Effects of law on corporate financing practices—international evidence from convertible bond issues

Journal of Corporate Finance 11 (2005) 809 – 831 www.elsevier.com/locate/econbase

Effects of law on corporate financing practices—international evidence from convertible bond issues Timo P. KorkeamakiT School of Business Administration, Gonzaga University, Spokane, WA 99258, United States Received 2 June 2003; accepted 16 October 2004 Available online 10 May 2005

Abstract Firms can adjust their convertibles to be more debt-like or equity-like through several contract terms. In particular, by providing call protection, a convertible issuer can assure its convertible bondholders that it will not force them to become equity holders during the call protection period. The possibility of a forced conversion instituted by an early call should be more threatening to investors in an economy where local laws are biased against shareholders. I examine call protection terms in an international sample and find evidence consistent with the hypothesis that convertible bond design varies based on the features of local law. D 2005 Elsevier B.V. All rights reserved. JEL classification: G15; G32; K22; N40 Keywords: International; Law; Convertible securities; Call protection

1. Introduction Country differences in legal infrastructure and the effects of those differences on local financial markets, corporate decision-making and firm performance have received a great deal of attention from economists and legal scholars recently. A growing body of research

T Tel.: +1 509 323 3430; fax: +1 509 323 5811. E-mail address: [email protected]. 0929-1199/$ - see front matter D 2005 Elsevier B.V. All rights reserved. doi:10.1016/j.jcorpfin.2004.10.003

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suggests that treatment of equity investors and creditors varies systematically across countries. La Porta et al. (LLSV hereafter) (1997, 1998) explore the effects of legal tradition on the structure of local financial markets, and find that in countries with strong minority shareholder protection, equity markets are more developed, and that strong creditor protection is connected with more developed debt markets. Recent empirical evidence confirms that international differences in business law affect corporate decisionmaking regarding dividends (LLSV, 2000), debt contract terms (Demirguc-Kunt and Maksimovic, 1999), and foreign equity listing decisions (Reese and Weisbach, 2002). Convertible bond issuers can adjust their convertibles to be more debt-like or equitylike by use of several contract terms such as call protection, maturity, conversion price, and call price (Lewis et al., 1998b). The main hypothesis of this study is that in countries with weak shareholder protection and strong creditor protection, investors have a stronger preference to remain creditors, and they are more threatened by issuers’ ability to force conversion. Therefore, firms from countries with weaker shareholder protection and stronger creditor protection should issue convertibles with stronger call protection. My tests constitute a test of a joint hypothesis since I am assuming not only that investor preferences are affected by local legal standards but also that the issuing firms vary their issuance terms to accommodate those preferences. I find support for the hypothesis above. Measured by the call protection terms attached to convertible issues, issuers domiciled in shareholder-friendly countries issue significantly more equity-like convertibles than issuers from countries where law is biased towards creditor protection. This finding is robust to several alternative measures of creditor and shareholder bfriendlinessQ, as well as various measures differentiating debtlike convertibles from equity-like convertibles. The rest of the paper is organized as follows. In Section 2, I make a connection between legal protection and call protection terms of convertibles. Section 3 describes the sample used in this study, Section 4 reports the results, and Section 5 concludes.

2. Legal systems and convertible design 2.1. Call provisions on bonds Studies on call provisions attached to straight bonds suggest that callability reduces agency costs of debt (Barnea et al., 1980; Bodie and Taggart, 1978; Thatcher, 1985). In the spirit of Myers (1977), shortened effective maturity of debt controls agency costs, as issuers’ ability to call upon good news about their prospects reduces underinvestment problems with their bonds. Mann and Powers (2003) provide recent evidence of a connection between default risk and call provisions by finding that firms with low credit ratings issue bonds with weaker call protection. However, it is questionable whether the agency cost motivations for use of call provisions apply to convertible bonds. Kahan and Yermack (1998) and Nash et al. (2003) suggest that the conversion feature may substitute for other common forms of agency cost control. Extant literature explaining the role of call protection in convertible securities is limited. Lewis et al. (1998a) extend the work on the backdoor equity explanation of convertible

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issuance by Stein (1992). In Stein’s model, firms that ultimately want equity in their capital structures issue convertibles due to current underpricing of their common stock. Consequently, Lewis et al. (1998a) suggest that firms that are more confident about their future prospects provide shorter call protection since in Stein’s model the threat of bankruptcy motivates all firms to force conversion as quickly as they can. As firms with better prospects expect to call their convertibles sooner, in order to be able to call them, they set weak call protection terms. In support of Stein (1992), Lewis et al. (1998a) find that firms with higher market-to-book ratios issue convertibles with shorter call protection periods. According to the sequential financing motivation of convertible issuance, forwarded by Mayers (1998), firms finance their planned multistage investment with convertibles. In Mayers’ model, firms with sequential investment plans are able to minimize both overinvestment problems and refinancing costs by using convertibles. Korkeamaki and Moore (2004) extend Mayers’ (1998) work by studying the implications of his model on call protection terms. If convertibles are used as vehicles to finance sequential investments, issuers want to be able to call their convertibles at the time of their next investment sequence. Firms with a short expected wait should therefore offer short call protection. Korkeamaki and Moore (2004) find evidence of a connection between issuers’ investment patterns following the convertible issue and call protection terms on their issues. 2.2. Effects of legal systems on corporate finance A prominent line of literature advanced by LLSV (1997, 1998) focuses on the effects of law and legal tradition on development and structure of financial markets in an economy. LLSV (1998) find systematic differences in investor protection across different types of legal systems. Common law countries (countries whose commercial law is based on the English origin) tend to be more shareholder friendly and promote equity ownership by providing shareholders with more extensive legal rights. In contrast, creditors have better rights in civil law countries (countries with German, French, or Scandinavian legal origin). The connection between the origins of a country’s legal system and its financial market development is not universally accepted among economists. Rajan and Zingales (2003), and Roe (2003) claim that political differences, rather than variation in legal systems, cause the observed differences in financial market development. In a recent paper, de Jong and Semenov (2002) argue for importance of cultural differences such as attitudes towards uncertainty in explaining international differences in market development. Stulz and Williamson (2003) suggest a role for religious inheritance in shaping up a country’s financial markets. Furthermore, numerous authors have divided countries into bank-based and market-based groups rather than differentiating them by legal origins. However, recent findings by Beck and Levine (2002) and Demirguc-Kunt and Levine (2001) suggest that the structure of capital markets cannot explain international variation in economic growth rates or efficiency in capital allocation. While some researchers doubt whether the letter of the law can directly affect corporate decision making,1 empirical studies offer support for the idea that international differences

1

See, e.g. Easterbrook (1997).

