Economic Consequences of Regulation of Financial Reporting: The Case of Contingent Convertible Securities

Transcription

1 Economic Consequences of Regulation of Financial Reporting: The Case of Contingent Convertible Securities Carol A. Marquardt New York University Christine I. Wiedman University of Western Ontario Abstract. This paper examines the economic consequences of changes in the financial reporting requirements for contingent convertible securities (COCOs). Using a sample of 199 COCO issuers from , we find that issuers are more likely to restructure or redeem existing COCOs to obtain more favorable accounting treatment when the financial reporting impact is greater and when earnings per share (EPS) is used as a performance metric in CEO bonus contracts. These results indicate that firms are willing to incur costs to retain perceived financial reporting and compensation benefits. Consistent with these findings, we also provide evidence of significantly negative stock returns around event dates associated with the financial reporting changes, which suggest that investors expect COCO issuers responses to these changes to impose net costs upon the firm. Our findings contribute to the literature examining the effects of new accounting rules on managerial decision-making and shareholder wealth and also underscore the importance of diluted EPS to both managers and investors. Keywords: Economic consequences; agency costs; diluted EPS; executive compensation; convertible securities. JEL Classification: M41

2 Economic Consequences of Regulation of Financial Reporting: The Case of Contingent Convertible Securities This paper examines the economic consequences of changes in the regulation of financial reporting for contingent convertible securities. Contingent convertibles (COCOs) are convertible securities that cannot be converted into shares of common stock until a pre-specified stock price is reached; i.e., conversion is contingent upon reaching the price threshold. From the time of their first appearance in late 2000 through mid-2004, firms were able to postpone including the effects of the COCOs in diluted earnings per share (EPS) calculations until the necessary conditions for conversion were satisfied. Marquardt and Wiedman (2005) show that this perceived financial reporting benefit was the primary determinant of firms decisions to issue COCOs rather than traditional convertible bonds during this time period. However, in mid-2004, the Financial Accounting Standards Board (FASB) revised the financial reporting requirements for COCOs. Beginning with the first reporting period after December 15, 2004, COCOs would be included in diluted EPS calculations regardless of whether market-based contingences were satisfied. 1 In this paper, we examine two dimensions of the economic consequences arising from this accounting change. 2 First, we examine the responses of the COCO issuers to the new financial reporting requirements. In particular, we examine the determinants of managerial decisions to undertake costly restructurings or cash redemptions of outstanding COCOs that would mitigate the financial reporting impact of the new rule. Second, we examine the shareholder wealth effects associated with the rule change, including mean effects as well as cross-sectional variation in shareholder reactions. Our analysis is based on a sample of 199 COCOs issuers from 2000 to early Using multivariate probit analysis, we first examine managers decisions to either modify the terms of the COCOs to require cash rather than stock settlement of par values at conversion (which would effectively nullify the reporting effects of the new rule) or to redeem the COCOs for cash prior to the adoption date. We find that the likelihood of these events is positively associated with the impact of the rule change on diluted EPS, which suggests that managers trade off the costs of these actions against the perceived benefits of reporting a higher diluted EPS figure; i.e., they buy a better diluted EPS number. We further find that the likelihood of a 1 See EITF Issue No. 04-8, The Effect of Contingently Convertible Debt on Diluted Earnings per Share. 2 Consistent with Holthausen and Leftwich (1983, p. 77), we view accounting choices as having economic consequences if changes in the rules used to calculate accounting numbers alter the distribution of firms cash flows, or the wealth of parties who use those numbers for contracting or decision making.

3 restructuring or redemption is positively associated with firms use of EPS as a performance metric in CEO bonus contracts, which is consistent with agency costs. In addition, firm size and lobbying efforts against the proposed ruling are positively associated with the likelihood of restructuring or redemption, while financial leverage is negatively associated, which suggests that highly-levered firms are less able to bear the costs associated with these decisions. We also examine stock returns around announcement dates of restructurings and redemptions and find that mean and median three-day abnormal returns are significantly negative, which suggests that shareholders view these managerial decisions as value-decreasing. We examine the shareholder wealth effects associated with rule change in our second set of tests. Using standard event study methodology (Schipper and Thompson 1983), we examine shareholder wealth effects around six separate dates related to the financial reporting changes for COCOs and document significantly negative effects around three of these dates. We also accumulate returns across all six event dates and report a significantly negative shareholder reaction of approximately three percent of firm value, which suggest that shareholders expect the potential responses of COCO issuers to the rule change to impose net costs on the firm. Using the estimation procedure presented in Sefcik and Thompson (1986), we also examine cross-sectional variation in shareholder reactions around the event dates. Consistent with our predictions, we find that the impact of the financial reporting change on diluted EPS is a significant determinant of shareholder reactions. We further find that shareholder reactions vary cross-sectionally with the disclosure quality of COCO-related information, whether EPS is used as a performance metric in CEO bonus contracts, the degree to which COCOs are out-ofthe-money, and whether the COCOs are call-protected. Overall, the findings are consistent with investors viewing the rule change as resulting in increased agency and renegotiation costs for COCO issuers. Our results contribute to the accounting literature in several ways. First, we extend the stream of literature that examines the effects of new accounting rules on managerial decisionmaking. For example, Imhoff and Thomas (1988) examine the effects of SFAS No. 13 on the capital structure decisions of lessees and document a systematic substitution from capital to operating leases and nonlease sources of financing following adoption of the standard. Mittelstaedt et al. (1995) report that the financial reporting consequences of SFAS No. 106, which required recognition of post-retirement benefit (PRB) obligations, played a significant role in explaining reductions in these benefits, and Amir and Livnat (1996) find that late adopters of SFAS No. 106 were more likely to reduce PRB obligations by negotiating a plan 2

