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Pension plan terminations, excess asset reversions and securityholder wealth
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BANKING & ELSEVIER
Journal of Banking& Finance 19 (1995) 245-259
FINANCE
Pension plan terminations, excess asset reversions and securityholder wealth Sudip Datta ~'*, Mai E. Iskandar-Datta Edward J. Zychowicz c
b,
• Department of Finance, Bentley College, Waltham, MA 02154, USA b Finance Research Associates, 151) Manning Roa~ Waltham, MA 02154-8000, USA c Department of Banking and Finance, Hofstra University, Hempstead, NY 11550, USA Received April 1992; final version received September 1993
Abstract The total finn valuation impact of an excess pension asset reversion is an unresolved issue. Prior studies focusing on stockholder wealth provide varied evidence. This study examines the valuation effects of excess asset reversions on bondholders (straight and convertible) and stockholders of the sponsoring f ' m . The redeployment and the negative signalling hypotheses provide a framework for the analysis. We provide evidence of wealth expropriation from straight bondholders to stockholders. Convertible debtholders are not impacted by plan terminations. Contingency table analysis also reveals evidence in support of the negative signalling hypothesis for a significant portion of the sample. Cross-sectional regression identifies financial weakening of the f'u'm, reversions undertaken for restructuring purposes and takeover defense related terminations as significant determinants of bondholder excess returns.
Keywords: Pension plan terminations; Bondholder and stockholder wealth; Asset reversions; Firm valuation JEL classification: G14; G30; G32
* Correspondingauthor. Tel. (617) 891-2513. We wish to thank E. William Fitzgerald of the Pension Benefit Guaranty Corporation for his generous help in providingus with the data. 0378-4266/95/$09.50 © 1995 Elsevier Science B.V. All rights reserved SSDI 0378-4266(94)00053-0
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1. Introduction
The termination of overfunded defined benefit pension plans has proved to be a significant financial resource for U.S. corporations. The Pension Benefit Guaranty Corporation (PBGC) reports that 2,246 overfunded plans were terminated during the period 1980-1990. The accompanying excess asset reversions represent an aggregate flow of $21.5 billion to plan sponsoring firms. The magnitude and frequency of pension asset reversions during the last decade has important policy implications for the U.S. public and private sectors. Therefore, a considerable need for academic research exists in this area. The objective of the study is to contribute to the understanding of the valuation effect of excess pension asset reversions on the overall firm value. Evidence from prior studies which examine the impact of such reversions on shareholder wealth leaves this issue unresolved. Alderson and Chen (1986), Mittelstaedt and Regier (1990) and Moore and Pruitt (1990) report normal returns to stockholders while Haw, Ruland and Hamdallah (1988), Mitchell and Mulherin (1989) and VanDerhei (1987) find significant positive impact on stockholder wealth. AIderson and VanDerhei (1992) attempt to resolve the dichotomous results of previous studies and conclude, based on statistically weak evidence, that the financial strength of the sponsoring firm and the type of the successor plan are important determinants of the stock price reaction. However, it is difficult to draw definitive conclusions about the valuation impact of such financial decisions without also considering the concomitant effect on the debtholders of the sponsoring firm. This study examines the valuation effects of excess asset reversions on the straight and convertible debtholders and the corresponding stockholders of the terminating firms. The redeployment and the negative signalling hypotheses are tested in the context of wealth impacts on these securityholder classes. Based on the premises of agency theory and asymmetric information, these two hypotheses can provide an alternative explanation of the dichotomous results reported in some of the prior stock price studies. It is possible that any gain experienced by the stockholders may be generated as a result of a wealth transfer from the bondholders. On the other hand, the insignificant wealth impact on the stockholders reported in some of the prior studies may arise due to the positive wealth transfer effect being offset by the negative signalling effect. The two-day announcement period excess returns indicate that bondholders suffer, on average, a significant loss. In contrast, a statistically significant gain is observed for the stockholders during the same period. Convertible debtholders, however, are not significantly impacted by plan terminations. This study provides evidence that the adverse effect on the bondholders is driven by the wealth transfer to the stockholders and the negative signal about the film'S financial condition emitted by the use of costly financing from overfunded pension plans. The cross-sectional analysis reveals that bondholder excess returns are significantly influenced by factors such as, financial weakening (supporting the negative
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signalling hypothesis), corporate restructuring and takeover defense related terminations (consistent with arguments presented under the redeployment hypothesis). The remainder of the paper is organized as follows: Section 2 presents the testable hypotheses. Section 3 describes the sample selection criteria, the properties of the sample and the data sources. The bond and stock daily event study methodologies are presented in Section 4. Section 5 reports the empirical results. Finally, the results of the study are summarized in Section 6.
2. Testable hypotheses In this paper we propose two testable hypotheses relating to excess pension asset reversions. The redeployment hypothesis contends that the reverted pension assets can be redeployed to uses that can either create, leave unchanged or destroy value for the bondholders a n d / o r the stockholders. 1 This hypothesis encompasses two effects. First, to the extent that the redeployment of surplus assets is unanticipated, such action by the f'Lrm may result in a change in securityholder wealth. The second effect is associated with the agency problem that may arise with such reallocation of plan assets. The positive valuation effect implied by the redeployment of excess pension assets to higher valued uses may not be realized for bondholders if it also results in a concomitant wealth transfer to stockholders. 2 Wealth expropriation from bondholders may occur in several ways. Overfunded pension plans can serve as a cushion protecting the priority of bondholder claims to corporate assets. Removing excess assets, in effect, reduces financial slack that has been stored in the form of overfunded plans. This may be tantamount to an increase in leverage if the proceeds are dissipated to the shareholders. Moreover, a wealth transfer from bondholders to stockholders need not correspond with an actual increase in dividend payments. The firm may use the reverted assets to maintain the current level of dividend payments which otherwise could no longer be supported by the expected cash flow from the operations of the firm. Conversely, if the management uses the proceeds to repurchase debt and reduce leverage, the bondholders could gain from plan terminations. The benefits from such action, however, may be offset by the fact that financial slack stored in the form of overfunded pension plans is eliminated.
1 One possiblesourceof securityholdergains is tax benefits. However,Mittelstaedt(1989) concludes that maximizingtax savings does not appear to be the primarymotive for these terminations. 2 Positive stock excess return and zero bond excess return would be consistent with the belief that terminations transfer wealth from employeesto stockholders. Thomas(1989) argues that terminations are not likely to result in expropriationof employeewealth since the PBGC, the TreasuryDepartment and the Departmentof Labor legally sanctioned terminationswith the joint implementationguidelines issued in 1984. Furthermore, he provides empirical evidence that does not support breach of implicit contracts with employees.
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Another adverse impact on the bondholders may result from their exposure to the 'subordination risk' when overfunded plans are terminated. Although restricted to a limited number of cases, this risk may relegate them to a lower rank in the priority of claims on the corporate assets. 3 Specifically, plan participants (employees) have priority claims to a firm's assets under certain conditions. If the present value of pension liabilities exceed the current value of pension fund assets, the P B G C - acting on behalf of plan participants - has the authority to place a lien on sponsoring firm assets up to 30% of the Fn'm's net worth. 4 This lien would be senior to all unsecured liabilities of the firm except employee wages. Lower levels of funding may increase the probability that the claims of bondholders will become subordinate to claims of employees thus diminishing bondholder wealth. 5 One motivation offered for plan terminations is that they constitute a part of a broader restructuring program undertaken by the firm. This is expected to impact stockholders positively. However, the relation between plan terminations and bondholder wealth is governed by several conflicting factors. In the context of restructuring, plan terminations may result in increased efficiency which has a positive effect on both securityholders. On the other hand, firms that restructure typically reduce financial slack by increasing leverage and reducing their free cash flow (Jensen, 1986). Consequently, the bondholders may be adversely affected by the reduction in the financial slack. Therefore, the net impact on straight bondholders can only be resolved empirically. Under certain conditions, wealth transfer may occur from stockholders to bondholders. For example, if the surplus pension assets make the firm an attractive target for a takeover, terminating overfunded plans can act as a takeover defense (Pontiff et al., 1989). Using plan terminations as a takeover defense may represent good news to straight bondholders as the likelihood of an increase in leverage diminishes and perhaps bad news to the stockholders as documented in the corporate takeover defense literature. Such corporate action may, therefore, result in a wealth transfer from stockholders to bondholders, assuming that the surplus assets are redeployed to similar valued uses under the target as they would have been if the takeover was consummated. The thrust of the negative signalling hypothesis is that excess asset reversions emit a negative signal to investors about the future cash flow of the firm. One recent motive for plan terminations is to provide Fmancially weak firms with a much needed infusion of funds. Since excess pension assets represent a source of
3 As per the-1984 PBGC guidelines, annuities must be purchased to defease pre-termination plan obligations. Therefore, subordination risk would be associated only with post-termination benefit accruals. 4 In accordance with OBRA 1987,-the sponsoring employers are deemed liable for 100% of the unfunded benefit obligations (even though the secured portion is limited to 30% of the net worth). s The amount of subordination risk the bondholders are e ~ d to will be mitigated if the terminated plan is replaced with a defined contribution plan or if annuities are purchased.