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in commercial law play a role in firms’ financing decisions. In a study among G-7 countries, Rajan and Zingales (1995) find evidence of higher leverage among firms from countries with stronger creditor protection. Demirguc-Kunt and Maksimovic (1998) report evidence of higher levels of both long-term debt and equity financing in countries that score high on an index of respect for legal norms. Demirguc-Kunt and Maksimovic (1999) further find that firms’ debt maturity choice depends on local legal institutions. In their sample, large firms in particular use longer maturity debt in countries with effective legal systems. LLSV (2000) find firms in countries with better shareholder protection paying higher dividends, and Reese and Weisbach (2002) find that foreign firms cross-list in the U.S. in order to bond themselves to the U.S. legal system. However, this bonding mechanism may be limited to equity cross-listings, as Miller and Puthenpurackal (2002) find that the home country legal system affects the cost of acquiring financing for a sample of Yankee bond issuers. On the supply-side of financing, Esty and Megginson (2003) find that lenders in countries with poor creditor protection tend to spread their risk more than lenders in countries with good quality creditor protection. 2.3. The connection between legal systems and call protection Lewis et al. (1998b) draw from literature on security choice (Bayless and Chaplinsky, 1991; Jung et al., 1996) and confirm that among convertible issuers, those that are predicted to issue equity tend to issue convertibles that are more equity-like, and those that are predicted to issue debt are more likely to issue debt-like convertibles. Their analysis is based on the issuing firms’ ability to adjust the balance between the two features of their convertible bonds by setting contract terms such as coupon rate, maturity, conversion price, call price, and call protection. The current study focuses on use of probably the most intuitive one of these adjustment mechanisms, namely call protection. Since call of a convertible bond typically induces investors to convert to equity, by calling a convertible bond, the issuer can force investors to switch from being bondholders to being equity holders. A convertible with weak call protection can be called more easily by the issuer, ceteris paribus. When issuers provide weak call protection, they are therefore more likely to force investors to the ranks of shareholders. Brennan and Schwartz (1988) suggest a role for the conversion feature in alleviating the threat of post-issuance wealth transfers from debt holders to equity holders. When poor shareholder protection coincides with strong creditor protection, which is often the case as indicated by LLSV (1998), the threat of wealth transfers is not as acute, while the threat of a forced conversion is more severe. Consequently, we can expect investors to demand strong call protection terms from companies in countries with strong creditor protection and weak shareholder protection. Harris and Raviv (1985), Stein (1992), and Hillion and Vermaelen (2004) indicate that management’s ability to force conversion by calling a convertible bond alleviates its concern for expected bankruptcy costs. However, while one could argue that the expected bankruptcy costs are higher in a more creditor-friendly country, a forced conversion in the financial distress state is unlikely since the stock price of the financially distressed firm is likely to be low, and the convertible holder can opt for redemption instead of conversion upon a call of a convertible with fixed conversion price. Thus, while it appears as if strong

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creditor protection would lead to incentives to offer more equity-like convertibles, it is unlikely that a weaker assurance not to call the security would reduce the expected bankruptcy costs of the convertible. I also expect firms from creditor-friendly economies to offer stronger call protection, ceteris paribus. Jensen and Meckling (1976) and Green (1984) offer convertibles as a solution to the risk-incentive problem between management and creditors. In countries with good quality creditor protection, the legal remedies against abuse of creditors’ invested funds are more onerous. Convertible investors should prefer to hold on to their legal powers in such environment, especially if the good quality creditor protection is paired with poor shareholder protection. In other words, in creditor-friendly and shareholder-unfriendly countries investors should find being creditors more attractive than being shareholders. However, Anderson (1999) illustrates how issuers’ incentives conflict with those of investors. His evidence from Brazil suggests that a threat of bankruptcy causes bond issuers to prefer flexibility. If creditor-friendliness increases the threat of bankruptcy, then we should expect to observe less call protection among issues from more creditor-friendly countries. Call protection is only one of many factors that can affect the magnitude of the threat felt in forced conversion systematically across countries. Lewis et al. (1998b) mention several other contract terms that can be used to adjust the balance between debt-like and equity-like features of a convertible bond. Also, in addition to contract design, factors such as stock volatility, yield differential between the convertible and the underlying stock, call price schedule, and expected post-issuance run up in the underlying stock price can increase the likelihood of a conversion-forcing call. I address these concerns by including measures of contract design as control variables in my empirical model. I also consider the effects of stock volatility, yield differential and post-issuance run up in my empirical tests. Meanwhile, it is worth pointing out that only call protection gives investors an absolute assurance against a forced conversion. Especially in environments with low quality legal protection, where manipulation of stock price is likely to be easier, assurances of a bcontinued right to remain a creditorQ that are made contingent on future stock price are likely to be less credible.

3. Data The sample of this study comes from the Securities Data Corporation’s (SDC) New Issues database, and covers time period from 1983 to 1998. SDC provides data on 4,043 convertible bond issues during the time period. After excluding issues by financial institutions, simultaneous issues,2 issues with variable coupon rate or conversion price, issuers that are not covered by either Center for Research in Security Prices (CRSP) database or Datastream International, and issuers for whom Datastream reports negative

2 In cases where SDC reports multiple convertible bond issues by the same issuer on the same date, I have included the bond with the longest time to maturity and/or the highest coupon rate in my sample. There are 85 such bonds in my sample. Excluding them from the analysis leaves the findings of the paper unaffected.

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Table 1 Distribution of convertible bond issues during the period 1983–1998 by call protection type and by issue year 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Total

No protection

Soft protection

Hard protection

Non-callable

Total

2 5 1 6 3 0 1 0 1 0 0 0 1 0 0 0 20

36 32 71 122 108 47 27 6 14 5 16 33 5 21 9 4 556

28 63 71 17 33 10 66 53 45 49 74 34 44 60 82 46 775

5 16 2 2 1 3 3 4 9 7 10 19 8 22 9 9 129

71 116 145 147 145 60 97 63 69 61 100 86 58 103 100 59 1480

Bonds with soft protection have a call protection period during which the bonds are callable if the issuer’s stock price exceeds a certain pre-determined level relative to the conversion price. Hard protection does not allow the issuer to call the issue under any circumstances. Bonds with initial period of hard protection that is followed by soft protection are classified as having hard call protection.

market to book ratio in issue year, 1480 convertible bonds from 27 different countries remain in the sample. Call protection can either prohibit calling under any circumstances (hard call protection), or allow calling only when the value of the underlying stock exceeds certain level relative to the conversion price (soft call protection). Convertibles can also be noncallable for their entire life (absolute protection). Types of call protection on convertible securities can therefore be divided into four distinct categories: (1) no protection, (2) soft protection, (3) hard protection, and (4) absolute protection (non-callable). The breakdown of the sample by issue year and call protection type is given in Table 1. As Table 1 indicates, there appears to be a structural break that occurred around 1988–1989. Until 1989, particularly in years 1986–1988, soft protection was the most popular call protection type, whereas its popularity has significantly decreased since then.3 Table 2 presents the distribution of the sample, along with means (and medians in parentheses) of call protection type and some issuer characteristics, by country. It is evident from Table 2 that Japan and the U.S. dominate the sample. Together, the two countries account for 84% of the total sample. While the unbalanced sample raises some concerns, it is representative of the global convertible markets during the sample period when compared to the industry estimates of global convertible market shares reported in Noddings et al. (1998) and Calamos (1998). 3 This shift is similar to that observed by Korkeamaki and Moore (2004) in the U.S. However, the shift from soft protection to hard protection as the dominant contract type appears to be somewhat delayed in this international sample. In the U.S. a very sharp shift took place in late 1987.