4 amendment than early adopters. More recently, Venkatachalam et al. (2005) show that firms accelerate vesting of employee stock options prior to the effective date of SFAS No. 123-R to avoid reporting an expense under the new standard, and Bens and Monahan (2005) provide evidence that U.S. banks restructure asset backed commercial paper conduits to avoid consolidation under FASB Interpretation No. 46. In empirically documenting the effect of the accounting change for COCOs on managerial decisions to restructure or redeem these securities, our study corroborates and extends previous findings in this stream of literature in a novel setting. However, a key distinction between our study and prior research is that the reporting changes we examine affect only diluted EPS; there are no income statement or balance sheet effects, as in the studies cited above. Our results thus provide compelling evidence that managers not only view diluted EPS as an important performance measure, consistent with Marquardt and Wiedman (2005), but will actually incur costs in order to report a higher figure. We are unaware of a similar finding in the accounting literature. We also contribute to the literature on the shareholder wealth effects associated with new accounting standards or other regulatory changes. Numerous studies have examined these effects, including Collins et al. (1981); Salatka (1989); Espahbodi et al. (1991); Espahbodi et al. (1995); Espahbodi et al. (2002); and Weber (2004). However, net income is affected in each of the rule changes examined in these studies. Our findings are unique in this literature in that we document significant shareholder wealth effects related purely to the reporting of diluted EPS, which underscores the importance that investors place on this financial measure. Relatedly, because diluted EPS is not generally used in financial contracts, the contracting cost arguments that are typically offered as an explanation for significant shareholder reactions around regulatory events, such as debt or political cost hypotheses, are less likely to apply. Instead, we are able to more closely focus on the role of agency costs in explaining shareholder reactions to the new accounting for COCOs, and our results are consistent with the existence of these costs. We thereby add new evidence to the stream of literature that attributes negative shareholder reactions around accounting rule changes to agency considerations. The remainder of this paper is organized as follows. Section 1 provides background on the financial reporting issues surrounding contingent convertible securities. In section 2, we develop our hypotheses regarding the managerial responses to the new reporting requirements, describe our sample, and present our empirical results from our probit analysis. In section 3, we 3

5 present our analysis of the shareholder wealth effects associated with the rule change, and in Section 4 we summarize our findings and conclusions. 1. Background COCOs are convertible securities that cannot be converted into shares of common stock until a pre-specified stock price, or conversion threshold, is reached. This is in contrast to traditional convertible securities, which may be converted into shares at any time. This convertible bond structure first appeared in late 2000 and quickly became a popular financing vehicle, with more than 300 firms issuing COCOs through the first half of Reports in the financial press attributed this growing popularity of COCOs to their financial reporting advantages over traditional securities (see Henry 2003). Marquardt and Wiedman (2005) provide a detailed discussion of the financial reporting effects associated with COCOs, which we briefly summarize here. Through mid-2004, SFAS 128 required that the effects of convertible securities be reflected in diluted EPS through application of the if-converted method. Under this method, after-tax interest charges are added back to the numerator, and the debt is assumed to be converted as of the beginning of the accounting period, with the resulting common shares included in the denominator. If, however, the shares were contingently issuable, then the dilutive effects of the securities were only included if the necessary conditions for issuance are satisfied at the end of the accounting period (see paragraph 30). As a result of this loophole in SFAS 128, firms could simply add contingent conversion to a traditional convertible security and postpone including its effects in diluted EPS until the conversion threshold was reached. Exhibit 1 illustrates these effects using Omnicom s 2003 financial statements. Omnicom Group Inc. issued three series of COCOs over for aggregate proceeds of $2.3 billion. All three series of COCO s were zero-coupon, zero-yield bonds with thirty-year maturities. Because the contingencies of these COCOs were not satisfied by the end of 2003, the dilutive effects of the combined offerings were excluded from their reported diluted EPS of $3.59 for that year. Had these effects been included, Omnicom would have reported diluted EPS of only $3.26. Omnicom is thus able to increase its reported profitability by over 10% by simply adding a contingent conversion feature to a traditional convertible bond. 4

