commenters to the previous post truly outdid themselves. I proposed a "novel" security intended to make debt-to-equity conversions gradual and automatic, in hopes of avoiding disruptive "discrete" bankruptcies. Commenters quickly pointed out earlier work along the same lines, and some serious problems that I hadn't considered. All in all, I remain convinced that "continuous bankruptcy" is a goal worth pursuing. But I'm equally convinced that the specific security I suggested would probably not quite do it.
First, it turns out that better minds than mine have considered debt-like securities that would convert to equity as firms became undercapitalized. The excellent Economics of Contempt pointed out two antecedents, Mark Flannery's "Reverse Convertible Debentures", and a recent proposal by the "Squam Lake Working Group on Financial Regulation". The Squam Lake piece is a diamond in the rough, but Flannery's ideas are carefully developed. Flannery considers and tries to address most of the problems I would have missed without help from the comments. He also includes a detailed review of related work.
Flannery's Reverse Convertible Debentures and my proposed "IACCPEs" are both fixed income securities convertible to common stock at a price not set in advanced, but determined by the market price of the stock at the time of conversion. Commenters Alex R and Independent Accountant were reminded of the infamous death-spiral convertibles from the late 1990s. bondinvestor pointed out that a form of catastrophe bond, "catastrophic equity puts" are similar, in that they allow the issuer to convert a fixed income obligation to equity in the event of a prespecified bad event. (Here the bad event that would trigger conversion is running short of capital.) Thomas Barker and jck of Alea pointed out that these securities resemble Islamic "sukuk convertibles". jck suggests that these, like the death-spiral convertibles, have mostly not worked out so well. (I'd like to know more about Islamic convertibles, both the theory behind them and their history in practice — if you know of a good reference, please do drop a note in the comments.)
The trouble with my proposal is that it failed to adequately consider how both investors and firms would try to game them. Alex R pointed out that investors shorted the hell out of "death-spiral convertibles". Those who owned them gained if prices could be pushed downward, as lower stock prices meant ownership of a larger fraction of the firm upon conversion. Other traders had incentives to short as well, since dilution caused share prices to drop post-conversion. If the conversion trigger is predictable to investors, and the same dynamic might hold for IACCPEs. (beezer thought this likely as well.)
Also, Alex R and Awake noticed that conversions are effectively at the option of the firm, since "IACCPEs" are only convertible "in arrears" — that is, when a firm hasn't paid a dividend owed on the preferred shares. Since conversions (under my proposal) are made on terms favorable to IACCPE holders and disadvantageous to incumbent equity, managers might insist on paying dividends to the bitter end, even if overall firm value would be enhanced by preserving cash. Shareholders might prefer to "gamble for redemption" rather than transfer wealth up the capital structure and adopt a more conservative strategy. (In other words, the option value of an undercapitalized firm might be worth more to the original shareholders than the expected value of their fraction of a better capitalized firm.) Further, the fact that convertibility is at the option of firm management creates an incentive towards opacity and surprise non-payment of dividends. Firms would want to skip dividends when shares are overvalued (so that conversion would be on terms favorable to existing shareholders), and would want to hide any possibility of skipping dividends in distress (so that short-sellers don't front-run à la death-spiral convertibles. Modifying capital structure in a way that creates incentives for managers to reduce transparency and promote mispricing doesn't seem like a good thing.
Mark Flannery's "Reverse Convertible Debentures" try to avoid gaming by managers and short sellers in three ways: First, RCDs convert automatically, at the option of neither issuers nor investors, based on a debt-to-market-equity trigger. Secondly, the securities are designed to avoid any transfer of net wealth from equityholders to creditors (or vice versa) upon conversion. Conversions would be based on the market value, not the par value, of the RCDs at the time of conversion, and the market price of the stock. In theory, this would make for a perfectly even exchange, so that no party would have strong incentives to game the trigger. Finally (as foreseen by commenter Bill) "triggered" RCDs wouldn't all convert all at once. Only the minimal fraction required to bring a firm to a set level of capitalization would be affected, which again might make the threshold event less of an event worth manipulating.