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Table 2 Means (medians) of convertible bond issuer and issue characteristics during the period 1983–1998 by issuer home country and legal system N English Australia 3 Canada 4 Hong Kong 33 India 5 Malaysia 7 Panama 1 South Africa 1 Thailand 22 UK 46 US 811 Common law 933 French Belgium 1 Italy 3 Netherlands 10 Mexico 3 France 17 Philippines 2 German Switzerland 8 Austria 1 China 1 Germany 3 Japan 402 Poland 2 South Korea 64 Taiwan 26 Scandinavian Denmark 1 Sweden 2 Finland 1 Civil law 547

Call protection type Market to book Coupon

Original maturity Proceeds

2.00 2.25 1.91 1.00 1.57 2.00 2.00 1.68 1.72 1.53 1.56

(2.00) (2.50) (2.00) (1.00) (1.00) (2.00) (2.00) (1.50) (2.00) (2.00) (2.00)

3.023 3.904 1.632 2.132 5.907 2.305 1.790 4.390 2.183 4.427 4.204

(1.570) (3.749) (0.950) (2.030) (5.250) (2.305) (1.790) (4.130) (1.871) (2.352) (2.335)

5.500 5.219 3.586 3.350 2.714 4.500 7.500 3.114 6.505 6.999 6.696

(5.000) 9.084 (9.981) (5.563) 9.307 (9.098) (3.500) 6.278 (6.000) (3.500) 5.237 (5.022) (2.750) 9.798 (10.025) (4.500) 5.006 (5.006) (7.500) 7.041 (7.041) (3.250) 8.154 (10.000) (6.375) 13.589 (15.045) (7.000) 16.082 (15.028) (6.750) 15.247 (15.000)

113.433 70.450 114.848 81.020 180.057 100.000 250.000 86.614 175.985 89.270 95.205

(125.000) (68.250) (100.000) (85.000) (175.000) (100.000) (250.000) (65.000) (143.750) (60.000) (65.000)

1.00 1.67 1.90 2.33 1.76 1.00

(1.00) (1.00) (2.00) (3.00) (2.00) (1.00)

4.340 2.670 5.114 1.226 5.244 1.530

(4.340) (2.250) (2.045) (0.607) (4.210) (1.530)

1.625 4.500 4.863 5.583 4.463 2.535

(1.625) 20.000 (20.000) (3.500) 6.010 (5.586) (4.875) 7.139 (7.034) (5.000) 6.387 (6.025) (3.750) 8.721 (8.315) (2.535) 8.500 (8.500)

107.700 199.567 76.000 233.333 240.606 80.800

(107.000) (251.200) (54.600) (300.000) (159.500) (80.800)

2.88 3.00 3.00 2.33 1.88 2.50 2.02 1.54

(3.00) (3.00) (3.00) (2.00) (2.00) (2.50) (2.00) (1.00)

4.106 1.570 1.140 2.457 3.273 1.360 1.218 2.245

(2.905) (1.570) (1.140) (2.060) (2.630) (1.360) (1.120) (2.200)

2.422 5.250 3.500 2.417 1.913 3.250 0.739 1.783

(2.500) (5.250) (3.500) (3.000) (1.750) (3.250) (0.250) (1.500)

191.700 63.500 85.000 212.167 59.393 84.000 38.845 103.481

(114.800) (63.500) (85.000) (200.000) (40.800) (84.000) (30.050) (75.000)

1.00 2.00 2.00 1.89

(1.00) (2.00) (2.00) (2.00)

1.630 0.751 0.800 3.046

(1.630) (0.751) (0.800) (2.350)

5.000 3.500 4.375 1.979

(5.000) 10.077 (10.077) (3.500) 15.360 (15.360) (4.375) 5.019 (5.019) (1.625) 6.554 (5.153)

147.200 106.100 300.000 70.522

(147.200) (106.100) (300.000) (42.500)

5.713 7.553 5.022 5.055 6.000 6.025 8.718 7.308

(5.099) (7.553) (5.022) (5.055) (5.000) (6.025) (8.023) (7.000)

Call protection type is 0 for no protection, 1 for soft protection, 2 for hard protection and 3 for absolute protection. Data for Market to book ratio comes from Datastream for non-U.S. issuers and from CRSP for U.S. issuers. MTB is calculated as common stock market capitalization divided by the book value of assets. Coupon is the coupon rate in percentages. Original maturity is the time to maturity in years. Proceeds are measured in U.S. dollars.

Table 2 also provides summary statistics by countries’ legal origins, obtained from LLSV (1998).4 Similar to LLSV (2000), small sample size in French and Scandinavian legal origin groups prompts a coarser classification to common law and civil law countries. Comparison of means between common law and civil law groups reveals that issues from civil law countries are larger and have lower coupon rates and shorter maturities. In 4

LLSV (1998) do not include China, Panama, or Poland in their analysis. Numerous law references were consulted to classify those countries.

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Table 3 Distribution of convertible bond issues during the period 1983–1998 by legal origin and by issue year

1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Total

U.S.

Other common law

Total common law

Japan

Other civil law

Total civil law

% Common law

60 37 85 127 113 20 39 17 34 41 52 19 28 44 60 35 811

0 1 2 3 11 2 3 4 3 3 23 27 7 16 11 6 122

60 38 87 130 124 22 42 21 37 44 75 46 35 60 71 41 933

11 77 58 16 20 34 55 40 23 11 18 12 5 12 5 5 402

0 1 0 1 1 4 0 2 9 6 7 28 18 31 24 13 145

11 78 58 17 21 38 55 42 32 17 25 40 23 43 29 18 547

84.5% 32.8% 60.0% 88.4% 85.5% 36.7% 43.3% 33.3% 53.6% 72.1% 75.0% 53.5% 60.3% 58.3% 71.0% 69.5% 63.0%

support of my hypothesis, the average call protection strength for issues from the creditorfriendly civil law countries (1.892) is higher than that for issues from the shareholderfriendly common law countries (1.560). The difference in call protection strength between the two groups is statistically significant according to a chi-squared test for the equality of two multinomial distributions ( pb0.0001). Given LLSV (1998) evidence that civil law countries exhibit strong creditor protection and weak shareholder protection, this finding supports the idea that good creditor protection and poor shareholder protection are related to stronger call protection terms. Table 3 reports issuance frequency by legal origin and issue year. To observe the dominance of the U.S. and Japan within their respective legal origin groups, issue frequency for each of the two countries is also indicated separately. While the U.S. is the single country standing for most of the issue volume in the sample, Japanese firms issued over 50% of the sample issues in 1984 and again in the late 1980s. The Japanese sub sample exhibits some clustering in the Japanese stock market bubble years during the late 1980s. However, the most intense bubble years do not weigh nearly as heavily in my Japanese sample as in convertible samples of Kang and Stulz (1996) and Kang et al. (1999), thanks to the longer time span of this study.