6 Marquardt and Wiedman (2005) provide empirical evidence that these financial reporting effects are indeed the primary determinant in the decision to issue COCOs. 3 They further show that firms bear minimal costs in choosing to issue COCOs rather than traditional convertible bonds, which is consistent with their growing popularity through the first half of In fact, by mid-2004, approximately 85% of all U.S. convertibles issuers included contingent conversion features. However, during 2004, the FASB began to take notice of the COCO phenomenon. First, in early 2004, the FASB released Staff Position 129-a, Disclosure Requirements under FASB Statement No. 129, Disclosure of Information about Capital Structure, Relating to Contingently Convertible Securities in response to constituents concerns that COCO-related disclosures were inconsistent between companies or inadequate in communicating necessary information to users of financial statements. 4,5 FAS 129-a proposed that COCO issuers disclose the significant terms of the conversion features to enable users to understand the circumstances of the contingency and the potential impact of conversion. It also required issuers to indicate whether issuable shares are included in diluted EPS and the reasons why or why not. These proposed disclosure requirements did not engender much controversy, if the comment letters are any indication. Only the Big 4 accounting firms offered comment letters, and all four voiced support for the proposed disclosures. At the end of 45-day comment period, the FASB posted the final draft of FAS 129-1, which became effective immediately, to its website. The mandated disclosure pronouncements were only the beginning of the FASB s actions. In May 2004, the Emerging Issues Task Force (EITF) added Issue No. 04-8, The Effect of Contingently Convertible Debt on Diluted Earnings per Share, to its agenda for its next meeting, scheduled for June 30 th and July 1 st. Discussion materials distributed before the 3 In addition to the financial reporting benefits, Marquardt and Wiedman (2005) also show that the use of earningsbased CEO bonus plans, reputation costs, free cash flows, and tax factors play significant roles in the decision to issue COCOs rather than traditional convertible bonds. 4 Equity analyst reports during this time (see, e.g., Gainey 2004) similarly characterized overall COCO-related disclosure as generally poor if the goal is to alert and inform analysts and investors of the existence of these instruments and their impact on the financials. 5 In February 2003, the FASB introduced the FASB Staff Position (FSP) to issue application guidance like that previously found in Staff Implementation Guides and Staff Announcements. Before issuing an FSP, the FASB staff circulates a draft of a proposed FSP to Board members for review. If a majority of the Board does not object to the proposed FSP, it is announced at an open public meeting of the Board. Following the meeting, the proposed FSP is posted to the FASB website for a comment period and is announced in that day s Action Alert. At the end of the comment period, the FASB staff drafts the final FSP. As with the proposed FSP, if a majority of the Board does not object to the final FSP, it is posted to the FASB website and announced in the Action Alert. The FSP is intended to ensure more timely and consistent communication about the application of FASB literature than the previous procedures that were in place (see 5

7 meeting expressed the view that the contingencies in COCOs do not have economic substance and are included solely to secure favorable accounting treatment under SFAS 128. On July 1, 2004, the EITF reached a tentative consensus that COCOs should be included in diluted earnings per share computations regardless of whether market-based contingencies have been met. In addition, the EITF proposed that prior period EPS amounts presented for comparison purposes be restated to conform to the new accounting treatment. The EITF s decision received some coverage in the financial press, as well as in equity analyst reports. The Wall Street Journal reported on the proposed changes on July 6 th and 8 th, and a Bear Stearns equity research report dated July 2, 2004 (see McConnell et al. 2004), described the EITF s tentative conclusion as a surprise and stated that confirmation of the tentative decision was expected at the next EITF meeting, scheduled for late September Furthermore, both sources predicted that the proposed accounting change would hurt the COCO market, at least temporarily while issuers waited for the FASB s final decision. This prediction proved to be correct -- Risk Magazine later reported on the downturn in the convertible bond market in a September 2004 article, noting in reference to investment bankers frequent exploitation of accounting rules that loopholes can sometimes turn into nooses. The FASB posted the draft abstract of Issue No to its website in mid-july 2004 and invited comments by constituents. Of the 32 comment letters posted to the FASB s website, 31 expressed opposition to some aspect of the proposed accounting change, and only one, written by an equity analyst, praised the move. Despite the views expressed in the overwhelming majority of the comment letters, the EITF reaffirmed at their Sept. 30, 2004 meeting their earlier tentative decision that COCOs should be included in diluted EPS calculations regardless of whether market contingencies are satisfied. They also agreed that this treatment should be applied retroactively as of the adoption date of the consensus i.e., the end of the first reporting period after December 15, The EITF also discussed at their September meeting what they termed the unique transition provisions for Issue 04-8, which would allow COCO issuers to avoid restatement or even the use of the if-converted method of calculating diluted EPS altogether: Diluted earnings per share of all prior periods presented for comparative purposes should be restated to conform to the consensus guidance. For instruments within the scope of this Issue whose terms have been modified prior to the date of adoption of this consensus, the consensus would apply to terms of the instrument in place at the date of adoption, and diluted earnings per share of all prior periods would be restated based upon the modified terms. For instruments within the scope of this Issue that have been cash settled before the 6