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financing, firms facing an unexpected decline in available funds may liquidate Financial slack stored in overfunded pension plans. Mittelstaedt (1989) and Thomas (1989) provide evidence indicating that f'Lrms which terminate pension funds exhibit signs of financial weakening, such as, declines in profitability, unavailability of funds and reduction in market values. For firms with an increased likelihood of f'mancial distress, excess asset reversions may constitute a new revelation (and perhaps a confirmation of prior indications) about the firm's cash flow prospects. The potential for excess asset reversions to convey negative information to the market is even more revealing when compared with the alternative method of accessing financial slack stored in overfunded plans. Rather than terminating plans, surplus assets may be accessed gradually over time through an adjustment in actuarial assumptions. Although plan terminations provide fast access to surplus funds, this mode of Fmancing has costs that are not incurred when pension financial slack is gradually depleted. For example, the firm incurs additional pension obligations upon plan termination since nonvested benefits become vested as required by Sections 4041 and 4044 of the Employee Retirement Income Security Act (E/USA) of 1974. In addition, terminations cause certain explicit transaction costs, related to purchasing annuities and implementing a replacement plan. And f'maUy, the Tax Reform Act of 1986 imposed a 10% excise tax on the amount of the reverted assets. 6 The willingness of firms to incur such costs associated with excess asset reversions seems to suggest that alternative lower cost funds are not sufficient. Myers and Majluf (1984) assert that as firms experience large declines in available funds, they are forced to move increasingly lower (higher cost) in the pecking order of f'mancing, such as plan terminations. Given the additional costs associated with plan terminations, management is not expected to terminate overfunded plans for relatively small declines in funds that can be offset by a cheaper source of funds such as slow withdrawals through adjustments of actuarial assumptions (Thomas, 1989). Thomas provides evidence that terminating firms, facing a reduction in available cash flow, respond by first reducing slack in working capital and by reducing dividends and then, only as a last resort, they liquidate pension financial slack to meet the shortfall of available funds. To the extent that reversions are not fully anticipated, an adverse valuation effect on all securityholders is expected ff the negative signalling hypothesis holds. In this context it is important to note, however, that the redeployment and the negative signalling hypotheses are not mutually exclusive. While the negative signalling and wealth transfer effects clearly have a negative impact on bondhold-
e The excise tax has been increased to 15% by the Technical and Miscellaneotts Revenue Act of 1988 and further to 20% by the Omm'bus Budget Reconciliation Act (OBRA) of 1990. However, our sample period ends in 1987 and hence is not impacted by these two acts.
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ers, the net impact on stockholders is ambiguous as the two effects act in opposite directions.
3. Sample and data sources
The pension termination data was obtained from two sources: (a) the quarterly termination logs and (b) compilation list, both of which were provided to us by the PBGC for excess asset reversions occurring between October 1982 and December 1987. Using the termination f'de date from the quarterly logs, we identified a list of plan terminations. If the plan sponsor were a subsidiary, the parent company was identified by examining Dun and Bradstreet's America's Corporate Families and National Register Publishing Company's Directory of Corporate Affiliations. The dollar amounts of plan assets and reversions were obtained from the PBGC compilation list. The Wall Street Journal Index (WSJI) was examined to identify the date of the announcement of the intent to terminate the pension plan. However, in only 8 cases (10.7%) was the intent to terminate announced in the Wall Street Journal (WSJ). Alderson and Chen (1986), Haw, Ruland and Hamdallah (1988) and Mitchell and Mulherln (1989) made similar observations about their samples. Since in all of these cases the WSJ date occurred prior to the fding date, the WSJ date was considered the announcement date (t -- 0). For the remaining firms which did not have a WSJ announcement date, the event date is the date on which the plan sponsor filed its intent to terminate with the PBGC. This filing date represents the best publicly available date announcing the firm's intention to terminate, since it precedes the actual termination date for all reversions examined in this study. 7 Some observations were excluded from the initial sample due to unavailability of data. Events were eliminated because of the absence of publicly traded debt or because of 'thin' trading. A bond is defined to be thinly traded if there are less than six trades during the 21 day event window. Additionally, a bond has to trade both before and after the announcement day to be included in the sample. Finally, the WSJI was examined for confounding events over the event window ( - 1, + 1). This sample selection criterion resulted in a final sample of 71 plan termination announcements made by 51 different fnans. Of these 71 events, there were 59 straight and 17 convertible debt issues (some firms had both). For firms with multiple plan terminations, the average period between plan terminations was 227 days.
Mitchell and Mulherin (1989) report that for 18% of the cases, the termination was retroactively dated to a time prior to filing date. They also empirically show that the appropriate announcement date is the filing date.
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Table 1 Plan termination sample characteristics, October 1982 to December 1987 Panel A: Sample distribution by year of Panel B: Distribution of termination bond ~tiags Year
Stocks Straight Convertible debt debt
S and P bond rating
Frequencyof straight debt
Frequencyof convertibledebt
1982 1983 1984 1985 1986 1987 Total
2 7 6 24 23 9 ~
AAA AA A BBB BB B CCC CC NR Total
2 5 5 22 8 14 2 0 1 ~-O
0 0 2 8 4 1 1 1 0 1"7
2 5 4 18 23 7 5-~
1 1 3 7 1 4 1-7
Panel C: Descriptive statistics on amount of debt ($ million)
Panel D: Frequencyof straight bonds by seniority
Statistics
Straight debt
Convertible debt
Type of bond
Number
Percentof the sample
Mean Minimum Maximum
98.8 3.7 300.0
75.8 4.2 215.0
Mortgage/senior Nonsubordinated Subordinated Total
3 30 26 5-'0
5.08% 50.85% 44.07% 1~ .--~--.'.'.'.'.'~o
Table 1 presents a description of the sample. In panel A, the frequency distribution of plan terminations by the year of announcement is similar to that provided by the PBGC list for the entire population of terminations during the study period. The mean dollar excess reversion for the sample of terminations is $66.84 million while the average reversion as a percent of the book value of c o m m o n equity of the plan sponsor is 5.21%. The remaining panels in Table 1 summarize the major characteristics of the bond samples. Examining the Standard and Poor's rating distribution of the straight (convertible) bond sample in panel B, we find that 57.5% (58.9%) are investment grade. The average outstanding dollar amount for the straight (convertible) bonds is $98.8 ($75.8) million. In addition, approximately one-half o f the straight bonds are nonsubordinated, while the remaining are subordinated. The daily prices of the most frequently traded bond for each sample firm were collected from the WSJ for 11 trading days before and 10 days after the announcement day. Treasury bond prices with coupons and maturities matching those of the sample bonds were also collected from the WSJ. To compute daily returns from bond prices, with cumulated daily coupon interest, Moody's Bond Record was used to identify the interest payment dates of the sample bonds.
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Financial information about the sample was retrieved from Compustat tapes and M o o d y ' s Industrial Manuals. Finally, stock price data were retrieved from the C R S P daily master tape.
