142 K.M. Torabzadeh et al. International Review of Economics and Finance 9 2000 139–156
on the bond prices. Section 3 defines the sample, data, and methodology. Section 4 presents and discusses the results, while Section 5 concludes the paper.
2. Hypotheses
The decision to finance via a bond issue and the type of covenants to be included involves at least three parties: shareholders, management, and prospective bondhold-
ers. Various hypotheses have been advanced as to how the relations among these groups affect the capital structure of the firm. These hypotheses are mainly based on the
presence of asymmetric information. Asymmetry of information between shareholders and management gives rise to a principal-agent problem that provides the foundation
for the managerial entrenchment hypothesis. In this context, Schleifer and Vishny 1989 argue that managers counter disciplinary forces i.e., the board of directors,
labor monitoring, takeover threats by making themselves valuable and costly to replace. One of the choices available to them is to sign a debt contract that includes
a covenant requiring full repayment if the firm is acquired.
5
Harris and Raviv 1988, Stulz 1988, Israel 1991, and Hendershott 1991 focus on the managerial entrenchment behavior in connection with the defensive takeover
role of financial leverage. Although the analyses differ, all agree that taking on addi- tional debt reduces the probability of takeover. Harris and Raviv 1988 and Stulz
1988 argue that this happens because managers use the proceeds from new debt to repurchase outstanding shares. As a result, the proportion of managerial equity
ownership increases, causing the probability of a hostile takeover to decrease. Israel 1991 maintains that a takeover by more efficient management increases the value
of the firm. The level of debt affects the distribution of this gain among various parties including the target’s shareholders and debtholders and the acquirer’s shareholders.
It is shown that the level of debt inversely affects the portion of the gain accumulating to the acquirer. Thus, the probability of takeover decreases as the target’s debt increases.
Hendershott 1991 explains the debt-takeover relation in a signaling context. He builds his model based on the notion that an increase in debt increases the probability
of bankruptcy which, in turn, reduces the welfare of management. At some level of debt, the expected benefit of control drops to the point at which an inefficient manager
will prefer to lose control of the firm rather than to issue a large amount of debt. On the other hand, efficient managers are able to accumulate additional debt without
increasing the probability of bankruptcy to an untenable level. This will lead efficient managers to signal their type by accumulating debt to a level not affordable to ineffi-
cient managers. Subsequently, acquirers will go after low debt firms. It follows that debt and probability of takeover are negatively related.
Issuing bonds with poison covenants distorts the signaling function of debt as explained by Hendershott 1991. Current management can still increase the costs of
takeover for a bidder without necessarily increasing the probability of bankruptcy. They achieve this by issuing a smaller amount of debt but with a poison covenant.
By introducing this asymmetry, inefficient managers can protect themselves from the discipline of the takeover market. In this situation the interests of management and
K.M. Torabzadeh et al. International Review of Economics and Finance 9 2000 139–156 143
bondholders are somewhat aligned through the protection extended to the bondhold- ers. Cook and Easterwood 1994 provide evidence for this “mutual interest hypothe-
sis.” They measure the wealth effect of issuing debt with and without poison put covenants on the outstanding debt and equity. Their sample of bonds with poison put
covenants consists of 63 bonds issued in the period of 1988 to 1989. They find that the presence of poison puts affects current stockholders negatively and existing bond-
holders positively. They conclude that the issuance of bonds with poison put covenants protects managers from hostile takeovers and bondholders from event risk, at the
expense of stockholders. Their findings, however, are in contrast to those reached by Bae et al. 1994. These authors use 83 E-rated bonds issued from 1982 to 1990 to
examine the effect of poison put provisions on stockholder wealth. Similar to Cook and Easterwood, they utilize an event-study methodology but find positive stock price
response to the announcement of an issuance of bonds with event-risk protection. Their regression analysis indicates that the presence of event-risk covenants increases
shareholder wealth primarily by reducing the firm’s agency costs of debt. Their findings basically support the argument offered by Kahan and Klausner 1993. Although they
maintain that managerial entrenchment is the primary motivation behind the issuance of poison bonds, Kahan and Klausner argue that to the extent that bondholders pay
for the protection by accepting a lower interest rate, the increased value accrues to the benefit of shareholders.
In sum, event-risk covenants can be designed to entrench managers andor provide protection to the bondholders. However, the yield effect, at the time of the issue,
depends on the bondholder’s perception of the structure of the covenant. We expect to see a positive reaction in the bond market when the option to put the bond back
to the firm is at the discretion of bondholders. Having this attribute, we hypothesize that bonds with super and simple poison puts are priced to yield lower return compared
to other comparable bonds without such covenants.
We suggest a different scenario for bonds with poison call provisions. These cove- nants are under the control of managers and are viewed as a mechanism to force the
prospective bidders to negotiate directly with them. These covenants, in return for some payoff for management, can be easily negated without bondholders’ recourse.
For this, we hypothesize that bonds with poison call provisions convey negative infor- mation to the bond market and tend to increase borrowing costs to the firm.
3. Sample, data, and methodology