8 date of adoption, restatement of diluted earnings per share is not required; however, for instruments that have been converted or stock settled before the date of adoption, restatement of diluted earnings per share for all prior periods presented is required to conform to the consensus guidance. The above transition rules allow issuers to avoid restatement of diluted EPS if they redeem outstanding COCOs for cash prior to the adoption date. The transition provisions also allow issuers to modify the terms of the COCOs prior to the adoption date to reduce their dilutive effect. In particular, if the bond indentures are amended to require, upon conversion, cash settlement of par values and stock settlement of any excess over par (now referred to as net shares convertibles), then issuers would be able to apply the treasury stock method rather than the if-converted method of calculating diluted EPS to any outstanding COCOs, which would greatly reduce their effect on diluted EPS. The FASB ratified the EITF s consensus decision in mid-october These events provide a unique setting in which to examine both managerial and investor responses to a change in financial reporting requirements. In addition, because the mandated changes affect only diluted EPS, with no income statement or balance sheet effects, this setting allows us an opportunity to assess the importance of the diluted EPS measure to both managers and investors. 2. Managerial responses to EITF Hypothesis development Restructurings and redemptions In this section we develop our hypotheses regarding managerial responses to the financial reporting changes for COCOs. Applying the if-converted method to COCOs regardless of whether market-based contingencies have been satisfied, as mandated by EITF 04-8, will decrease most COCO issuers diluted EPS figures for 2004 and thereafter, as well as for any prior periods in which COCOs were outstanding. 6 However, as per the transition rules described above, issuers may avoid reporting a decrease in diluted EPS if they either redeem the COCOs for cash prior to the adoption date of the ruling, or if they amend the bond indentures to require cash settlement of par values and stock settlement of any excess over par at conversion. We consequently focus our analysis of managerial responses to the ruling on these two possible choices. 6 In cases where the COCOs are anti-dilutive to EPS, or where the contingency has been met, the accounting change will have no effect on diluted EPS. 7

9 Cash redemptions of COCOs are perhaps the most obvious solution to the financial reporting problem posed by the new accounting rule. Issuers could simply call the bonds and settle them for cash without issuing additional shares. Because the COCOs would no longer exist, they would not need to be included in diluted EPS for the current year; issuers would also avoid restatement of past periods. However, virtually all COCOs are call-protected for three to five years after issuance. Therefore, few COCO issuers would be able to take this course of action. In addition, in cases where call protection has expired (or will expire prior to the adoption date), this response is costly to implement, as it requires either the use of available cash or, if cash is not readily available, additional financing equal to the par value of the COCOs. Also, if it were optimal from a corporate financing perspective to redeem the COCOs for cash, the issuers should have already done so prior to EITF These issues render it unlikely that many COCO issuers will opt for redemption in responding to the change in reporting requirements, though some may view the benefits of redemption as exceeding the costs. The transition rules of EITF 04-8 also allow issuers to avoid restatement and use of the if-converted method of calculating diluted EPS if they restructure their COCOs prior to the adoption date. Specifically, the bond indentures must be amended to require cash settlement of par values and stock settlement of any excess over par; issuers would then be able to apply the treasury stock method of calculating diluted EPS to any outstanding COCOs. 7 Because most COCOs are issued far out-of-the-money with high conversion premiums, treasury stock treatment will effectively exclude COCOs from diluted EPS until the conversion price is met, and even then will generally result in a much smaller impact on diluted EPS than under the ifconverted method. However, restructurings impose costs. In cases where the issuers may elect to settle in stock or cash, issuers must irrevocably elect to settle in cash, thereby relinquishing financial flexibility as they lose the option to settle the COCOs in stock. 8 In cases where issuers had 7 The impact of COCOs on diluted EPS under the treasury stock method depends on the company s stock price. If the average stock price for the period is below the conversion price of the COCOs, then diluted EPS would be unaffected, as only COCOs that are in-the-money would have a dilutive effect on EPS. As the average stock price rises above the conversion price, the treasury stock method would require that shares be added to the denominator of diluted EPS, computed as the conversion value less the principal amount of the securities divided by the share price. 8 Specifically, the FASB did not allow issuers to simply state an intention to settle conversions in cash rather than stock, as General Motors (GM) publicly announced it would on August 5, GM had $8 billion of COCOs outstanding and faced a possible decrease in its forecasted diluted EPS for 2004 of $1.00 from $7.00 if the proposed accounting change was ratified. The company announced that it would settle any conversions of its COCOs in cash rather than stock, thereby effectively nullifying the effects of the proposed change on its diluted 8