4. Results and analysis I begin a more thorough analysis of the data by comparing the frequency of call protection types in different legal systems. Table 4 breaks down the sample by call protection type and issuers’ legal origin. As suggested by the summary statistics above, common law country issuers seem to provide weaker call protection terms than civil law

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Table 4 Distribution of convertible bond issues during the period 1983–1998 by call protection type and legal origin U.S. Other common law Common law total Japan Other civil law Civil law total

No protection

Soft protection

Hard protection

Non-callable

20 0 20 0 0 0

355 54 409 100 47 147

421 44 465 250 60 310

15 24 39 52 38 90

Bonds with soft protection have a call protection period during which the bonds are callable if the issuer’s stock price exceeds a certain pre-determined level relative to the conversion price. Hard protection does not allow the issuer to call the issue under any circumstances. Bonds with initial period of hard protection that is followed by soft protection are classified as having hard call protection.

country issuers. Common law countries are divided almost equally between soft protection and hard protection, while in civil law countries hard protection clearly dominates. Additionally, absolute call protection is much more prevalent in civil law countries. Similar to Korkeamaki and Moore (2004), I use an ordered probit model as my main method of analysis. The dependent variable (PROT) represents a four-part scale of call protection: no protection–soft protection–hard protection–no call provisions (=absolute call protection). The main test variables (LOWSHP and LOWCRP) are defined using data from LLSV (1998). LOWSHP is an indicator variable that takes on value of 1 for issues by firms from countries with anti-director index value less than 4, and LOWCRP takes on value of 1 for countries with LLSV (1998) creditor rights index value less than 3, 0 otherwise. The results are reported in Table 5. Controlling for market to book ratio (MTB) is motivated by both the sequential financing motive of convertible issuance (Mayers, 1998) and the backdoor equity hypothesis (Stein, 1992). The two theories have opposite predictions on call protection strength, causing the expected sign of MTB to be ambiguous. If convertibles are used as vehicles for sequential financing, faster growth predicts stronger call protection due to increased time to optimal investment. According to the backdoor equity hypothesis, firms with more valuable growth options want to force a switch to equity sooner, suggesting an inverse relation between market to book and call protection strength. I obtain MTB on the issue date from CRSP for U.S. firms and from Datastream International for non-U.S. issuers.5 Both issue size (PROCEEDS) and time to maturity (MAT) control for agency costs of debt. MAT also controls for the direct effect that legal systems have on debt maturity, advanced by Demirguc-Kunt and Maksimovic (1999). Systematic differences in both PROCEEDS and MAT by legal system indicated in Table 2 further motivate controlling for them. PROCEEDS is calculated as the natural logarithm of issue proceeds in U.S. dollars, and maturity (MAT) is the natural logarithm of time to maturity in years. Data for both variables come from SDC New Issues database. Quality of investor protection in general may have a direct effect on whether the local market is biased towards equity or debt financing. Shleifer and Vishny (1997) point out that since default on a loan is easy to define and observe, a debt contract is less ambiguous 5

MTB is calculated as common stock market capitalization divided by the book value of assets.

818

(a) C LOWSHP LOWCRP MTB PROCEEDS MAT RULE ACCT BF89 JAPAN80 PRIVATE LOGGDP INFLATE COUPON PUT LEVERAGE JAPAN US Scaled R 2 N

1.054 0.518TT 0.373TT 0.000 0.039 0.516TTT 0.247 0.003 1.057TT 0.273 0.053 0.166 5.701TT 0.046TT 0.606TTT 0.002

0.395 978

(b) (0.580) (3.406) ( 2.074) (0.016) (0.830) ( 4.821) (1.625) ( 0.145) ( 8.336) (0.770) (0.397) (0.818) (2.112) ( 2.125) ( 4.276) ( 0.890)

5.568TTT 0.640TTT 0.176 0.000 0.056 0.417TTT 0.634TTT 0.029TT 1.210TTT 0.050 0.164 0.450TTT 3.550T 0.076TTT 0.789TTT

0.337 1450

(7.419) (5.431) ( 1.292) ( 0.021) ( 1.489) ( 4.794) (6.751) ( 2.285) ( 11.676) ( 0.360) (1.645) ( 5.092) (1.748) ( 4.164) ( 8.484)

(f)

(g)

4.777TTT 0.688TTT 0.283TT 0.000 0.034

(c) (6.065) (5.814) ( 2.247) (0.018) ( 0.938)

1.354 1.191TTT 0.396 TT 0.000 0.023

(1.264) (5.828) ( 2.256) (0.056) ( 0.627)

4.722TTT 0.466TTT 0.440TTT 0.000 0.034

(6.310) (4.063) ( 3.704) (0.028) ( 0.950)

5.203TTT (6.947) 0.349TTT (3.169) 0.492TTT ( 4.202)

2.346TTT (19.019) 0.327TTT (3.699) 0.179TT ( 2.054)

0.763TTT 0.039TTT 1.361TTT 0.018 0.285TTT 0.549TTT 0.281 0.047TTT

(8.552) ( 3.156) ( 14.819) (0.138) (3.255) ( 6.307) ( 0.166) ( 2.873)

0.725TTT 0.010 1.366TTT 0.221 0.253TTT 0.562TTT 2.354 0.032T

(7.179) (0.705) ( 14.479) ( 1.319) (2.867) ( 5.498) (1.172) ( 1.921)

0.738TTT 0.044TTT 1.306TTT 0.033 0.300TTT 0.476TTT

(8.294) ( 3.605) ( 14.350) (0.253) (3.421) ( 5.536)

0.639TTT 0.066TTT 1.371TTT 0.362TTT

0.279 1450

(d)

0.962TTT (3.553) 0.258 (1.307) 0.289 1450

(e)

(7.321) ( 5.719) ( 16.237) (3.485)

0.305TTT ( 3.662)

0.039TT ( 2.534)

0.266 1476

0.254 1476

0.016 1476

The table provides ordered probit estimates. The dependent variable is a four-part scale of call protection. T-statistics that are reported in parentheses are calculated using heteroskedasticityconsistent standard errors. TTT, TT, and T indicate statistical significance at 1%, 5%, and 10% levels.

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Table 5 Determinants of call protection strength

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than an equity contract. They therefore suggest that debt is the preferred mode of financing in countries with poor investor protection. LLSV (1998) discuss the possibility that weaker rules of law might be substituted by stronger enforcement and vice versa. Whether the quality of law enforcement has an effect on call protection terms is questionable since enforceability of a convertible contract should not depend on its call protection terms. However, when quality of law enforcement falls to a level where the likelihood of reneging on call protection increases, we might observe weaker call protection since strong call protection terms could be deemed incredible by the market in such an environment.6 I obtain a proxy for the quality of enforcement of law in a country (RULE) from LLSV (1998). The variable is an index based on opinions of various country risk estimation services, and includes measures of efficiency of the judicial system, rule of law, corruption, risk of expropriation, and likelihood of contract repudiation by the government. Following LLSV (1998), I also control for the quality of local accounting standards (ACCT). Relaxed accounting standards can allow management to manipulate earnings and consequently make equity ownership less appealing and the prospect of forced conversion more threatening. In particular, lower level of transparency, caused by weaker accounting standards, may allow management to induce the stock price to exceed a soft protection threshold, causing investors to shy away from issues with soft protection terms. Given these predictions, the expected sign for ACCT is negative. Data for ACCT are obtained from LLSV (1998). The measure is an index describing the extent of disclosure in local financial statements. Indicator variable BF89 takes on value of one for bonds that were issued prior to 1989, zero otherwise. The purpose of this variable is to control for the apparent shift in the overall market that occurred in late 1980s and is evident in Table 1. Furthermore, in order to account for more stringent regulation and the bubble economy present in the Japanese markets in the 1980s, I include an indicator variable JAPAN80 that takes on value of 1 for Japanese bonds that were issued in 1983–1989, 0 otherwise.7 Tighter regulatory control during that period suggests lower agency costs of those bonds. If shortened effective maturity controls agency costs as suggested by Myers (1977), bonds issued during the 1980s in Japan will have stronger call protection. Also, if investors see soft protection as an increased threat during a period of fast stock market growth, they will demand hard call protection during such periods. Furthermore, Hoshi et al. (1990) report that as a consequence of deregulation, many Japanese companies used their new direct access to financing and consequently weakened their ties to bank-controlled keiretsu systems. They argue that decreased bank monitoring and increased cost of financial distress affected the cost of debt financing for Japanese firms. This could be viewed as a supply-side motivation for weaker call protection or more equity-like convertibles in post-deregulation era. Issuance of convertibles as private placements is common world-wide, and SDC New Issues indicates that about 35% of the sample issues were targeted to private markets. PRIVATE is an indicator variable that takes on value of one for private placements. The 6