I don't think that Flannery has solved all problems of strategic behavior — both the "automatic" trigger and the effective conversion ratio are susceptible to gaming, and I don't think it would be either possible or desirable to define terms under which investors would be indifferent to conversion. Nevertheless, Flannery's paper makes a serious attempt to address the problem of gaming the trigger, which really is the achilles heel of this genre of proposal.
But let's pull back. There might not even be a need for an explicit conversion scheme. Plain vanilla cumulative preferred equity has a built-in duality. As long as an issuer is paying out dividends, cumulative preferred equity is very debt-like. Investors expect a fixed coupon, and firms have strong incentive to pay it (so that common shareholders can take dividends, and because nonpayment of preferred dividends is taken as a bad signal by the market). When preferred goes "in arrears", it suddenly becomes very equity-like: Its value becomes dependent on the promise of dividend payments at some unspecified future date, and the probability that dividends will actually get paid is sensitive to the operating performance of the firm. Cumulative preferred equity has already been invented. So why do we still have a problem?
The first, easiest, and most important thing we could do to reduce the systemic risk and deadweight bankruptcy costs caused by brittle capital structure is change the %*$%&! tax code to eliminate the tax preference for debt over preferred equity. Long-term debt and cumulative preferred equity are basically identical, except for two things: 1) Taxpayers subsidize the issuance of debt while 2) debt contracts are enforceable via socially costly bankruptcy. Taxing preferred equity dividends but not interest on debt is like taxing people for the privilege wearing seatbelts, then wondering in gape astonishment at highway mortality rates. It is bass ackwards. We can either make dividends (at the very least cumulative preferred dividends) tax deductible, or we can make interest payments non-deductable (as Richard Serlin prefers). But we have got to stop tilting the capital structure scales towards bankruptcy-enforceable debt finance. The status quo is absurd, ridiculous, untenable.
(I have yet to encounter even an attempt to justify why interest payments should be deductible but CPE dividends not. There are arguments by definition — expenses are deductible, obligatory payments are expenses, obligatory means enforceable by bankruptcy, q.e.d. But the tax code needn't be slave to an arguable and legally alterable set of definitions.)
If cumulative preferred equity were not tax disadvantaged, firms might find that it is not much more expensive than debt. But there are two other problems with vanilla CPE as "natural convertibles". First, there is the question of control. When a firm runs into trouble and then deep goes into arrears on cumulative preferred equity, economically speaking, the preferred becomes equity-like, while the common stock becomes option like. Unfortunately, control usually in the hands of common equity, whose incentives may be to maximize the volatility rather than expected value of firm assets. Secondly, as a matter of convention, financial regulators and analysts often treat preferred equity like debt. When a financial firm is in jeopardy of skipping preferred dividends, regulators become inclined to intervene their "prompt corrective action" mandate. Markets may view skipping preferred dividends as tantamount to a default, and question firm viablity, potentially leading to self-fulfilling distress.
The second issue may or may not be easy to address. Economists pay too little attention to the role of convention in shaping corporate finance, and even less attention to the dynamics of convention. If preferred equity is going to serve as a means of strengthening firm capital structures, we need to move to an equilibrium where occasional periods of missed dividend payments are normalized, and not taken as a death knell for a firm. Sure, skipping preferred dividends is usually bad news, just as it is not a good sign when firms cut common stock dividends. But a skipped dividend needn't signal a death spiral for a well-capitalized firm. Perceptions might change naturally if preferred equity managed to shed its tax disadvantage. Firms might then lever themselves to the hilt with preferred stock, and over a period of time, investors would observe viable companies go into brief arrears and then emerge. Regulators could help quite a lot by treating preferred equity as equity full stop rather than as a kind of pseudo debt. For financial firms, regulators should commit not to intervene if preferred payments are skipped or threatened, so long as the value (primarily the market value) of a firm's total equity base remains high. Regulators should treat preferred equity as high risk capital. Regulated insurers, pension funds, etc. should be required to invest as if preferred shares are no less risky than common stock. Regulators should make it clear that during resolutions, preferred shares would go to zero as easily as common if any payout is made on guaranteed liabilities.
