Docstoc

Investor Protection and Convertible Debt Design

Document Sample
Investor Protection and Convertible Debt Design Powered By Docstoc
					Investor Protection and
Convertible Debt Design
              Cheng-Few Lee
          Rutgers Business School
Rutgers, The State University of New Jersey
               United States

             Kin-Wai, Lee*
       Nanyang Business School
    Nanyang Technological University
          Singapore 639798.
         Tel: +(65)-67904663
       Email : akwlee@ntu.edu.sg


        Gillian Hian-Heng, Yeo
    Nanyang Technological University
               Singapore.


             *Contact Author




                                              1
Abstract
An important issue that firms consider when designing convertible debt is to specify security
features such as conversion ratio, maturity date and call period. Following Lewis, Rogalski and
Seward (2003), we employ a single measure that simultaneously considers all of these features:
the expected probability (measured at issue date) that the convertible will be converted to equity
at maturity. We find that firms in countries with stronger shareholder rights issue convertible
debt with a higher expected probability of converting to equity.         The positive association
between the expected probability of conversion and shareholder rights is less pronounced in
firms for which ownership structures create potentially high managerial agency costs.
Specifically, in countries with stronger shareholder rights, firms with higher separation of control
rights and cash flow rights tend to issue convertibles with lower probability of conversion.
Furthermore, we find that large non-management block ownership strengthens the likelihood of
issuing convertible debt with higher probability of conversion in countries with stronger
shareholder rights. In contrast, firms in countries with stronger creditor rights issue convertibles
with lower probability of conversion. We also document that the negative association between
creditor rights and probability of conversion is more pronounced in firms with higher separation
of control rights and cash flow rights.




                                                                                                  2
1. Introduction

           Convertible debt is a hybrid security that contains both debt and equity characteristics.
When firms design convertible debt, they choose how debt-like or equity-like the offer will be by
specifying security features such as conversion ratio, maturity date and call period. Lewis,
Rogalski and Seward (2003) argue that the expected probability of converting the convertible
debt to equity at maturity is a useful summary measure that simultaneously considers various
security design features. Thus, the higher (lower) the expected probability that the convertible
debt will be converted from debt to equity at maturity, the more equity-like (debt-like) is the
convertible’s security design. This paper examines the association between investor protection
and the security design of convertibles, as measured by the expected probability of converting
the convertibles at maturity.
           Prior papers examine the theoretical motivations underlying the offering of convertible
debt. Green (1984) argues that convertible debt mitigates the managerial incentives to over-
invest in risky projects. Brennan and Schwartz (1988) argue that firms with high operating and
financial risk face high costs of issuing standard securities such as straight debt or common
equity. Thus, high risk firms issue convertibles because the value of convertible debt is relatively
insensitive to the risk of the issuing firms. Stein (1992) suggests that firms issue convertible debt
to avoid the adverse selection problem associated with issuing conventional equity. Mayers
(1998) argues that convertibles reduces over-investment problem and minimizes issue costs.
Firms obtain funds when they issue convertibles, together with an option to obtain additional
equity financing with no flotation costs if positive net present value projects are available later1.
In general, the empirical evidence (Stein 1992; Lewis, Rogalski and Seward 2003) suggests that
convertibles tend to be issued by firms with high market-to-book ratios and higher level of
business risk than firms that issue straight debt or equity.
           A common theme in these papers is that firms that issue convertible debt have high
agency costs of external finance and high information asymmetry between managers and
external investors. However, these papers tend to be country-specific and do not investigate
cross-country variation in the design of convertible debt. We suggest that in an international
setting, country-level investor protection and the separation of control rights and cash flow rights
1
    In contrast, Alderson et al. (2006) do not find evidence supporting Mayers’ (1998) staged financing hypothesis.

                                                                                                                      3
of the controlling shareholder at the firm-level constitute important factors that affect the agency
costs and information asymmetry of convertible debt issuers. LaPorta et al. (2002) find that in
most countries, listed firms generally have controlling shareholders who have the ability and
incentives to expropriate minority shareholders and creditors. Consequently, the central agency
problem in such firms is the expropriation of minority shareholders and creditors by controlling
shareholders.
       Our central theme is that country-level shareholder rights and creditor rights should affect
the security design of convertible debt. We posit that the contractual terms that make the nature
of convertible debt more debt-like or more equity-like are associated with investor protection.
Convertible debt provides an excellent setting to test the effect of investor protection on hybrid
security design given that convertibles have both the properties of debt and equity. This allows
us to distinguish the relative effect of two kinds of investor protection - shareholder rights and
creditor rights - on the design of convertible debt.
       We find that firms in countries with stronger shareholder rights issue convertible debt
with a higher expected probability of converting to equity (i.e., more equity-like). The positive
association between the expected probability of conversion and shareholder rights is less
pronounced in firms for which ownership structures create potentially high agency costs.
Specifically, in countries with stronger shareholder rights, firms in which the controlling
shareholders have higher separation of control rights and cash flow rights issue convertibles with
lower probability of conversion. Furthermore, we find that equity ownership by large non-
management shareholders strengthens the propensity of firms to issue convertibles with higher
probability of conversion in countries with stronger shareholder rights. Our results suggest that
convertible debt holders are more likely to convert their claims to equity in countries with
stronger shareholder rights. Stronger country-level shareholder rights combined with lower
expected agency problems between controlling shareholders and minority shareholders reduce
the risk of expropriation of minority shareholders and encourage investors to hold convertibles
with higher probability of conversion. In addition, a strong macro environment such as strong
country-level shareholder rights provides the necessary infrastructure for large non-management
shareholders to increase monitoring effectiveness and efficiency. Our empirical results suggest
that this manifests itself in a greater prevalence that firms issue convertible debt with higher
expected probability of conversion to equity.