This argument is related to Diamond (1991, 1993) and Rajan (1992) findings that inefficient legal systems motivate shorter term debt. 7 For details on regulatory issues in the Japanese corporate bond market see Hoshi et al. (1990), Miyajima (1998), and Kang and Stulz (1996).

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variable controls for the possibility that call protection terms for private issues are set in a manner different from public issues. Such a difference could be motivated, for example, by lower levels of information asymmetry leading to a reduction in agency problems. Following prior empirical research in international financial market development, I include an independent variable LOGGDP that controls for the issuer’s home country’s per capita Gross Domestic Product. LLSV (1998) suggest that prosperity affects the quality of law enforcement. LOGGDP is also set to capture any cross-country variation in the role of convertibles that depends on the developmental stage of the economy.8 The data come from International Financial Statistics. Underdeveloped debt markets in most of the countries in my sample disallow controlling for the shape of the yield curve at issuance, which affects call protection setting of convertibles in the U.S. (Korkeamaki and Moore, 2004). However, I account for the nominal interest rate environment in the country at the time of the issuance by including INFLATE, which is defined as change in issuer’s home country’s GDP deflator during the issue year, as reported by the International Financial Statistics. Lewis et al. (1998b) indicate coupon rate as an alternative adjustment mechanism between debt-like and equity-like features of convertible bonds, which motivates COUPON as a control variable. Some of the bonds in the sample also have a put feature. If the put feature and stronger call protection are viewed by investors as two alternative contract terms that control the threat of forced conversion, the coefficient on dummy variable PUT will be negative. Unfortunately, poor availability of accounting data among the sample firms disallows controlling for issuer-specific factors such as leverage, a proxy for agency costs of debt. For example, Worldscope reports accounting information for issuers of only 42 out of the 881 Japanese issues in the original sample. Inclusion of issuer leverage shrinks the overall sample from 1480 to 978 and makes it very heavily U.S. dominated. While column (a) of Table 5 reports results with leverage included in the regression, I exclude accounting measures from the rest of the analysis in order to gain a fuller international sample. Results in column (b) of Table 5 confirm that firms from countries with weak shareholder protection provide stronger call protection. Also, the coefficient for poor creditor protection is negative as expected, albeit not statistically significant. Among control variables, original maturity (MAT) is inversely related to call protection strength, which is consistent with U.S. findings by Korkeamaki and Moore (2004). Interestingly, the results indicate a positive relation between quality of legal enforcement mechanism (RULE) and call protection strength, which is consistent with stronger call protection being used in countries where such contract feature is more credible, but inconsistent with better legal standards favoring equity financing. Weaker accounting standards (ACCT) are connected with stronger call protection, consistent with forced conversion representing a more serious threat in countries with low quality accounting standards. Not surprisingly, given evidence in Table 1, bonds offered before 1989 have weaker call protection. The coefficient for LOGGDP is negative and significant.

8

Demirguc-Kunt and Maksimovic (1998) further motivate inclusion of GDP per capita in their cross-sectional analysis as a proxy for institutional determinants not explicitly captured in their empirical model.

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COUPON enters with a negative and significant sign, suggesting that issuers are more concerned about maintaining their ability to call bonds that have higher coupon rates. The coefficient for the dummy variable indicating putable bonds (PUT) is negative, suggesting that put feature and stronger call protection terms substitute each other in controlling the threat of forced conversion. This is consistent with Nash et al. (2003) finding that call features are typically complementary to other bond characteristics dealing with agency issues. Endogeneity could potentially cause the results in column (b) to be biased and inconsistent. I follow Korkeamaki and Moore (2004) and perform endogeneity tests suggested by Rivers and Vuong (1988). I treat PROCEEDS, MAT, PUT, COUPON, and PRIVATE as potentially endogenous variables and use an indicator variable for issues out of predominantly catholic countries (CATHOLIC) as the additional exogenous variable required by the test procedure. The tests strongly suggest that the decisions on both putability (PUT) and maturity (MAT) of a bond are endogenously related to the decision on call protection type.9 Meanwhile, I fail to reject exogeneity of the other three variables. To ensure that inclusion of PUT and MAT in the model is not driving my results, I rerun the specification in column (b) of Table 5 without the two variables. The results are reported in column (c). The findings on a relation between the investor-protection variables (LOWSHP and LOWCRP) and call protection type (PROT) only gain strength. Both test variables are now statistically significant with expected signs. Due to the endogeneity problems, I exclude PUT and MAT from further analysis. Recall from Table 4 that the U.S. and Japan represent large market shares within the sample. Findings reported in column (c) could thus be due to some country-specific factors, other than legal origin, related to the two countries. In an effort to control for such factors, I include a dummy variable for both countries in column (d). Evidence of the connection between investor protection and call protection terms remains strong. The role of the home country legal system may be questioned for companies that issue their convertibles outside their home market. However, the results in column (c) are robust both to analyzing only non-U.S. issuers and including a dummy variable for foreign companies with U.S. stock listing prior to the issue, and to a control variable for companies issuing outside their home markets (results not reported). International Financial Statistics does not report information for Taiwan. By excluding INFLATE in column (e), I am able to include the country into the analysis.10 The only noticeable difference between columns (c) and (e) is that LOWCRP is now significant at the 1% level. Further exclusion of issuer and issue specific variables in column (f), and time-specific and country specific indicators in column (g) leaves the findings on LOWSHP and LOWCRP intact. 4.1. Alternative measures of the nature of law To test robustness of the findings reported above, I specify alternative measures of bias towards creditors and shareholders in local business law in Table 6. First, I replace 9

The t-statistics for residuals used in the endogeneity test are 2.61 for PUT, and 2.55 for MAT. Note also that since LLSV (1998) excludes China, Poland, and Panama, the four bonds from those countries are excluded from most of the cross-sectional analysis. 10