10 agreed to settle in stock, an exchange offer is necessary to amend the bonds to require cash settlement. In addition to any legal and underwriting fees associated with the transaction, the issuer also bears the costs of any sweeteners typically included in exchange offers to entice the security holders to complete the exchange. These sweeteners may include: cash payments (in the case of the COCO exchange offers, 25 basis points per $1000 face value bond is typical); additional put options; additional call protection; cash takeover protection; dividend protection; or a combination of the above. And, as in the above case of irrevocable elections, the issuer again loses financial flexibility in committing to cash settlement. The following is an example of a restructuring. On October 26, 2004, PPL Corp. announced that it was offering to pay $2.50 in cash for each $1,000 in principal amount of convertible notes to amend the provision of the original notes through an exchange offer, with the new securities requiring cash settlement of par values. Their news release stated: The accounting rule changes themselves do not change the underlying cash flows of PPL. However, given investors' valuation focus related to the diluted earnings per share calculation, PPL is seeking to modify the terms of the convertible notes to mitigate the dilutive earnings per share impact of these accounting rule changes. PPL believes that the proposed modifications are in the best interest of its investors, including the holders of the convertible notes. This suggests that this company was willing to pay $1 million to restructure the entire $400 million COCO issuance to avoid a decrease in reported diluted EPS (forecasted diluted EPS was predicted to decrease from $3.66 to $3.54). For firms with larger issuances, such as General Motors and Omnicom, the out-of-pocket costs would be significantly higher, and, of course, this cost estimate does not include any legal or underwriting costs, or the firm s loss of financial flexibility. However, as PPL s new release suggests, some firms clearly believe that the benefits of modifying the bond indentures is worth the associated cost. We examine managerial decisions to either redeem for cash or to restructure the COCOs as net shares convertibles using multivariate probit analysis. While both responses mitigate the financial reporting effects of EITF 04-8, they do not bear the same explicit costs, and redemptions could be undertaken for reasons other than the rule change. 9 We therefore conduct EPS figure (Boudette 2004). However, after the transition rules of EITF 04-8 were ratified, GM followed up its original announcement with an irrevocable election by the board directors on November 5, 2004 to settle par values in cash, thereby securing their right to apply the treasury stock method of calculating diluted EPS to their outstanding COCOs. 9 Brennan and Schwartz (1977) present conditions under which it is optimal to call convertible bonds. 9

11 our empirical analysis of managerial responses to the rule change by first examining only restructurings and then adding redemptions to the analysis. 10 We predict that firms will be more likely to incur restructuring or redemption costs when the perceived financial reporting benefits provided by COCOs are greater, when the personal benefits to managers are higher, and when the relative costs are smaller. We consequently expect the following factors to relate to the restructuring/redemption choice: 1. Financial Reporting Effects. We predict that managers are more likely to undertake costly restructurings or redemptions of COCOs when the financial reporting effects are relatively large, as perceived benefits are assumed to be increasing with the reporting effect. We measure financial reporting effects using two variables. The first is IMPACT, defined as the difference between firms First Call annual diluted EPS estimate for 2004 minus the comparable figure that would result if all outstanding COCOs were immediately included in diluted EPS, divided by share price. 11 If the COCOs are anti-dilutive, then IMPACT equals zero; IMPACT is thus always a non-negative amount. When the impact on diluted EPS is large, firms have greater incentive to maintain any financial reporting advantages gained from issuing the COCOs in the first place. We consequently expect a positive association between the likelihood of restructuring or redemption and IMPACT. The perceived financial reporting benefit provided by COCOs also depends on whether the securities conversion threshold has been reached. Once the issuing firm s stock price exceeds the conversion threshold, the financial reporting advantages vanish because firms must now apply the if-converted method of calculating diluted EPS to the COCOs. We consequently predict that firms with stock prices in excess of the conversion threshold are less likely to restructure their COCOs. We create an indicator variable, TRIGMET, that equals one if the stock price threshold for conversion of the COCOs had been met as of July 1, 2004, and zero otherwise. 12 We expect a negative association between TRIGMET and the likelihood of restructuring or redemption. 2. Bonus Contracts. We also expect compensation contracts to affect the restructuring or redemption decision. Managers compensated on EPS will be eager to maintain at least some of the reporting advantages associated with COCOs by amending the conversion terms of the security. We create an indicator variable, BONUS, that equals one if EPS is explicitly mentioned 10 Unfortunately, the small number of redemptions (six) prevents us from carrying out a separate analysis of this response. 11 We have forecasts of 2004 annual diluted EPS as of September 30, We divide the forecast by the share price as of February 18, 2004, that is, the share price one week before our first regulatory event occurs. 12 Reliable data on price thresholds is available only as of June

12 in firms 2003 proxy statements as one of the determinants of annual cash bonuses for the CEO and zero otherwise. 13 We predict a positive association between the likelihood of restructuring and the BONUS variable. 3. Lobbying Efforts. We also consider firms lobbying efforts against EITF 04-8 as a determinant of the restructuring or redemption decision. Prior research on corporate lobbying suggests that firms most affected by an accounting change are more likely to lobby against it. For example, Dechow et al. (1996) find that the likelihood of submitting a comment letter opposing mandatory expensing of employee stock-based compensation is strongly related to the use of stock options in top-executive compensation, and Deakin (1989) finds that lobbying behavior around a series of changes to oil and gas accounting rule changes in the 1970 s is based on the expected economic effects of the changes on the firm or its management. Firms that expect to incur greater costs if EITF 04-8 is approved should be more likely to lobby against its ratification. We consequently predict a positive association between lobbying efforts against EITF 04-8 and the likelihood of COCO restructuring. We define an indicator variable, COMMENT, that equals one if the firm submitted a comment letter to the FASB opposing the ratification of EITF 04-8, and zero otherwise. We predict a positive association between COMMENT and the likelihood of restructuring. 4. Ability to bear costs of restructuring. We predict that the ability to bear the costs of COCO restructuring will also affect firms decisions to undertake these transactions. Because firms relinquish a degree of financial flexibility when they commit themselves to cash rather than stock settlement of par values, we predict that the likelihood of COCO restructuring or redemption is positively associated with free cash flows (FCF), and negatively associated with leverage (LEV), as firms with high free cash flows and low leverage are better able to give up this flexibility in financial planning. We define FCF as operating cash flows minus capital expenditures, divided by total assets, and LEV as total liabilities divided by total assets. Both are measured as of the end of fiscal In addition, exchange offers generally include a sweetener to entice the security holders to complete the exchange. In general, we expect more profitable firms to be better able to provide these inducements and therefore predict a positive association between the likelihood of COCO restructuring and firms return on assets (ROA), where ROA is defined as net income divided by beginning period total assets for fiscal We obtain this information from the Report of the Compensation Committee within the proxy statement. This report typically outlines the general compensation philosophy and then provides details about the CEO s compensation more specifically. 11