                                                                                                  4
        In contrast, firms in countries with stronger creditor rights issue convertibles with lower
expected probability of converting to equity at maturity (i.e., more debt-like). The negative
association between creditor rights and the probability conversion is more pronounced in firms
with higher separation of control rights and ownership rights. Our results suggest that convertible
debt holders are less likely to convert their claims to equity in countries with stronger creditor
rights. Furthermore, in firms with higher expected agency problems between controlling
shareholders and minority shareholders, convertible debt holders are less likely to convert to
equity to avoid expropriation of their wealth by controlling shareholders.
        Our results are robust to an alternative measure of probability of conversion: expected
time to conversion2. We find that convertibles with higher probability of conversion tend to have
shorter expected time of conversion. Specifically, convertibles issued in countries with stronger
shareholder rights and weaker creditor rights have shorter expected time of conversion (i.e. more
equity-like). Moreover, in countries with stronger shareholder rights, firms with lower separation
of control rights and cash flow rights, tend to issue convertibles with even shorter expected time
of conversion. Higher equity ownership by block-holders also reduces the expected time of
conversion in countries with strong shareholder rights.
        Additional analysis indicates that investor reaction to announcement of convertibles
depends on a complex interplay between the design of convertibles, country-level investor
protection and expected agency costs associated firm-level corporate ownership structure. Debt-
like convertibles issued in countries with stronger creditor rights are associated with positive
investor reaction whereas equity-like convertibles issued in countries with stronger shareholder
rights are associated with positive investor reaction. We also document that for equity-like
convertibles issued in countries with stronger shareholder rights, investors recognize misaligned
managerial incentives and discount firms with higher expected agency costs arising from greater
separation of control rights and cash flow rights and lower monitoring intensity by non-
management block-holders.
        We contribute to the literature on corporate financing in several ways. First, prior studies
document a positive association between creditor rights and straight debt financing3. Other


2
  In essence, the expected time to conversion measures the estimated duration for the convertibles to be at-the-
money (see section 3.3).
3
  Demirguc-Kunt and Maksimovic (1999) find that stronger enforcement of creditor rights is associated with higher
leverage and longer debt maturity in a sample of 30 countries during the period 1980-1991. Gianetti (2003) finds

                                                                                                               5
studies examine the effect of shareholder rights on equity market development4. Yet, there is
limited research on the effect of investor protection on hybrid securities, which contain both debt
and equity characteristics. By investigating the effect of investor protection on convertible debt
financing around the world, we contribute to this stream of research on hybrid securities5.
Second, we show that country-level investor protection has incremental explanatory power to
explain the design of convertible debt. We extend Lewis, Rogalski and Seward (2003) by
demonstrating that shareholder rights and creditor rights have systematically different impact on
the agency costs in firms issuing convertibles. We provide evidence on the interaction between
country-level investor protection and firm-level corporate ownership structure in shaping the
design of convertible debt offerings. Our results are broadly consistent with the notion of the
complementary effects between country-level investor protection and firm-level corporate
governance structure in shaping corporate financing decisions. Third, our result also
complements prior findings that large non-management shareholders play an effective
monitoring role in constraining managerial discretion over corporate resources (Lins 2003; Li et
al., 2006). In our setting of convertible debt design, the benefit of more effective monitoring by
large non-management shareholders in a strong macro environment is the higher likelihood of
convertible investors converting their claims to equity – which provides equity financing when
profitable investment opportunities are available. Our result highlights the corporate governance
role of large non-management shareholders in affecting corporate financing decisions. Thus, our
analysis contributes to link between “Law and Finance” and “Shareholder Activism” streams of
literature.