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C CRPREF SHPREF MKTCAP DOMCR RULE*MKTCAP RULE*DOMCR MTB PROCEEDS RULE ACCT BF89 JAPAN80 PRIVATE LOGGDP INFLATE COUPON Scaled R 2 N

(a)

(b)

(c)

(d)

(e)

4.283TTT (5.229) 1.023TTT (5.509)

6.400TTT (9.006)

4.592TTT (5.546) 0.934TTT (5.015) 0.336TTT ( 2.923)

3.318TTT (3.977)

3.104TTT (3.660)

0.402TTT ( 3.538)

0.566TTT ( 6.688) 0.423TT (2.432)

0.000 0.012 0.826TTT 0.036TTT 1.411TTT 0.112 0.251TTT 0.611TTT 1.772 0.059TTT 0.276 1450

(0.025) ( 0.334) (8.166) ( 3.050) ( 15.515) ( 0.088) (2.866) ( 6.862) (1.043) ( 3.709)

0.000 0.039 0.563TTT 0.049TTT 1.311TTT 0.013 0.244TTT 0.436TTT 1.393 0.043TTT 0.272 1450

(0.022) ( 1.050) (7.517) ( 4.252) ( 14.528) ( 0.102) (2.799) ( 5.724) ( 0.797) ( 2.631)

0.000 0.020 0.878TTT 0.045TTT 1.383TTT 0.003 0.276TTT 0.596TTT 0.102 0.046TTT 0.280 1450

(0.027) ( 0.518) (8.936) ( 3.888) ( 15.051) ( 0.026) (3.143) ( 6.738) ( 0.057) ( 2.881)

0.000 0.002 0.398TTT 0.004 1.509TTT 0.176 0.306TTT 0.323TTT 3.262T 0.060TTT 0.287 1447

(0.106) ( 0.057) (5.402) ( 0.307) ( 15.916) (1.305) (3.582) ( 3.775) (1.741) ( 3.809)

0.063TTT 0.045TT 0.000 0.001 0.395TTT 0.004 1.510TTT 0.191 0.308TTT 0.296TTT 3.274T 0.060TTT 0.287 1447

( 6.597) (2.271) (0.111) ( 0.039) (5.158) ( 0.310) ( 15.877) (1.414) (3.608) ( 3.449) (1.743) ( 3.784)

The table provides ordered probit estimates. The dependent variable is a four-part scale of call protection. T-statistics that are reported in parentheses are calculated using heteroskedasticity-consistent standard errors. TTT, TT, and T indicate statistical significance at 1%, 5%, and 10% levels.

T.P. Korkeamaki / Journal of Corporate Finance 11 (2005) 809–831

Table 6 Alternative measures of the nature of law

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LOWCRP and LOWSHP by two variables indicating if the issuer comes either from a country that has both good creditor protection and poor shareholder protection (CRPREF) or vice versa (SHPREF), using again the LLSV (1998) indices measuring the quality of each protection type.11 As columns (a) through (c) indicate, the results are similar to those in Table 5. However, it is questionable whether static measures such as the origin of a country’s legal system can capture a dynamic process of evolvement of legal and financial systems in an economy. For example, Reese and Weisbach (2002) point out variation in legal rules among countries with identical legal origins. I address these concerns by introducing two time-varying measures of creditor friendliness and shareholder friendliness of an economy. Both LLSV (1998) and Modigliani and Perotti (2000) motivate a connection between the depth of financial markets and the legal infrastructure of a country. Consequently, assuming that shareholder-friendly legal systems lead to more developed stock markets, such legal systems should lead to larger equity markets. I obtain home country’s stock market capitalization in the issue year for each bond, and divide it by the country’s gross domestic product in respective year, and call this variable MKTCAP.12 For a measure on credit market development to be used as a proxy of creditor friendliness (DOMCR), I normalize total domestic private credit claims in issue year from the International Financial Statistics (item 32d) again by the country’s GDP in the same year. Using these dynamic proxies only strengthens my empirical results as evidenced by column (d) of Table 6. Stock market size is negatively related to call protection strength and credit market development is positively related to it. Finally, in column (e) of Table 6, I measure the marginal effect that stock market and credit market development have on the choice of call protection terms, given the quality of each country’s law enforcement. This is done by replacing the market development variables in column (d) with two interaction variables (RULE*MKTCAP and RULE*DOMCR). Even in this setting, more developed stock markets are related to weaker call protection terms and more developed credit markets lead to stronger call protection terms. While the LLSV creditor rights index is used, both in this study and in numerous other papers, as a proxy of the nature of commercial code in each country, it may not be a perfect measure of rights pertaining to investments in convertible bonds that are predominantly unsecured.13 In particular, components of the LLSV index that indicate whether the code provides for automatic stay on secured assets and whether secured creditors enjoy a priority specifically address secured creditors’ interests, and their presence may even weaken the rights of unsecured creditors. However, using only the two remaining components of the LLSV index in the analysis only strengthens the findings reported in Table 5. Furthermore, replacing the LLSV creditor right proxy with measures of bankruptcy time and cost reported in World Bank (2004) also strengthens the findings reported in this paper. In all specifications using these alternative creditor right proxies, 11 CRPREF is an indicator variable for countries with LOWSHP=1 and LOWCRP=0, and when LOWSHP=0 and LOWCRP=1, SHPREF=1. 12 Market capitalization data is obtained from the 1991 and 1999 editions of the World Bank’s Emerging Stock Markets Factbook. 13 I thank an anonymous referee for pointing this out.

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both the shareholder right measure enters with a negative and significant sign and the creditor right measure enters with a positive and significant sign (results not reported). 4.2. Alternative measures of call protection strength The main hypothesis of this paper is that firms adjust call protection of their convertible bonds depending on which type of security, debt or equity, receives a more preferential treatment from the home country law. Call protection type, as defined in the tests reported in Tables 5 and 6, is admittedly a crude measure of call protection strength. Soft call protection may be effectively as onerous restriction against calling as hard protection if the likelihood that the company’s shares reach the soft protection threshold price is very low. To account for this potential problem, I develop alternative proxies of call protection strength. The first one, RELFST, is the relative time until the first possible call date, measured as time to first call divided by time to maturity. As column (a) of Table 7 reveals, the results are very similar to the ordered probit results reported above. Column (b) of Table 7 reports results of a probit regression in which the dependent variable takes on value of one if call protection (regardless of its type) is longer than 3 years. LOWSHP enters with a positive sign and LOWCRP enters with a negative sign, and both coefficients are statistically significant at the 1% level. Finally, following Korkeamaki and Moore (2004), I define a dependent variable LENGTH that represents the length of call protection in years, again

Table 7 Alternative measures differentiating debt-like convertibles from equity-like convertibles Estimation method Dependent variable C LOWSHP LOWCRP MTB PROCEEDS RULE ACCT BF89 JAPAN80 PRIVATE LOGGDP INFLATE COUPON R2 Adj. R 2 N

(a)

(b)

(c)