13 5. Expiration of Call Protection. In our analysis that includes the redemption decision, we control for the ability of the firm to redeem the COCOs for cash by including an indicator variable, CALLEXP, that equals one if the COCO security s call protection period has expired prior to the adoption date of EITF 04-8, and zero otherwise. We expect CALLEXP to be positively associated with the likelihood of redemption. 6. Firm Size. Lastly, we include firm size as a control variable in our analysis of firms restructuring decisions. The costs of restructuring may be relatively smaller for large firms, as underwriting costs and other fees associated with the restructuring typically decrease as a percentage of the total dollar value of the offering. Therefore predict a positive association between firm size (SIZE) and the likelihood of COCO restructuring, where SIZE is defined as above. To summarize, we expect the likelihood of COCO restructurings and redemptions to be positively associated with IMPACT, BONUS, COMMENT, FCF, ROA, CALLEXP, and SIZE and negatively associated with TRIGMET and LEV. We present two models, as follows: Pr( RESTRUCTURE) = β + β IMPACT + β TRIGMET + β BONUS + β COMMENT β ROA + β FCF + β LEV + β SIZE + ε (1) Pr( RESTRUCTURE / REDEEM ) = β + β IMPACT + β TRIGMET + β BONUS + β COMMENT β ROA + β FCF + β LEV + β CALLEXP + β SIZE + ε. ( 2) In equation 1, we define our dependent variable, RESTRUCTURE, as an indicator variable that equals one if the firm restructured at least one of its outstanding COCOs between July 1, 2004 and the adoption date of EITF 04-8, and zero otherwise. In equation 2, we define RESTRUCTURE/REDEEM as an indicator variable that equals one if the firm restructured or redeemed the COCOs for cash between July 1, 2004 and the adoption date of EITF 04-8, and zero otherwise. We obtained information regarding firms restructuring/redemption activities from press release data available from their corporate websites. If there was no press release announcing an exchange offer, an irrevocable election to settle COCO par values in cash, or a cash redemption of the COCOs, we then examined 8-K and registration statements for each firm through the SEC s Edgar website to ensure that the dependent variables are properly coded. 14 All other variables are as defined above. 14 To the extent that firms respond to EITF 04-8 through means other than exchange offers or irrevocable elections to settle par values in cash rather than stock, there is potential for measurement error in our RESTRUCTURE 12

14 2.2 Sample Selection and Descriptive Statistics We obtained our convertible securities data from Kynex, Inc., a risk-management firm that maintains an extensive database of active convertible securities in the U.S. market. Our original sample included 234 firms that issued COCOs from the time of the initial Tyco offering in November 2000 through February 15, 2004, which is one week before the first event date included in our analysis of the shareholder wealth effects associated with the rule change. For firms with multiple offerings, we include only the first offering over the sample period - the majority of sample firms in our sample had only one offering. Of these firms, 207 were also covered in a Bear Stearns report that analyzed the impact of the COCOs on 2004 forecasted EPS and from which we obtain data to estimate our IMPACT and TRIGMET variables. Four firms were eliminated because Compustat company identifiers were not available, and 4 additional firms did not have price / returns data available on CRSP. Our final sample includes 199 firms. Table 1 presents descriptive statistics for the 199 COCO offerings in our sample. The mean (median) COCO offering is $372.4 ($201.0) million, representing 13.7% (9.7%) of total assets. COCOs have long maturities, with a mean (median) of 21.6 (20.0) years, and are typically call-protected for five years. The majority of offerings (91%) offer at least one put, on average 4.9 years from the issue date. Further, 85% offer a second put, on average 8.6 years from the issue date. Consistent with the relatively low interest rates over our sample period, mean (median) coupon rates are 2.4% (2.5%) and yields are 3.0% (2.9%). The mean (median) conversion premium of 39.5% (36.3%) is quite high relative to that of traditional convertibles, but is consistent with the addition of the COCO feature. 15 Further, the contingency feature of the convertible security is expressed as a fixed percentage of the conversion price for 197 of the 199 sample firms, with the percentage ranging from ranging from 110 to 145% of the conversion price, but set to 120% for the majority of firms. In only two cases (Interpublic and Omnicom) did the trigger increase over time. Finally, 83% of the COCOs are 144a private placements. We present the industry membership of sample firms in Table 2. Our sample of 199 COCO issuers is well-distributed across 35 of 48 possible industry categories, as defined by Fama and French (1997). For comparison purposes, we also provide the distribution of all 2003 Compustat firms; in general, the distribution of COCO issuers appears representative of the variable. For example, firms may initiate or accelerate stock repurchase programs to offset the dilutive effects of EITF A preliminary review revealed no evidence that such responses were taken by sample firms, perhaps because such action would impact basic as well as diluted EPS. In addition, any misclassification error will bias our tests against finding significant differences across the two groups. 15 Prior to EITF 04-8, a high conversion premium ensured that the dilutive effects of the COCOs would be excluded from diluted EPS over a longer time period, as the stock price would have to rise even higher before conversion conditions were satisfied. 13