4. M e t h o d o l o g y
To determine the stock price reaction to pension termination announcements, we use the mean excess returns generated by the market model. The estimation period for the market model parameters is from day - 2 5 0 to day - 6 1 . The mean adjusted returns methodology developed by Masulis (1980) and adapted for bonds by Handjinicolaou and Kalay (1984) is used to estimate excess bond returns. To adjust for changes in the term structure of interest rates, the corporate bonds are matched with treasury bonds according to maturity and coupon rate, and the adjusted bond return (ABRi, d) is calculated as follows: A B R i , a -~ BRi, d - TBRi,d,
where BR~,d is the holding period bond return for firm i for day d and TBRi, a is the return over the same period for an equivalent treasury bond. Daily accrued coupon interest is added to the price change to calculate the bond's holding period return. A nineteen day interval around the event is used to estimate the comparison and announcement period returns. The comparison period is day t - 10 to day t - 2 and day t + 1 to day t + 10. The mean comparison period return (R~m,) for fh'm i is as follows: 1
R,.o,-
ABRi, a
E
'
where ( d t - d k _ 1) is the number of trading days that elapsed between two successive trades. Since bond returns are a series of single and multiple day returns they are adjusted to yield equivalent single day returns and standardized using the estimated standard deviation of the comparison period returns for the bond. Finally, the standardized mean excess return for the portfolio of bonds for each day over the entire 21 day period is estimated. Assuming that individual standardized excess bond returns are Student-t distributed with mean O and k - 2 degrees of freedom (where k is the number of business days in which a particular bond traded), it follows from the central limit theorem, the standardized portfolio mean excess return for any event day is normally distributed with mean 0 and variance 1 / n t (where n t is the number of observations on day t). However, as suggested by Handjinicolaou and Kalay (1984), s we report the crude dependence test statistics (distributed as Student-t) for the daily standardized portfolio mean s For a complete discussion of the test statistics, see Handjinicolaou and Kalay (1984, pp. 45--46).
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Table 2 Standardized mean excess returns for three types o f securityholders over various intervals around the termination filing date during the period 1 9 8 2 - 1 9 8 7 (t-statistics in parentheses) Panel A: Multiple plan terminations
Panel B: One plan termination
per firm
per firm
Event window t - 10, t - 2 t - 1, t t {t + 1, t + 10
Stockholder CEILs
Straight debt CEILs
Convertible CERs
Stockholder CERs
Straight debt CERs
N~71
N=59
N=I7
N=51
N~44
0.990 (1.38) 0.642 ° (1.81) 0.399 (1.33) -0.052 (-0.07)
-0.045 ( - 0.08) -0.794 " " ( - 2.92) - 0.737 " " (-3.84) -0.189 (-0.33)
-0.207 ( - 0.27) 0.271 (0.76) - 0.029 (-0.12) - 0.595 (-0.78)
1.042 (1.16) 0.854 " (1.97) 0.436 (1.38) - 0.168 (-0.19)
-0.284 ( - 0.46) -0.639 " ' ( - 2.20) - 0.635 " " (-3.10) 0.141 (0.23)
"'" " Significant at 10% and 1% levels, respectively.
excess returns since the cross-sectional independence between individual bond excess returns cannot be guaranteed. This t-statistic is computed by dividing the standardized portfolio mean bond excess return for the event day by the standard deviation of the daily portfolio excess returns.
5. Empirical results 5.1. Overall results Table 2 presents the bond and stock price reactions to plan terminations over different intervals with the corresponding t-statistics. The straight bond standardized excess return on the announcement day is - 0 . 7 4 percent with a t-statistic of - 3 . 8 4 which is significant at the 1 percent level. The two-day (days - 1 and 0) cumulative excess bond return is - 0 . 7 9 and significant at the 1 percent level. Of the 59 bonds, 46 bonds (77.97%) reacted negatively to the termination fding and only 13 had a positive reaction. A nonparametric binomial sign test was conducted to confirm that this negative effect on bondholder wealth is not driven by outliers. This test yields a z=statistic of 4.30 which is statistically significant at the 1 percent level. The above results indicate that plan terminations, on average, have a significantly negative impact on the firms' straight bondholders. The analysis of the market model residuals for the stock sample reveals that the two-day cumulative excess return is 0.64 percent which is significant at the 10 percent level (t = 1.81). The cumulative excess returns for other intervals are not significant. Although restricted to the sample of firms with publicly traded debt,
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our overall stock results corroborate the results obtained by Mitchell and Mulherin (1989), VanDerhei (1987) and Alderson and VanDerhei (1992). These results hold even though the s o u r c e of the event date used by these studies vary. 9 Finally, the impact on convertible debtholder wealth is insignificant for all intervals centered around the termination filing date. The securityholder excess returns are re-estimated using a subset of the samples where only one plan termination (the first one) per firm is included. The results presented in panel B of Table 2 are very similar to the complete samples. To obtain the impact of the reversion on firm value, we compute the dollar gains for both bondholders and stockholders. The dollar equityholder (bondholder) gains (losses) are calculated by multiplying the stock (bond) excess return for days - 1 and 0 by the market (book) value of the equity (long-term debt) at the year-end preceding the termination. The average dollar gains to stockholders is $1.32 million. In contrast, the mean dollar losses experienced by the long-term bondholders is a statistically significant -$7.46 million (t = -2.64). However, the total wealth impact of the reversion ( - $ 6 . 1 4 million) is statistically insignificant (t = - 1.12). These results imply that the negative overall valuation impact of the redeployment of excess pension assets is absorbed by bondholders, while stockholders' wealth gain from such redeployment of assets, although positive, is statistically insignificant. Following Dennis and McConnell (1986), we compute the correlation coefficient between individual bond and stock excess returns to be -0.274 which is statistically significant (t = -2.04). Thus, the combined results indicate that the benefits accruing to the shareholders are offset by the adverse wealth effects experienced by the straight bondholders supporting the notion of wealth transfer from bondholders to stockholders. To observe any effect of the Single Employer Pension Plan Amendments Act (SEPPAA), 1o results are re-estimated using a sample period restricted to events occurring before May 1986. The average announcement day excess return for bondholders ( - 0 . 8 2 % ) and stockholders (0.38%) are still significant, implying that the passage of the act did not substantially alter the overall results. The same conclusion, based on examining stockholder wealth, is reported in Alderson and VanDerhei (1992). Analyzing the distribution of standardized excess returns for bonds and stocks it is observed that the most frequent (40.7%) bond excess return is in the range -1.00% and 0%. On the other hand, the comparable range for stocks and
9 Mitchelland Muiherin(1989) and AIdersonand VanDerhei(1992) use the terminationfilingdates contained on a tape provided by the PBGC, while VanDerhei (1987) used the quarterly termination l°~0s 0•
SEPPAA passed on May 1986 requires sponsoring finns to inform plan participants at least 60 days prior to filing for plan termination.
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Table 3 Joint frequency distribution of excess returns for 56 a straight bonds and stocks on the termination filing day and characteristics of firms in quadrants QIII and QIV Panel A: Joint frequency distribution of bond and stock excess returns
Sign of bond excess return
Positive Negative
Sign of stock excess return Positive
Negative
N,%
N,%
QI 6 (10.7%) QIV 25 (44.6%)
QII 6 (10.7%) QIII 19 (33.9%)
Panel B: Attributesof firms in wealth transfer and negativesignalling quadrants Variables Insider ownership b (%) Growth in CFPS c (%) Growth in DPS d (%)
Wealth transfer (QIV) 10.63 7.61 10.79
Negativesignalling (QIII) 4.86 3.66
2.92
Mean difference t-statistics - 1.42 ° - 1.67 " " -- 2.04 " " "
Variable definitions: b Insider ownership reflects the ownership by the top five directors of the terminating firm. c Growth in CFPS reflects the growth in cash flow per share over the five years prior to plan termination. Growth in DPS reflects the growth in dividends per share over the five years prior to plan
termination. All three variableswere obtained from Value Line InvestmentSurvey. convertible bonds is between 0% and 1.00%. Since, on average, the convertible bonds do not react to the termination announcement, the analysis hereafter focuses only on stockholders and straight bondholders. Using a contingency table framework, the announcement day excess bond returns are paired with corresponding excess stock returns in Table 3, panel A. The highest frequency of pairs (44.6%) occurs in the fourth quadrant (QIV), where stockholders gain while bondholders experience a negative wealth effect associated with the redeployment hypothesis. The next highest frequency (33.9%) is observed in the third quadrant (QIII) where both securityholders experience adverse wealth effects supporting the negative signalling hypothesis. There are six pairs in the fu'st quadrant with a positive wealth effect for both securityholders. A wealth transfer from stockholders to bondholders applies to six pairs located in the second quadrant. With a significant portion of the sample pairs located in QIV and QIII, we conclude that wealth transfer and negative signalling effects play an important role in the determination of the valuation impact on securityholders. This dichotomous split in the sample may provide an explanation of the inconsistent stock event study results found in previous studies. The observed effect on stockholder wealth could be a function of the composition of the sample. The greater the number of firms in a sample that face financial distress and more severe the financial weakening, the more likely it is that the stockholders would gain from such terminations.