OLS RELFST

Probit Protection N3 years

Poisson Length of call protection

5.846TTT 1.225TTT 0.651TTT 0.000 0.014 0.776TTT 0.066TTT 0.264TT 0.047 0.213TT 0.549TTT 3.759 0.155TTT 0.150

2.083TTT 0.465TTT 0.274TTT 0.000 0.027 0.225TTT 0.042TTT 0.157TTT 0.220TTT 0.048 0.158TTT 3.181TT 0.039TTT 0.168

1.679TTT 0.181TTT 0.200TTT 0.000 0.043TTT 0.270TTT 0.024TTT 0.239TTT 0.052 0.024 0.168TTT 0.680 0.030TTT 0.276 1459

(2.851) (2.752) ( 3.422) ( 0.959) ( 4.428) (6.227) ( 4.096) ( 9.923) ( 1.100) ( 1.038) ( 2.957) (0.598) ( 5.206)

1453

( 3.280) (6.719) ( 4.452) ( 0.104) ( 0.326) (5.886) (3.829) ( 1.988) ( 0.240) ( 2.202) ( 2.945) (1.639) ( 7.418)

( 3.254) (5.750) ( 2.916) (0.693) (1.312) (3.845) (4.512) ( 3.577) (3.077) ( 1.111) ( 2.773) (2.094) ( 3.901)

1453

Estimation methods and dependent variables are indicated for each column. RELFST is defined as time to first call divided by time to maturity. RELPAR is defined as time to par call divided by time to maturity. T-statistics that are reported in parentheses are calculated using heteroskedasticity-consistent standard errors. TTT, TT, and T indicate statistical significance at 1%, 5%, and 10% levels.

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regardless of protection type. Since LENGTH is a count variable, I use Poisson regression. The results are given in column (c) of Table 7. Again, the main findings are unaffected. 4.3. Additional features increasing the risk of forced conversion Lewis et al. (1998b) provide a thorough study of different means for issuers to adjust the balance between the equity-like and debt-like features of their convertible issues. Besides call protection, coupon rate, and maturity are also among Lewis et al. (1998b) adjustment mechanisms. All these factors were considered in Table 5 analysis. The relation between stock price at issuance and the conversion price is another feature that could be used as an alternative way to provide assurance to investors against an early call. Similarly, a high call price could prevent the issuer from calling, even in absence of call protection. Furthermore, Asquith and Mullins (1991) suggest that yield differential between the convertible and the underlying common stock plays a role in call decisions. They expect convertible issuers to delay calling their convertibles when the after-tax cost of bond financing is lower than the dividend yield expected by their shareholders. Therefore, high yield on a convertible compared to the issuer’s dividend yield would increase the threat of an early call. Besides the contract terms, volatility of the underlying stock can affect the threat seen by investors in an early call as low stock volatility reduces issuers’ chances to force conversion at an inopportune time. Post-issuance stock price run up (provided that such run up is foreseen by investors) could also threaten investors in a poor shareholder protection environment. Since call provisions are typically only employed when a call results in a forced conversion, low predicted stock price gains should lower investors’ demand for call protection in poor shareholder protection environment. Means (and medians) of each of the features discussed above are reported in Table 8. The mean levels for the relation between conversion price and stock price [RELCON, calculated as (conversion price price at issuance)/price at issuance], volatility (annualized standard deviation of the stock returns during the year prior to the issue), and yield advantage (convertible bond issue yield common stock dividend yield) are higher for issuers from common law countries than for issuers from civil law countries. The lower RELCON in civil law countries should increase the threat of early conversion, while the lower volatility and yield advantage should lower it. Call premium (the percentage by which the initial call price is above the issue price) values are very similar between common law countries and civil law countries. Post-issuance growth is slightly lower in common law countries. If expected at time of issuance, this lower growth should lower the need for call protection and could partially explain weaker call protection terms observed among common law country issuers. However, the higher volatility increases the need for call protection if investors are threatened by the prospect of forced conversion. Including variables that require detailed stock price information causes deterioration in sample size. Also, the SDC New Issues database reports yield advantage for only a small subset of bonds in the sample. However, inclusion of each (or any combination) of these alternative adjustment mechanisms has only a minor effect on the regression findings reported above (results not reported).14 14

The t-statistic for the coefficient on LOWSHP is +2.4 or higher in each specification. LOWCRP enters each specification with a negative sign but is not statistically significant in all specifications.

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Table 8 Alternative features increasing the threat of early forced conversion N

English Australia

3

Canada

4

Hong Kong

33

India

5

Malaysia

7

Panama

1

South Africa

1

Thailand

22

UK

46

US

811

Common law

French Belgium Italy Netherlands

933

1 3 10

Mexico

3

France

17

Philippines

2

German Switzerland

8

Austria

1

China

1

Germany

3

Japan

402

Call protection type

Volatility

Growth

RELCON

Call premium

Yield advantage

2.00 (2.00) 2.25 (2.50) 1.91 (2.00) 1.00 (1.00) 1.57 (1.00) 2.00 (2.00) 2.00 (2.00) 1.68 (1.50) 1.72 (2.00) 1.53 (2.00) 1.56 (2.00)

0.324 (0.251) 0.432 (0.421) 0.518 (0.387) 0.358 (0.394) 0.500 (0.427) 0.355 (0.355) 0.409 (0.409) 0.450 (0.436) 0.327 (0.261) 0.574 (0.537) 0.554 (0.512)

0.268 (0.170) 0.098 (0.010) 0.029 ( 0.252) 0.115 ( 0.226) 0.125 ( 0.079) 0.374 (0.374) 0.219 ( 0.219) 0.431 ( 0.426) 0.032 (0.017) 0.125 (0.023) 0.099 ( 0.001)

N/A

0.010 (0.010) 0.078 (0.078) 0.030 (0.025) 0.095 (0.095) 0.000 (0.000) 0.009 (0.009) N/A

N/A

1.00 (1.00) 1.67 (1.00) 1.90 (2.00) 2.33 (3.00) 1.76 (2.00) 1.00 (1.00)

0.275 (0.275) 0.365 (0.337) 0.308 (0.271) 0.651 (0.704) 0.297 (0.295) 0.430 (0.430)

0.240 ( 0.240) 0.085 ( 0.197) 0.468 (0.011) 0.358 ( 0.417) 0.140 (0.054) 0.144 ( 0.144)

2.88 (3.00) 3.00 (3.00) 3.00 (3.00) 2.33 (2.00) 1.88 (2.00)

0.277 (0.268) 0.191 (0.191) 0.748 (0.748) 0.388 (0.411) 0.351 (0.340)

0.087 (0.010) 0.135 ( 0.135) 0.641 ( 0.641) 0.074 (0.463) 0.140 (0.041)

0.303 (0.303) 0.184 (0.170) N/A N/A 0.225 (0.225) 0.086 (0.086) 0.108 (0.095) 0.115 (0.160) 0.217 (0.220) 0.213 (0.219)

0.245 (0.245) N/A 0.082 (0.082) 0.200 (0.200) 0.206 (0.206) 0.100 (0.100) 0.246 (0.246) N/A 0.017 (0.017) 0.258 (0.258) 0.040 (0.050)

0.035 (0.000) 0.012 (0.000) 0.059 (0.055) 0.056 (0.054)

N/A 0.000 (0.000) 0.015 (0.020) 0.010 (0.010) 0.034 (0.000) 0.000 (0.000) N/A N/A N/A 0.000 (0.000) 0.050 (0.040)