15 greater Compustat population. This broad industry representation suggests that the potential problem of cross-sectionally correlated residuals, which is a particular concern in our analysis of the shareholder wealth effects, is less of a problem in our sample. In addition, the generalizability of our results is likely to be enhanced by wide industry membership. 2.3 Results Restructurings and redemptions EITF 04-8 presented transition rules that allowed firms to redeem for cash or restructure their COCOs to qualify for preferred accounting treatment. Forty firms in our sample modified the terms of at least one outstanding COCO between July 1, 2004 and the adoption date of EITF Further, twelve firms in the sample had COCOs outstanding where the call protection on the bonds had expired, and six of these twelve firms redeemed their debt for cash prior to the adoption date. While the restructurings are clearly linked to EITF 04-8, the rationale behind the cash redemptions is somewhat less clear. In light of this, we conduct two separate analyses. In the first, we exclude the redemptions and compare the 40 RESTRUCTURE firms with the 153 firms that did not restructure or redeem their bonds. In the second analysis, we include the redemptions with the restructurings and compare these 46 RESTRUCTURE/REDEEM firms to the 153 NON-RESTRUCTURE firms. 16 Table 3, Panel A presents the results from univariate tests of differences in our variables of interest. We find that the RESTRUCTURE firms face a greater potential IMPACT on diluted EPS than non-restructure firms (p-values of and for the t-test and Wilcoxon tests, respectively) and that the stock prices of RESTRUCTURE firms are, on average, less likely to have met the COCOs conversion threshold (p-values of and , for the t-test and Wilcoxon test on TRIGMET, respectively). Most notable, however, are the differences in BONUS, COMMENT, and SIZE. EPS is explicitly mentioned as a determinant of CEO annual cash bonuses for 57.5 percent of the RESTRUCTURE firms but only 34.0 percent on the non-restructure firms (p = 0.01). Further, 27.5 percent of the RESTRUCTURE firms submitted comment letters to the FASB opposing EITF Issue No while only 3.3 percent of non-restructure firms did (p = 0.01). SIZE is also significantly higher for RESTRUCTURE firms (p = 0.01). Differences in ROA, FCF, and LEV do not attain statistical significance in the univariate tests. As shown in 16 To more rigorously examine alternative motivations for early redemption, it would be necessary to identify a control sample of non-contingent convertible securities, specify a prediction model of early redemption, and compare the probability of redemption across the two groups. As noted earlier, the very small number of redemptions prevents our undertaking a more thorough analysis. 14

16 Table 3, Panel B, inferences from our univariate tests are unchanged when we include the firms that redeemed their COCOs for cash with the RESTRUCTURE firms. Multivariate tests of our empirical predictions are presented in Table 4. This table reports the estimated coefficients and significance levels from a multivariate probit analysis of the dependent variable RESTRUCTURE on the nine variables hypothesized to affect the restructuring decision. In Model 1, the six firms who redeemed their debt are excluded. In Models 2 and 3, these firms are included with the RESTRUCTURE firms. In general, our findings are consistent with our predictions. In Model 1, we find that the decision to restructure the COCO prior to the adoption date is positively related to IMPACT (p=0.0124), BONUS (p=0.0409), COMMENT (p=0.0049), and SIZE (p=0.0394) and negatively related to LEV (p=0.0409). TRIGMET, ROA, and FCF are not significant at conventional levels. The pseudo-r 2 for the model is 19.8 per cent. 17 In Models 2 and 3, we include the six firms who redeemed their COCOs. Results are very similar to Model 1, except that the negative coefficient for TRIGMET becomes marginally significant at p= and p= for Models 2 and 3, respectively. Further, CALLEXP is significantly positive in Model 3 (p=0.0003) as predicted, since only those firms whose call protection had expired were able to redeem their bonds. 18 In summary, our results suggest that firms with greater incentives to maintain the perceived financial reporting benefits originally provided by COCOs, as reflected in IMPACT and BONUS, were also the ones more likely to bear the costs of restructuring these securities. Further, results for LEV provide evidence that firms with lower leverage were better able to bear the cost of reduced financial flexibility resulting from these restructurings. Our findings of a positive association between the decision to restructure and firm size are consistent with restructurings being less costly for large firms. These results also build on Marquardt and Wiedman (2005), who find that both IMPACT and BONUS were significant determinants of the original decision to issue COCOs rather than traditional convertible securities. However, Marquardt and Wiedman (2005) also conclude that 17 To assess potential multicollinearity for our multivariate analysis, we compute condition numbers of the matrices of explanatory variables (Greene 2003). Condition numbers between 30 and 100 indicate moderate to strong dependencies among the variables (Judge et al. 1985). The highest condition number for the matrix of explanatory variables in all three models is less than 18.0, indicating that multicollinearity is not a problem. 18 As an additional sensitivity test, we also exclude the firm 3M from the sample. This company did not restructure its COCO, but also did not comply with EITF The company argued in its K that due to the FASB s delay in issuing SFAS No. 128R and the Company s intent and ability to settle this debt security in cash versus the issuance of stock, the impact of additional diluted shares will not be included in the diluted earnings per share calculation until SFAS No. 128R is effective. Results are very similar for all three models when 3M is excluded. 15