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Panel B of Table 3 documents that firms in QIII and QIV differ significantly where QIII finns (associated with the negative signalling hypothesis) indeed exhibit attributes of financial weakening. First, f'n'ms in QIV experienced significantly greater cash flow and dividend growth rates than firms in QIII indicating that asset reversion by QIII firms are more likely to be motivated by financial weakening or deficient cash flows when compared with QIV. Second, for firms where there is a transfer of wealth from bondholders to shareholders (firms in QIV), insider ownership is more pervasive in comparison with those in QIII. When insiders have a greater ownership stake in the firm, managerial interests are more aligned with those of shareholders. This coalescence of interests may increase the willingness of the management to expropriate wealth from bondholders to shareholders via excess asset reversions, n
5.2. Cross-sectional analysis Mitchell and Mulherin (1989), using a sample stratification analysis, report that the various circumstances motivating asset reversions play a significant role in determining stock excess returns. However, no evidence currently exists on the cross-sectional determination of bond excess returns. This section investigates, using cross-sectional regression analysis, whether different circumstances of pension asset reversions are significant in determining bond excess returns. We estimate two versions of the following regression model: BER = a o + al(WEAK) + a2(RESTR1 ) + aa(RESTR2 ) + a4(TKVR ) + e, where BER is the two-day announcement period (days - 1 , 0) standardized bond excess return, WEAK is a binary variable which takes a value of 1 ff there is evidence of financial weakness in the year preceding the termination, such as, downgrading of bond ratings or default on debt obligations, RESTR1 is a dummy variable which assumes a value of 1 if the reversion is motivated by financial restructuring, such as stock repurchase, and 0 otherwise, RESTR2 is a dummy variable that takes a value of 1 if the reversion is motivated by general strategic reorganization or financial restructurings and the binary variable TKVR assumes a value of 1 if the reason for the termination is takeover defense. To classify the termination as a takeover defense, we identify whether the management adopted an anti-takeover measure (such as, poison pills, staggered board, etc.) in the two-year period surrounding the filing date from WSJI. Information pertaining to restructuring is also obtained from the WSJI by examining a two-year period centered around the termination. The highest frequency of plan terminations (69.5%) were motivated by a major restructuring. Financial weakening was the
xx Recent increases in excise tax on reverted assets (OBRA 1990) render plan terminations costlier and thus seem to provide protection to bondholders as well as plan participants.
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Table 4 Regression analysis to explain straight bond excess returns using motivations to terminate overfunded pension plans as independent variables for plans terminated between 1982-1987 (t-statistics in parentheses) BER - a 0 + at(WEAK)+ a2(RESTR1)+ a3(RESTR2)+ a4(TKVR) Independent variables Constant
Model 1
Model 2
- 0.290
- 0.583
(-0.25) WEAK
- 0.508
(-0.51) " "
( - 1.78)
RESTR1
- 0.572 ( - 2.01)
-0.611 * " ( - 1.86)
RESTR2 TKVR
Adjusted R 2
0.819 * * " (2.46) 0.194
- 0.657 ( - 1.74) 1.016 (2.85) 0.185
•
•
Variable definitions: BER: WEAK:
the two-day announcement period (days - 1, 0) standardized bond excess return. a binary variable which takes a value of 1 if there is evidence of financial weakness in the year preceding the termination such as downgrading of bond rating or default on debt
obligations. RESTRI: a dummy variable which assumes a value of 1 if the reversion is motivated by financial restructuring, such as a stock repurchase, and 0 otherwise. RESTR2: a dummy variable that takes a value of 1 if the reversion is motivated by general strategic
reorganization or financial restructurings and 0 otherwise. TKVR:
a dummy variable indicating if the reason for termination is takeover defense.
reason behind 52.5% of the terminations. Corroborating Mittelstaedt's (1989) evidence, we find only a small proportion (28.8%) of the terminations were takeover defense related. The coefficient estimates of the two models are presented in Table 4. In both models 1 and 2, we f'md that the coefficients of the variable WEAK are negative and significant at the 5 percent level, supporting the negative signalling hypothesis which predicts that asset reversions by financially weak firms have an adverse wealth impact on bondholders. Perhaps the bondholders interpret such action by the firm as a desperate attempt to supplement deficient cash flows. This result also supports Thomas' (1989) contention that bondholders are exposed to a greater risk of a wealth loss if the asset termination is motivated by a financial weakening of the firm. In model 1, the financial restructuring variable, RESTR1, has a coefficient of - 0 . 6 1 1 which is significant at the 5 percent level. Similar result is obtained for RESTR2 which is included in model 2. Typically, in a restructuring the business entity seeks to improve its financial and operational efficiency. A direct result of such action is a reduction in the financial slack which may adversely affect the bondholders by reducing the excess asset cushion that supports pension obligations
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and protects their priority claims. In contrast, prior studies examining stockholder wealth, such as Mitchell and Mulherin (1989), show that asset reversions undertaken for restructuring purposes result in a significant positive stock excess return. Finally, the coefficients of the TKVR variable is positive and significant in both models lending support to the contention that anti-takeover defense motivated terminations benefit the bondholders, perhaps, by temporarily mitigating the immediate threat of an increase in leverage. This result obtained for bondholders is in contrast to the results reported in Mitchell and Mulherin (1989) examining stock price reaction that pension parachutes adopted to thwart a takeover attempt results in a significant loss in stockholder wealth. In summary, the regression analysis enables us to document the interesting empirical result that the different circumstances for asset reversions examined above have exactly the opposite wealth effects on bondholders as compared to the impact on the stockholders reported by Mitchell and Mulherin (1989).
6. Summary This study investigates the valuation effects of terminating overfunded pension plans on bondholders and stockholders. In this context the redeployment and the negative signalling hypotheses are tested. It is documented that there is a substantial wealth loss for the straight bondholders while the stockholders gain significantly. In addition to wealth transfer effects, the contingency analysis provides support for the negative signalling hypothesis for a significant portion of the sample. Cross-sectional regression analysis reveals that the circumstances under which the terminations are undertaken significantly influence the bond excess returns.
References Alderson, M.J. and K.C. Chen, 1986, Excess asset reversions and shareholder wealth, Journal of Finance 41, 225-241. Alderson, MJ. and J.L. VanDerhei, 1992, Additional evidence on the reaction of shareholders to the reversion of surplus pension assets, Journal of Risk and Insurance 59, 262-274. Dennis, D.K. and JJ. McConnell, 1986, Corporate mergers and security returns, Journal of Financial Economics 16, 143-187. Handjinicolaou, G. and A. Kalay, 1984, Wealth redistribution or changes in firm value: An analysis of returns to bondholders and stockholders around dividend announcements, Journal of Financial Economics 13, 35-63. Haw, I., W. Ruland and A. HamdaUah, 1988, Investor evaluation of oveffunded pension plan terminations, Journal of Financial Research 11, 81-88. Jensen, M.C., 1986, Agency costs of free cash flow, corporate finance and takeovers, American Economic Review, Papers and Proceedings 76, 323-329. Masulis, R.W., 1980, The effects of capital structure change on security prices: A study of exchange offers, Journal of Financial Economics 8, 139-177.