5.535 (5.535) 3.750 (4.500) N/A N/A 2.530 (2.530) 7.500 (7.500) 3.083 (3.250) 6.262 (6.125) 6.601 (6.750) 6.543 (6.580)

9.190 (9.190) N/A 5.250 (5.250) 4.420 (4.420) 5.240 (5.720) 2.570 (2.570) 2.500 (2.500) N/A 3.500 (3.500) 4.250 (4.250) 1.534 (0.750)

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Table 8 (continued) N

German Poland

2

South Korea

64

Taiwan

26

Scandinavian Denmark

1

Sweden

2

Finland

1

Civil law

547

Call protection type

Volatility

Growth

RELCON

Call premium

Yield advantage

2.50 (2.50) 2.02 (2.00) 1.54 (1.00)

0.441 (0.441) 0.452 (0.414) 0.428 (0.394)

0.083 ( 0.083) 0.041 ( 0.207) 0.190 ( 0.176)

N/A

0.300 (0.300) 0.077 (0.023) 0.061 (0.030)

N/A

1.00 (1.00) 2.00 (2.00) 2.00 (2.00) 1.89 (2.00)

0.241 (0.241) 0.338 (0.338) 0.530 (0.530) 0.366 (0.345)

0.256 (0.256) 0.256 ( 0.256) 0.024 (0.024) 0.127 (0.020)

N/A

0.000 (0.000) 0.020 (0.020) 0.000 (0.000) 0.052 (0.040)

N/A

1.969 (0.200) 0.102 (0.100)

0.167 (0.167) N/A 0.102 (0.050)

1.275 (0.250) 1.393 (1.500)

3.500 (3.500) N/A 1.745 (1.000)

Call protection varies from no protection (0) to absolute protection (4). Volatility is the annualized standard deviation of common stock during the year prior to the convertible issuance. GROWTH is the percentage growth is stock market capitalization in the year following the issuance. RELCON is the percentage that the conversion price is above the stock price at issuance. Call premium is the percentage by which the initial price exceeds the issue price of the convertible. Yield advantage is the percentage point advantage in yield of the convertible compared over dividend yield of the common stock.

4.4. Alternative factors favoring one security type over the other As mentioned above, several researchers have questioned whether the existing findings on the connection between legal systems and market development are spurious, caused by some other country-specific variables. de Jong and Semenov (2002) suggest that international differences in cultural norms and values determine development of stock markets in different countries. They use country-specific measures of uncertainty avoidance and masculinity, defined and measured by Hofstede (1980). They argue that more masculine countries are more likely to encourage competition in the financial markets and therefore protect shareholders’ rights better. In countries with higher scores on uncertainty avoidance, investors are expected to require a higher equity risk premium, effectively leading to a bias towards debt investments. Also, Stulz and Williamson (2003) suggest a role for the dominant religious beliefs of a country. Their evidence suggests that countries that are predominantly catholic provide weaker creditor protection. Table 9 reports ordered probit coefficients for three culture-based variables, together with the test variables for shareholder protection (LOWSHP) and creditor protection (LOWCRP). Proxies for masculinity (MASC) and uncertainty avoidance (UNCERT) are from Hofstede (1980). An indicator variable for predominately catholic countries (CATHOLIC) is defined by Stulz and Williamson (2003). In these specifications, I employ all control variables that were used in column (c) of Table 5 but in interest of space, their coefficients are not reported. The findings of stronger call protection in

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Table 9 Alternative determinants of a bias between shareholders and creditors (a) LOWSHP LOWCRP UNCERT MASC CATHOLIC Adj. R 2 N

(b) 0.495TTT (3.945) 0.266T ( 1.763) 0.016TTT (4.667)

(c) 1.415TTT (7.322) 0.071 ( 0.512)

(d) 1.066TTT (5.856) 0.192 ( 1.387)

0.025TTT (6.154) 0.305 1379

0.314 1379

0.560TT ( 2.550) 0.282 1450

2.151TTT (5.636) 0.066 (0.420) 0.007 ( 1.189) 0.033TTT (4.750) 0.571TT ( 2.200) 0.316 1379

The table reports ordered probit coefficients for the three variables, UNCERT, MASC, and CATHOLIC, when entered into the main regression model of column (c) of Table 5. UNCERT measures uncertainty avoidance and MASC measures masculinity, both from Hofstede (1980). CATHOLIC is an indicator variable for countries that are predominantly catholic according to Stulz and Williamson (2003). T-statistics that are reported in parentheses are calculated using heteroskedasticity-consistent standard errors. TTT, TT, and T indicate statistical significance at 1%, 5%, and 10% levels.

countries with weaker shareholder protection are not affected by inclusion of culture-based variables. The sign on LOWCRP is generally negative, albeit weak. Column (a) of Table 9 suggests that in countries categorized by uncertainty avoidance, convertibles tend to be more debt-like. Perhaps, investors in those countries also dislike uncertainty in form of the threat of forced conversion, and thus demand convertibles with stronger call protection. Masculinity is also positively related to call protection strength in column (b), counter to intuition of de Jong and Semenov (2002). In catholic countries, convertibles come with weaker call protection terms, which finding indirectly supports Stulz and Williamson (2003). If creditor protection is weaker in catholic countries, investors will be less concerned about the prospect of being forced from creditors to shareholders. When all three culture-based variables are added to the specification in column (d), both LOWCRP and UNCERT switch signs, albeit neither is statistically significant. Given that the culturebased and law-based variables are highly correlated, it is almost surprising to see that the coefficients on LOWSHP, MASC, and CATHOLIC remain as strong as they are. The main conclusion of column (d) is that even after controlling for culture-based factors, weak shareholder protection is connected to strong call protection. Roe (2003) explores the effects of countries’ political views on their financial markets further. Like Roe (2003), I obtain data on political views of each country from Cusack (1997). While no specific theoretical guidance on a connection between a country’s location on the political spectrum and creditor/shareholder protection exists, I include this political proxy as an additional control variable to observe whether political factors rather than the nature of law explain call protection setting in convertible issues. Inclusion of this proxy leaves findings on LOWSHP intact (results not reported).

5. Summary and conclusions This study focuses on adjustments in corporate financing practices induced by local legal infrastructure. I draw from literature on convertible bond design and

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observe contract term choices of firms from countries with different legal systems, focusing on call protection. Building upon work by LLSV (1998), I find that firms from countries with weak shareholder protection issue more debt-like convertibles, and that firms from countries with weak creditor protection issue more equity-like convertibles. My findings are consistent with the hypothesis that in countries where commercial law makes share ownership less appealing, investors view issuer’s ability to force conversion as a threat and therefore shy away from convertible bonds with features that are more likely to allow forced conversion. My evidence adds to the growing body of literature suggesting that the financing terms available to companies vary significantly based on their home country legal systems.

Acknowledgements I am grateful to Jan Breuer, Bonnie Buchanon, Kent Hickman, Steve Mann, Ted Moore, Jeffry Netter (editor), Greg Niehaus, Solomon Tadesse, an anonymous reviewer, and seminar participants at the University of South Carolina and the 2002 FMA meetings for helpful comments and suggestions.

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