17 firms experience only minimal costs when issuing COCOs, while, in contrast, our analysis of COCO restructurings reveals that issuers incur significant costs in order to maintain the financial reporting benefits associated with COCOs. These results also complement recent findings by Erickson et al. (2004) that shows firms are willing to incur costs, namely higher taxes, when they inflate accounting earnings. Further, to confirm that investors viewed COCO restructurings as costly, we examine shareholder returns around announcements of restructurings and report significantly negative market-adjusted returns in a three-day window around announcement dates. Mean (median) abnormal returns are 0.75% (-0.97%) with a p-value of (0.0139). These findings of significantly negative shareholder reactions around restructuring announcement dates further suggest that investors viewed the costs of restructuring as exceeding any potential benefits, thereby representing an agency cost to shareholders. We examine the shareholder wealth effects associated with rule change more fully in the following section. 3. Shareholder wealth effects 3.1 Mean shareholder wealth effects Hypothesis development Holthausen and Leftwich (1983) view accounting choices as having economic consequences if they affect the wealth of parties who use those numbers for contracting or decision making. Therefore, to complete our exploration of the economic consequences associated with the financial reporting changes for COCOs, we examine the investor reaction to events relating to the new accounting requirements. 19 In particular, because our analysis of managerial responses in the previous section suggests that the rule change led to increased agency costs for COCO issuers, we are especially interested in determining whether investors were able to anticipate these costs when the rule changes were initially announced. Table 5 provides the date for each regulatory pronouncement and summarizes the event. Events D1 and D2 relate to FASB Staff Position 129-a, which mandated footnote disclosure of COCO-related information, and events R1 through R4 relate to EITF 04-8 and the recognition of COCOs in diluted EPS. 19 Ideally, we would also examine the bondholder wealth effects associated with EITF 04-8 but are unable because the overwhelming majority of COCOs are 144a private placements. 16

18 3.1.1 Disclosure events We first explore the investor reaction to the release of FASB Staff Position 129-a and 129-1, which mandated disclosure of COCO-related information in firms financial statements. Because FSP 129 was initiated in response to FASB constituents concerns over poor disclosure, we expect that its release will increase the quality and amount of information available about firms outstanding COCOs. Specifically, the required disclosure should provide enough information to permit financial statement users to apply the if-converted method of calculating diluted EPS. If, as equity analysts argue, that investors were previously unable to perform this calculation, and, as shown empirically by Marquardt and Wiedman (2005), that managers primary motivation in issuing COCOs was to manage diluted EPS upwards, then the new disclosure requirements should render any past or future earnings management attempt through this means transparent to financial statement users. This increased transparency regarding earnings management could affect stock prices either positively or negatively. On the one hand, mandating full disclosure of COCO-related information could serve a corporate governance role, as managers may now be less likely to issue COCOs purely for earnings management motives. This suggests that improved disclosure of COCO-related information would be value increasing and that shareholders would react positively to news of the mandated disclosure requirements. Lo (2003) presents evidence consistent with this governance improvement hypothesis in his examination of the 1992 revision of executive compensation proxy disclosures. Alternatively, there may be costs associated with increased disclosure that are value decreasing. Grossman (1981) and Milgrom (1981) show that a full disclosure equilibrium is possible only in the absence of disclosure costs. The marked variability that Gainey (2004) documents in COCO-related disclosure practices prior to 2004 indicates that a full disclosure equilibrium was clearly not in place, consistent with the presence of such costs. For example, if investors were not aware that COCOs were excluded from diluted EPS calculations, or were uncertain about the extent of their impact on diluted EPS, then disclosures that reveal this information may be costly to COCO issuers. Also, prior to the mandated disclosure changes, COCO issuers had already determined their optimal disclosure level regarding COCO-related information. Requiring greater disclosure will result in suboptimal levels for at least some firms. This suggests that stock prices will react negatively to regulations requiring greater disclosure of COCO-related information. 17