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Mitchell, M.L. and J.H. Mulherin, 1989, The stock price response to pension terminations and the relation of terminations with corporate takeovers, Financial Management 18, 41-56. Mittelstaedt, H.F., 1989, An empirical analysis of the factors underlying the decision to remove excess assets from overfunded pension plans, Journal of Accounting and Economics 11, 399-418. Mittelstaedt, H.F. and P.R. Regier, 1990, Further evidence on excess asset reversions and shareholder wealth, Journal of Risk and Insurance 57, 471-486. Moore, N.H. and S.W. Pruitt, 1990, Excess asset reversions and shareholder wealth: A comment, Journal of Finance 45, 1709-1714. Myers, S.C. and N.J. Majluf, 1984, Corporate financing and investment decisions when flu-ms have information that investors do not have, Journal of Financial Economics 13, 187-221. Pontiff, L, A. Shleifer and M.S. Weisbach, 1989, Reversions of excess pension assets and takeovers, Working Paper, University of Rochester. Thomas, J.K., 1989, Why do firms terminate their overfunded pension plans?, Journal of Accounting and Economics 11, 361-398. VanDerhei, J., 1987, The effect of voluntary termination of overfunded defined pension plans on shareholder wealth, Journal of Risk and Insurance 54, 131-156.
Journalof
,
BANKING & ELSEVIER
Journal of Banking& Finance 19 (1995) 245-259
FINANCE
Pension plan terminations, excess asset reversions and securityholder wealth Sudip Datta ~'*, Mai E. Iskandar-Datta Edward J. Zychowicz c
b,
• Department of Finance, Bentley College, Waltham, MA 02154, USA b Finance Research Associates, 151) Manning Roa~ Waltham, MA 02154-8000, USA c Department of Banking and Finance, Hofstra University, Hempstead, NY 11550, USA Received April 1992; final version received September 1993
Abstract The total finn valuation impact of an excess pension asset reversion is an unresolved issue. Prior studies focusing on stockholder wealth provide varied evidence. This study examines the valuation effects of excess asset reversions on bondholders (straight and convertible) and stockholders of the sponsoring f ' m . The redeployment and the negative signalling hypotheses provide a framework for the analysis. We provide evidence of wealth expropriation from straight bondholders to stockholders. Convertible debtholders are not impacted by plan terminations. Contingency table analysis also reveals evidence in support of the negative signalling hypothesis for a significant portion of the sample. Cross-sectional regression identifies financial weakening of the f'u'm, reversions undertaken for restructuring purposes and takeover defense related terminations as significant determinants of bondholder excess returns.
Keywords: Pension plan terminations; Bondholder and stockholder wealth; Asset reversions; Firm valuation JEL classification: G14; G30; G32
* Correspondingauthor. Tel. (617) 891-2513. We wish to thank E. William Fitzgerald of the Pension Benefit Guaranty Corporation for his generous help in providingus with the data. 0378-4266/95/$09.50 © 1995 Elsevier Science B.V. All rights reserved SSDI 0378-4266(94)00053-0
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1. Introduction
The termination of overfunded defined benefit pension plans has proved to be a significant financial resource for U.S. corporations. The Pension Benefit Guaranty Corporation (PBGC) reports that 2,246 overfunded plans were terminated during the period 1980-1990. The accompanying excess asset reversions represent an aggregate flow of $21.5 billion to plan sponsoring firms. The magnitude and frequency of pension asset reversions during the last decade has important policy implications for the U.S. public and private sectors. Therefore, a considerable need for academic research exists in this area. The objective of the study is to contribute to the understanding of the valuation effect of excess pension asset reversions on the overall firm value. Evidence from prior studies which examine the impact of such reversions on shareholder wealth leaves this issue unresolved. Alderson and Chen (1986), Mittelstaedt and Regier (1990) and Moore and Pruitt (1990) report normal returns to stockholders while Haw, Ruland and Hamdallah (1988), Mitchell and Mulherin (1989) and VanDerhei (1987) find significant positive impact on stockholder wealth. AIderson and VanDerhei (1992) attempt to resolve the dichotomous results of previous studies and conclude, based on statistically weak evidence, that the financial strength of the sponsoring firm and the type of the successor plan are important determinants of the stock price reaction. However, it is difficult to draw definitive conclusions about the valuation impact of such financial decisions without also considering the concomitant effect on the debtholders of the sponsoring firm. This study examines the valuation effects of excess asset reversions on the straight and convertible debtholders and the corresponding stockholders of the terminating firms. The redeployment and the negative signalling hypotheses are tested in the context of wealth impacts on these securityholder classes. Based on the premises of agency theory and asymmetric information, these two hypotheses can provide an alternative explanation of the dichotomous results reported in some of the prior stock price studies. It is possible that any gain experienced by the stockholders may be generated as a result of a wealth transfer from the bondholders. On the other hand, the insignificant wealth impact on the stockholders reported in some of the prior studies may arise due to the positive wealth transfer effect being offset by the negative signalling effect. The two-day announcement period excess returns indicate that bondholders suffer, on average, a significant loss. In contrast, a statistically significant gain is observed for the stockholders during the same period. Convertible debtholders, however, are not significantly impacted by plan terminations. This study provides evidence that the adverse effect on the bondholders is driven by the wealth transfer to the stockholders and the negative signal about the film'S financial condition emitted by the use of costly financing from overfunded pension plans. The cross-sectional analysis reveals that bondholder excess returns are significantly influenced by factors such as, financial weakening (supporting the negative
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signalling hypothesis), corporate restructuring and takeover defense related terminations (consistent with arguments presented under the redeployment hypothesis). The remainder of the paper is organized as follows: Section 2 presents the testable hypotheses. Section 3 describes the sample selection criteria, the properties of the sample and the data sources. The bond and stock daily event study methodologies are presented in Section 4. Section 5 reports the empirical results. Finally, the results of the study are summarized in Section 6.
2. Testable hypotheses In this paper we propose two testable hypotheses relating to excess pension asset reversions. The redeployment hypothesis contends that the reverted pension assets can be redeployed to uses that can either create, leave unchanged or destroy value for the bondholders a n d / o r the stockholders. 1 This hypothesis encompasses two effects. First, to the extent that the redeployment of surplus assets is unanticipated, such action by the f'Lrm may result in a change in securityholder wealth. The second effect is associated with the agency problem that may arise with such reallocation of plan assets. The positive valuation effect implied by the redeployment of excess pension assets to higher valued uses may not be realized for bondholders if it also results in a concomitant wealth transfer to stockholders. 2 Wealth expropriation from bondholders may occur in several ways. Overfunded pension plans can serve as a cushion protecting the priority of bondholder claims to corporate assets. Removing excess assets, in effect, reduces financial slack that has been stored in the form of overfunded plans. This may be tantamount to an increase in leverage if the proceeds are dissipated to the shareholders. Moreover, a wealth transfer from bondholders to stockholders need not correspond with an actual increase in dividend payments. The firm may use the reverted assets to maintain the current level of dividend payments which otherwise could no longer be supported by the expected cash flow from the operations of the firm. Conversely, if the management uses the proceeds to repurchase debt and reduce leverage, the bondholders could gain from plan terminations. The benefits from such action, however, may be offset by the fact that financial slack stored in the form of overfunded pension plans is eliminated.
1 One possiblesourceof securityholdergains is tax benefits. However,Mittelstaedt(1989) concludes that maximizingtax savings does not appear to be the primarymotive for these terminations. 2 Positive stock excess return and zero bond excess return would be consistent with the belief that terminations transfer wealth from employeesto stockholders. Thomas(1989) argues that terminations are not likely to result in expropriationof employeewealth since the PBGC, the TreasuryDepartment and the Departmentof Labor legally sanctioned terminationswith the joint implementationguidelines issued in 1984. Furthermore, he provides empirical evidence that does not support breach of implicit contracts with employees.