Control issues may be more difficult to address, but not impossible. In one of several very helpful e-mails, Economics of Contempt pointed out that
[D]ebenture indentures have included a wide range of covenants over the years that were designed to serve as early warning systems (e.g., the negative pledge clause). No need to reinvent the wheel.
Debt covenants are the means by which divergence of interests within firm capital structures are usually addressed. Lenders do not explicitly exercise control over firms, but they can attach very stringent conditions to loans that limit the ability managers and stockholders to gamble with creditors' money. Lenders hold a very big stick — if covenants are violated, they can demand immediate repayment of funds that will usually have already been spent. Debt covenants are violated quite frequently, but firms are not often forced to liquidate assets and cough up the cash. Instead, occasional violations allow lenders to renegotiate the terms of loans from a position of strength. So, even though lenders are not represented on a company's board of directors, their interests are protected both passively (firm managers strive not to violate covenants) and actively (when a covenant is breached — and they are designed to be breached easily — lenders can intervene to actively shape firm decisions).
Preferred stock can include covenants as well, but how to enforce them is a tricky question. It would defeat the purpose of replacing debt with preferred equity if preferred shareholders could force repayment upon a covenant violation. I know
very little nothing at all about how preferred stock covenants are written and work in practice. (Hint, hint, amazing commenters!) However, via Google books, I came upon the notion of "contingent proxy" in Raising Entrepreneurial Capital by John Vinturella and Susan Erickson. Apparently there is precedent for clauses that transfer voting rights as "a penalty for breach of covenant". This idea could be very helpful. As preferred shares become more equity-like and common shares take on properties of options, control might be transferred quite directly to preferred shareholders without a formal debt-to-equity conversion. Transfers of voting rights could be architected so as to be gradual. They might be a function of the degree to which a firm is in-arrears, rather than the mere fact of in-arrear-edness, so that common shareholders would not much surrender control during occasional, brief lapses. Preferred shareholder control rights could depend upon the full mix of the solvency and health metrics typically included in debt covenants, so that there is little incentive by firm managers to game any one potential trigger. Formal options to convert to common equity could gradually be extended as well. Obviously, devils are in the details, and I don't yet know enough to attempt an exorcism. But, as EoC reminds us, we don't have to reinvent the wheel. Investors up and down firm capital structures have been eying one another warily for centuries. We have millions of paranoid legal documents to draw ideas from.
It seems to me that the right species of "trigger convertible", in David Murphy's coinage might well evolve from negotiation and experimentation, if fairly minimal changes in policy were made. First, we desperately need to level the tax playing field between debt and equity. At the very least, the differential treatment of debt and near-debt-but-safer cumulative preferred equity needs to be eliminated. Secondly, for financial firms, regulators should radically increase capital requirements for financial firms. Bankers will do what they do best, which is to seek the cheapest means possible of pretending to hold capital by inventing the most debt-like equity that they possibly can. Regulators should scrutinize these instruments carefully, but only to enforce two very simple requirements — that under no circumstances are dividend or principal repayments obligatory, and that no agreements made between the different classes of equity encumber firm assets or compel behavior that would compromise the interests of claimants higher in the capital structure. (Regulators, and creditors, would have to guard against "poison pill" arrangements, in which some form of "equity" is cheap because purchases have some means of sabotaging the firm if they are not paid. But this is not a new problem, see the negative pledge clause in EoC's comment.)
Finally, regulators would have to severely curtail the ability of regulated entities from holding preferred equity. All equity securities should be treated like common stock for risk-weighting purposes. No matter how the contract is writtem, when a security acquires a sufficiently high weighting in the portfolios of insurance companies, pension funds, and banks, it acquires an implicit state guarantee that issuers will aggressively exploit. One lesson of the current crisis is that the distinction between debt and equity has less to do with the legal characteristics of securities than with the political connectedness, financial interconnectedness, and risk-bearing capacity of the entities who hold them. Equity securities, preferred or common, must be restricted to parties whose losses the state would tolerate.
|Steve Randy Waldman — Tuesday May 19, 2009 at 1:13am||permalink|