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Another adverse impact on the bondholders may result from their exposure to the 'subordination risk' when overfunded plans are terminated. Although restricted to a limited number of cases, this risk may relegate them to a lower rank in the priority of claims on the corporate assets. 3 Specifically, plan participants (employees) have priority claims to a firm's assets under certain conditions. If the present value of pension liabilities exceed the current value of pension fund assets, the P B G C - acting on behalf of plan participants - has the authority to place a lien on sponsoring firm assets up to 30% of the Fn'm's net worth. 4 This lien would be senior to all unsecured liabilities of the firm except employee wages. Lower levels of funding may increase the probability that the claims of bondholders will become subordinate to claims of employees thus diminishing bondholder wealth. 5 One motivation offered for plan terminations is that they constitute a part of a broader restructuring program undertaken by the firm. This is expected to impact stockholders positively. However, the relation between plan terminations and bondholder wealth is governed by several conflicting factors. In the context of restructuring, plan terminations may result in increased efficiency which has a positive effect on both securityholders. On the other hand, firms that restructure typically reduce financial slack by increasing leverage and reducing their free cash flow (Jensen, 1986). Consequently, the bondholders may be adversely affected by the reduction in the financial slack. Therefore, the net impact on straight bondholders can only be resolved empirically. Under certain conditions, wealth transfer may occur from stockholders to bondholders. For example, if the surplus pension assets make the firm an attractive target for a takeover, terminating overfunded plans can act as a takeover defense (Pontiff et al., 1989). Using plan terminations as a takeover defense may represent good news to straight bondholders as the likelihood of an increase in leverage diminishes and perhaps bad news to the stockholders as documented in the corporate takeover defense literature. Such corporate action may, therefore, result in a wealth transfer from stockholders to bondholders, assuming that the surplus assets are redeployed to similar valued uses under the target as they would have been if the takeover was consummated. The thrust of the negative signalling hypothesis is that excess asset reversions emit a negative signal to investors about the future cash flow of the firm. One recent motive for plan terminations is to provide Fmancially weak firms with a much needed infusion of funds. Since excess pension assets represent a source of
3 As per the-1984 PBGC guidelines, annuities must be purchased to defease pre-termination plan obligations. Therefore, subordination risk would be associated only with post-termination benefit accruals. 4 In accordance with OBRA 1987,-the sponsoring employers are deemed liable for 100% of the unfunded benefit obligations (even though the secured portion is limited to 30% of the net worth). s The amount of subordination risk the bondholders are e ~ d to will be mitigated if the terminated plan is replaced with a defined contribution plan or if annuities are purchased.
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financing, firms facing an unexpected decline in available funds may liquidate Financial slack stored in overfunded pension plans. Mittelstaedt (1989) and Thomas (1989) provide evidence indicating that f'Lrms which terminate pension funds exhibit signs of financial weakening, such as, declines in profitability, unavailability of funds and reduction in market values. For firms with an increased likelihood of f'mancial distress, excess asset reversions may constitute a new revelation (and perhaps a confirmation of prior indications) about the firm's cash flow prospects. The potential for excess asset reversions to convey negative information to the market is even more revealing when compared with the alternative method of accessing financial slack stored in overfunded plans. Rather than terminating plans, surplus assets may be accessed gradually over time through an adjustment in actuarial assumptions. Although plan terminations provide fast access to surplus funds, this mode of Fmancing has costs that are not incurred when pension financial slack is gradually depleted. For example, the firm incurs additional pension obligations upon plan termination since nonvested benefits become vested as required by Sections 4041 and 4044 of the Employee Retirement Income Security Act (E/USA) of 1974. In addition, terminations cause certain explicit transaction costs, related to purchasing annuities and implementing a replacement plan. And f'maUy, the Tax Reform Act of 1986 imposed a 10% excise tax on the amount of the reverted assets. 6 The willingness of firms to incur such costs associated with excess asset reversions seems to suggest that alternative lower cost funds are not sufficient. Myers and Majluf (1984) assert that as firms experience large declines in available funds, they are forced to move increasingly lower (higher cost) in the pecking order of f'mancing, such as plan terminations. Given the additional costs associated with plan terminations, management is not expected to terminate overfunded plans for relatively small declines in funds that can be offset by a cheaper source of funds such as slow withdrawals through adjustments of actuarial assumptions (Thomas, 1989). Thomas provides evidence that terminating firms, facing a reduction in available cash flow, respond by first reducing slack in working capital and by reducing dividends and then, only as a last resort, they liquidate pension financial slack to meet the shortfall of available funds. To the extent that reversions are not fully anticipated, an adverse valuation effect on all securityholders is expected ff the negative signalling hypothesis holds. In this context it is important to note, however, that the redeployment and the negative signalling hypotheses are not mutually exclusive. While the negative signalling and wealth transfer effects clearly have a negative impact on bondhold-
e The excise tax has been increased to 15% by the Technical and Miscellaneotts Revenue Act of 1988 and further to 20% by the Omm'bus Budget Reconciliation Act (OBRA) of 1990. However, our sample period ends in 1987 and hence is not impacted by these two acts.
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ers, the net impact on stockholders is ambiguous as the two effects act in opposite directions.
3. Sample and data sources
The pension termination data was obtained from two sources: (a) the quarterly termination logs and (b) compilation list, both of which were provided to us by the PBGC for excess asset reversions occurring between October 1982 and December 1987. Using the termination f'de date from the quarterly logs, we identified a list of plan terminations. If the plan sponsor were a subsidiary, the parent company was identified by examining Dun and Bradstreet's America's Corporate Families and National Register Publishing Company's Directory of Corporate Affiliations. The dollar amounts of plan assets and reversions were obtained from the PBGC compilation list. The Wall Street Journal Index (WSJI) was examined to identify the date of the announcement of the intent to terminate the pension plan. However, in only 8 cases (10.7%) was the intent to terminate announced in the Wall Street Journal (WSJ). Alderson and Chen (1986), Haw, Ruland and Hamdallah (1988) and Mitchell and Mulherln (1989) made similar observations about their samples. Since in all of these cases the WSJ date occurred prior to the fding date, the WSJ date was considered the announcement date (t -- 0). For the remaining firms which did not have a WSJ announcement date, the event date is the date on which the plan sponsor filed its intent to terminate with the PBGC. This filing date represents the best publicly available date announcing the firm's intention to terminate, since it precedes the actual termination date for all reversions examined in this study. 7 Some observations were excluded from the initial sample due to unavailability of data. Events were eliminated because of the absence of publicly traded debt or because of 'thin' trading. A bond is defined to be thinly traded if there are less than six trades during the 21 day event window. Additionally, a bond has to trade both before and after the announcement day to be included in the sample. Finally, the WSJI was examined for confounding events over the event window ( - 1, + 1). This sample selection criterion resulted in a final sample of 71 plan termination announcements made by 51 different fnans. Of these 71 events, there were 59 straight and 17 convertible debt issues (some firms had both). For firms with multiple plan terminations, the average period between plan terminations was 227 days.
Mitchell and Mulherin (1989) report that for 18% of the cases, the termination was retroactively dated to a time prior to filing date. They also empirically show that the appropriate announcement date is the filing date.
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Table 1 Plan termination sample characteristics, October 1982 to December 1987 Panel A: Sample distribution by year of Panel B: Distribution of termination bond ~tiags Year
Stocks Straight Convertible debt debt
S and P bond rating
Frequencyof straight debt
Frequencyof convertibledebt
1982 1983 1984 1985 1986 1987 Total
2 7 6 24 23 9 ~
AAA AA A BBB BB B CCC CC NR Total
2 5 5 22 8 14 2 0 1 ~-O
0 0 2 8 4 1 1 1 0 1"7
2 5 4 18 23 7 5-~
1 1 3 7 1 4 1-7
Panel C: Descriptive statistics on amount of debt ($ million)
Panel D: Frequencyof straight bonds by seniority
Statistics
Straight debt
Convertible debt
Type of bond
Number
Percentof the sample
Mean Minimum Maximum
98.8 3.7 300.0
75.8 4.2 215.0
Mortgage/senior Nonsubordinated Subordinated Total
3 30 26 5-'0
5.08% 50.85% 44.07% 1~ .--~--.'.'.'.'.'~o
Table 1 presents a description of the sample. In panel A, the frequency distribution of plan terminations by the year of announcement is similar to that provided by the PBGC list for the entire population of terminations during the study period. The mean dollar excess reversion for the sample of terminations is $66.84 million while the average reversion as a percent of the book value of c o m m o n equity of the plan sponsor is 5.21%. The remaining panels in Table 1 summarize the major characteristics of the bond samples. Examining the Standard and Poor's rating distribution of the straight (convertible) bond sample in panel B, we find that 57.5% (58.9%) are investment grade. The average outstanding dollar amount for the straight (convertible) bonds is $98.8 ($75.8) million. In addition, approximately one-half o f the straight bonds are nonsubordinated, while the remaining are subordinated. The daily prices of the most frequently traded bond for each sample firm were collected from the WSJ for 11 trading days before and 10 days after the announcement day. Treasury bond prices with coupons and maturities matching those of the sample bonds were also collected from the WSJ. To compute daily returns from bond prices, with cumulated daily coupon interest, Moody's Bond Record was used to identify the interest payment dates of the sample bonds.
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Financial information about the sample was retrieved from Compustat tapes and M o o d y ' s Industrial Manuals. Finally, stock price data were retrieved from the C R S P daily master tape.
4. M e t h o d o l o g y
To determine the stock price reaction to pension termination announcements, we use the mean excess returns generated by the market model. The estimation period for the market model parameters is from day - 2 5 0 to day - 6 1 . The mean adjusted returns methodology developed by Masulis (1980) and adapted for bonds by Handjinicolaou and Kalay (1984) is used to estimate excess bond returns. To adjust for changes in the term structure of interest rates, the corporate bonds are matched with treasury bonds according to maturity and coupon rate, and the adjusted bond return (ABRi, d) is calculated as follows: A B R i , a -~ BRi, d - TBRi,d,
where BR~,d is the holding period bond return for firm i for day d and TBRi, a is the return over the same period for an equivalent treasury bond. Daily accrued coupon interest is added to the price change to calculate the bond's holding period return. A nineteen day interval around the event is used to estimate the comparison and announcement period returns. The comparison period is day t - 10 to day t - 2 and day t + 1 to day t + 10. The mean comparison period return (R~m,) for fh'm i is as follows: 1
R,.o,-
ABRi, a
E
'
where ( d t - d k _ 1) is the number of trading days that elapsed between two successive trades. Since bond returns are a series of single and multiple day returns they are adjusted to yield equivalent single day returns and standardized using the estimated standard deviation of the comparison period returns for the bond. Finally, the standardized mean excess return for the portfolio of bonds for each day over the entire 21 day period is estimated. Assuming that individual standardized excess bond returns are Student-t distributed with mean O and k - 2 degrees of freedom (where k is the number of business days in which a particular bond traded), it follows from the central limit theorem, the standardized portfolio mean excess return for any event day is normally distributed with mean 0 and variance 1 / n t (where n t is the number of observations on day t). However, as suggested by Handjinicolaou and Kalay (1984), s we report the crude dependence test statistics (distributed as Student-t) for the daily standardized portfolio mean s For a complete discussion of the test statistics, see Handjinicolaou and Kalay (1984, pp. 45--46).
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Table 2 Standardized mean excess returns for three types o f securityholders over various intervals around the termination filing date during the period 1 9 8 2 - 1 9 8 7 (t-statistics in parentheses) Panel A: Multiple plan terminations
Panel B: One plan termination
per firm
per firm
Event window t - 10, t - 2 t - 1, t t {t + 1, t + 10
Stockholder CEILs
Straight debt CEILs
Convertible CERs
Stockholder CERs
Straight debt CERs
N~71
N=59
N=I7
N=51
N~44
0.990 (1.38) 0.642 ° (1.81) 0.399 (1.33) -0.052 (-0.07)
-0.045 ( - 0.08) -0.794 " " ( - 2.92) - 0.737 " " (-3.84) -0.189 (-0.33)
-0.207 ( - 0.27) 0.271 (0.76) - 0.029 (-0.12) - 0.595 (-0.78)
1.042 (1.16) 0.854 " (1.97) 0.436 (1.38) - 0.168 (-0.19)
-0.284 ( - 0.46) -0.639 " ' ( - 2.20) - 0.635 " " (-3.10) 0.141 (0.23)
"'" " Significant at 10% and 1% levels, respectively.
excess returns since the cross-sectional independence between individual bond excess returns cannot be guaranteed. This t-statistic is computed by dividing the standardized portfolio mean bond excess return for the event day by the standard deviation of the daily portfolio excess returns.
5. Empirical results 5.1. Overall results Table 2 presents the bond and stock price reactions to plan terminations over different intervals with the corresponding t-statistics. The straight bond standardized excess return on the announcement day is - 0 . 7 4 percent with a t-statistic of - 3 . 8 4 which is significant at the 1 percent level. The two-day (days - 1 and 0) cumulative excess bond return is - 0 . 7 9 and significant at the 1 percent level. Of the 59 bonds, 46 bonds (77.97%) reacted negatively to the termination fding and only 13 had a positive reaction. A nonparametric binomial sign test was conducted to confirm that this negative effect on bondholder wealth is not driven by outliers. This test yields a z=statistic of 4.30 which is statistically significant at the 1 percent level. The above results indicate that plan terminations, on average, have a significantly negative impact on the firms' straight bondholders. The analysis of the market model residuals for the stock sample reveals that the two-day cumulative excess return is 0.64 percent which is significant at the 10 percent level (t = 1.81). The cumulative excess returns for other intervals are not significant. Although restricted to the sample of firms with publicly traded debt,
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our overall stock results corroborate the results obtained by Mitchell and Mulherin (1989), VanDerhei (1987) and Alderson and VanDerhei (1992). These results hold even though the s o u r c e of the event date used by these studies vary. 9 Finally, the impact on convertible debtholder wealth is insignificant for all intervals centered around the termination filing date. The securityholder excess returns are re-estimated using a subset of the samples where only one plan termination (the first one) per firm is included. The results presented in panel B of Table 2 are very similar to the complete samples. To obtain the impact of the reversion on firm value, we compute the dollar gains for both bondholders and stockholders. The dollar equityholder (bondholder) gains (losses) are calculated by multiplying the stock (bond) excess return for days - 1 and 0 by the market (book) value of the equity (long-term debt) at the year-end preceding the termination. The average dollar gains to stockholders is $1.32 million. In contrast, the mean dollar losses experienced by the long-term bondholders is a statistically significant -$7.46 million (t = -2.64). However, the total wealth impact of the reversion ( - $ 6 . 1 4 million) is statistically insignificant (t = - 1.12). These results imply that the negative overall valuation impact of the redeployment of excess pension assets is absorbed by bondholders, while stockholders' wealth gain from such redeployment of assets, although positive, is statistically insignificant. Following Dennis and McConnell (1986), we compute the correlation coefficient between individual bond and stock excess returns to be -0.274 which is statistically significant (t = -2.04). Thus, the combined results indicate that the benefits accruing to the shareholders are offset by the adverse wealth effects experienced by the straight bondholders supporting the notion of wealth transfer from bondholders to stockholders. To observe any effect of the Single Employer Pension Plan Amendments Act (SEPPAA), 1o results are re-estimated using a sample period restricted to events occurring before May 1986. The average announcement day excess return for bondholders ( - 0 . 8 2 % ) and stockholders (0.38%) are still significant, implying that the passage of the act did not substantially alter the overall results. The same conclusion, based on examining stockholder wealth, is reported in Alderson and VanDerhei (1992). Analyzing the distribution of standardized excess returns for bonds and stocks it is observed that the most frequent (40.7%) bond excess return is in the range -1.00% and 0%. On the other hand, the comparable range for stocks and
9 Mitchelland Muiherin(1989) and AIdersonand VanDerhei(1992) use the terminationfilingdates contained on a tape provided by the PBGC, while VanDerhei (1987) used the quarterly termination l°~0s 0•
SEPPAA passed on May 1986 requires sponsoring finns to inform plan participants at least 60 days prior to filing for plan termination.
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Table 3 Joint frequency distribution of excess returns for 56 a straight bonds and stocks on the termination filing day and characteristics of firms in quadrants QIII and QIV Panel A: Joint frequency distribution of bond and stock excess returns
Sign of bond excess return
Positive Negative
Sign of stock excess return Positive
Negative
N,%
N,%
QI 6 (10.7%) QIV 25 (44.6%)
QII 6 (10.7%) QIII 19 (33.9%)
Panel B: Attributesof firms in wealth transfer and negativesignalling quadrants Variables Insider ownership b (%) Growth in CFPS c (%) Growth in DPS d (%)
Wealth transfer (QIV) 10.63 7.61 10.79
Negativesignalling (QIII) 4.86 3.66
2.92
Mean difference t-statistics - 1.42 ° - 1.67 " " -- 2.04 " " "
Variable definitions: b Insider ownership reflects the ownership by the top five directors of the terminating firm. c Growth in CFPS reflects the growth in cash flow per share over the five years prior to plan termination. Growth in DPS reflects the growth in dividends per share over the five years prior to plan
termination. All three variableswere obtained from Value Line InvestmentSurvey. convertible bonds is between 0% and 1.00%. Since, on average, the convertible bonds do not react to the termination announcement, the analysis hereafter focuses only on stockholders and straight bondholders. Using a contingency table framework, the announcement day excess bond returns are paired with corresponding excess stock returns in Table 3, panel A. The highest frequency of pairs (44.6%) occurs in the fourth quadrant (QIV), where stockholders gain while bondholders experience a negative wealth effect associated with the redeployment hypothesis. The next highest frequency (33.9%) is observed in the third quadrant (QIII) where both securityholders experience adverse wealth effects supporting the negative signalling hypothesis. There are six pairs in the fu'st quadrant with a positive wealth effect for both securityholders. A wealth transfer from stockholders to bondholders applies to six pairs located in the second quadrant. With a significant portion of the sample pairs located in QIV and QIII, we conclude that wealth transfer and negative signalling effects play an important role in the determination of the valuation impact on securityholders. This dichotomous split in the sample may provide an explanation of the inconsistent stock event study results found in previous studies. The observed effect on stockholder wealth could be a function of the composition of the sample. The greater the number of firms in a sample that face financial distress and more severe the financial weakening, the more likely it is that the stockholders would gain from such terminations.
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Panel B of Table 3 documents that firms in QIII and QIV differ significantly where QIII finns (associated with the negative signalling hypothesis) indeed exhibit attributes of financial weakening. First, f'n'ms in QIV experienced significantly greater cash flow and dividend growth rates than firms in QIII indicating that asset reversion by QIII firms are more likely to be motivated by financial weakening or deficient cash flows when compared with QIV. Second, for firms where there is a transfer of wealth from bondholders to shareholders (firms in QIV), insider ownership is more pervasive in comparison with those in QIII. When insiders have a greater ownership stake in the firm, managerial interests are more aligned with those of shareholders. This coalescence of interests may increase the willingness of the management to expropriate wealth from bondholders to shareholders via excess asset reversions, n
5.2. Cross-sectional analysis Mitchell and Mulherin (1989), using a sample stratification analysis, report that the various circumstances motivating asset reversions play a significant role in determining stock excess returns. However, no evidence currently exists on the cross-sectional determination of bond excess returns. This section investigates, using cross-sectional regression analysis, whether different circumstances of pension asset reversions are significant in determining bond excess returns. We estimate two versions of the following regression model: BER = a o + al(WEAK) + a2(RESTR1 ) + aa(RESTR2 ) + a4(TKVR ) + e, where BER is the two-day announcement period (days - 1 , 0) standardized bond excess return, WEAK is a binary variable which takes a value of 1 ff there is evidence of financial weakness in the year preceding the termination, such as, downgrading of bond ratings or default on debt obligations, RESTR1 is a dummy variable which assumes a value of 1 if the reversion is motivated by financial restructuring, such as stock repurchase, and 0 otherwise, RESTR2 is a dummy variable that takes a value of 1 if the reversion is motivated by general strategic reorganization or financial restructurings and the binary variable TKVR assumes a value of 1 if the reason for the termination is takeover defense. To classify the termination as a takeover defense, we identify whether the management adopted an anti-takeover measure (such as, poison pills, staggered board, etc.) in the two-year period surrounding the filing date from WSJI. Information pertaining to restructuring is also obtained from the WSJI by examining a two-year period centered around the termination. The highest frequency of plan terminations (69.5%) were motivated by a major restructuring. Financial weakening was the
xx Recent increases in excise tax on reverted assets (OBRA 1990) render plan terminations costlier and thus seem to provide protection to bondholders as well as plan participants.
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Table 4 Regression analysis to explain straight bond excess returns using motivations to terminate overfunded pension plans as independent variables for plans terminated between 1982-1987 (t-statistics in parentheses) BER - a 0 + at(WEAK)+ a2(RESTR1)+ a3(RESTR2)+ a4(TKVR) Independent variables Constant
Model 1
Model 2
- 0.290
- 0.583
(-0.25) WEAK
- 0.508
(-0.51) " "
( - 1.78)
RESTR1
- 0.572 ( - 2.01)
-0.611 * " ( - 1.86)
RESTR2 TKVR
Adjusted R 2
0.819 * * " (2.46) 0.194
- 0.657 ( - 1.74) 1.016 (2.85) 0.185
•
•
Variable definitions: BER: WEAK:
the two-day announcement period (days - 1, 0) standardized bond excess return. a binary variable which takes a value of 1 if there is evidence of financial weakness in the year preceding the termination such as downgrading of bond rating or default on debt
obligations. RESTRI: a dummy variable which assumes a value of 1 if the reversion is motivated by financial restructuring, such as a stock repurchase, and 0 otherwise. RESTR2: a dummy variable that takes a value of 1 if the reversion is motivated by general strategic
reorganization or financial restructurings and 0 otherwise. TKVR:
a dummy variable indicating if the reason for termination is takeover defense.
reason behind 52.5% of the terminations. Corroborating Mittelstaedt's (1989) evidence, we find only a small proportion (28.8%) of the terminations were takeover defense related. The coefficient estimates of the two models are presented in Table 4. In both models 1 and 2, we f'md that the coefficients of the variable WEAK are negative and significant at the 5 percent level, supporting the negative signalling hypothesis which predicts that asset reversions by financially weak firms have an adverse wealth impact on bondholders. Perhaps the bondholders interpret such action by the firm as a desperate attempt to supplement deficient cash flows. This result also supports Thomas' (1989) contention that bondholders are exposed to a greater risk of a wealth loss if the asset termination is motivated by a financial weakening of the firm. In model 1, the financial restructuring variable, RESTR1, has a coefficient of - 0 . 6 1 1 which is significant at the 5 percent level. Similar result is obtained for RESTR2 which is included in model 2. Typically, in a restructuring the business entity seeks to improve its financial and operational efficiency. A direct result of such action is a reduction in the financial slack which may adversely affect the bondholders by reducing the excess asset cushion that supports pension obligations
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and protects their priority claims. In contrast, prior studies examining stockholder wealth, such as Mitchell and Mulherin (1989), show that asset reversions undertaken for restructuring purposes result in a significant positive stock excess return. Finally, the coefficients of the TKVR variable is positive and significant in both models lending support to the contention that anti-takeover defense motivated terminations benefit the bondholders, perhaps, by temporarily mitigating the immediate threat of an increase in leverage. This result obtained for bondholders is in contrast to the results reported in Mitchell and Mulherin (1989) examining stock price reaction that pension parachutes adopted to thwart a takeover attempt results in a significant loss in stockholder wealth. In summary, the regression analysis enables us to document the interesting empirical result that the different circumstances for asset reversions examined above have exactly the opposite wealth effects on bondholders as compared to the impact on the stockholders reported by Mitchell and Mulherin (1989).
6. Summary This study investigates the valuation effects of terminating overfunded pension plans on bondholders and stockholders. In this context the redeployment and the negative signalling hypotheses are tested. It is documented that there is a substantial wealth loss for the straight bondholders while the stockholders gain significantly. In addition to wealth transfer effects, the contingency analysis provides support for the negative signalling hypothesis for a significant portion of the sample. Cross-sectional regression analysis reveals that the circumstances under which the terminations are undertaken significantly influence the bond excess returns.
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