that in countries with strong creditor protection, it is easier for European firms with high intangible assets to obtain
loans. Using project finance loans in 61 countries, Esty and Megginson (2003) find that in countries with stronger
creditor rights and reliable legal enforcement, lenders create smaller and more concentrated syndicates to facilitate
monitoring and low cost contracting.
4
  LaPorta et. al (1998) provide evidence that equity markets are better developed in countries with stronger
shareholder rights. Aggarwal et al. (2005) and Gelos and Wei (2005) find that strong investor protection and
corporate transparency promote the aggregate equity investments of mutual funds.
5
  The investor protection and call protection study by Korkeamaki (2005) is the most closely related to ours. He
finds that firms in countries with weaker shareholder rights and stronger creditor rights issue convertibles with
stronger call protection. We complement Korkeamaki’s study by examining the effect of investor protection on a
broader measure of convertibles design – the probability of conversion at maturity – that simultaneously
encapsulates several contractual features such as conversion premium, coupon rate and maturity. Our study differs
from Korkeamaki in that we examine the interaction country level investor protection (shareholder rights and
creditor rights) and firm-level expected agency costs associated with separation of control rights from cash flow
rights in affecting the probability of conversion. Furthermore, we also investigate the monitoring role of large non-
management shareholders in affecting the association between convertible debt design and investor protection.

                                                                                                                      6
           The remainder of this paper is organized as follows. Section 2 formulates our hypotheses
on the association between convertible debt and investor protection. Section 3 describes our data
and method. Section 4 contains the results on the association between investor protection and
convertible debt usage. Section 5 provides our conclusions.


2. Hypotheses
           LaPorta, Lopez, Shleifer and Vishny (2002) find that in most countries, listed firms
generally have controlling shareholders who have the ability and incentives to expropriate
minority shareholders and creditors. The central agency problem in such firms is the
expropriation of minority shareholders and creditors by controlling shareholders.             When
controlling shareholders have control in excess of their proportional ownership, the expected
consumption of the private benefits is high because such ownership structure reduces cash flow
incentive alignment and increases the potential for entrenchment. LaPorta et al. find evidence of
higher valuation of firms in countries with stronger shareholder protection and in firms with
higher cash-flow ownership by the controlling shareholders.
           Firms issuing convertibles can vary various security design features such as maturity and
conversion premium that affect the expected probability of conversion at maturity. We predict
that the probability of conversion varies systematically with the country-level investor
protection. Specifically, convertibles issued in countries with stronger shareholder rights have
higher expected probability of conversion because convertible investors are more likely to
convert their claims to equity when their rights as shareholders (post-conversion) are well-
protected. Conversely, convertibles issued in countries with stronger creditor rights have lower
expected probability of conversion because convertible investors are less likely to convert their
claims to equity when the legal remedies against the abuse of creditors’ invested funds are more
onerous. The intuition underpinning our hypothesis is that if shareholder (creditor) protection is
strong, equities (debt) generally have high value and thus are a relatively cheap source of capital.
Thus, if shareholder (creditor) protection is strong, convertibles may be designed to be more
(less) likely converted into relatively more valuable or relatively cheaper equity (debt)6.
           We also predict that the positive association between shareholder rights and probability
of conversion is mitigated in firms with higher expected agency costs associated with the higher

6
    We thank the referee for suggesting this point.

                                                                                                  7
separation of control rights and cash flow rights of the controlling shareholder. In such cases,
investors have lower incentives to convert their convertibles to equity because of potential risk of
expropriation of minority shareholders by the controlling shareholders. Thus, for countries with
stronger shareholder rights, firms with higher separation of control rights and cash flow rights of
the controlling shareholder are more likely to issue convertibles with lower probability of
conversion.
        Lins (2003) finds that the presence of large non-management shareholders is positively
associated with firm valuation in countries with weaker shareholder rights. Thus, large non-
management shareholders play an important corporate governance role to mitigate expected
agency costs. Li, Moshirian, Pham and Zein (2006) find that countries with strong shareholder
rights and effective legal enforcement tend to have a greater extent of large non-management
institutional ownership. In countries with strong macro governance environment, strengthened
intervention ability and reduced monitoring costs can increase the propensity of large non-
management shareholders to monitor. We expect stronger country-level shareholder rights
provides the necessary infrastructure for large non-management shareholders to increase their
monitoring effectiveness and efficiency. If large non-management shareholders monitor more
effectively and efficiently where strong shareholder rights improve their ability to constrain self-
serving controlling shareholders, we hypothesize that in countries with stronger shareholder
rights, firms with the higher equity ownership by large non-management shareholders tend to
issue convertibles with higher expected probability of conversion.


3. Data and method
3.1. Sample
        To measure creditor rights and shareholder rights, we employ the creditors’ index and
shareholders’ rights measures developed by LaPorta, Lopez, Shleifer and Vishny (1998). LaPorta
et. al. construct these measures for 49 countries; hence, we only include firms from these
countries in our analysis. We collect data on convertible debt issues by listed firms from the
Security data Corporation database for the period 1995 to 2005. We exclude issues by financial
institutions, simultaneous issues7 and delete mandatory convertibles8. We also eliminate


7
 If the issuer has multiple convertible bond issues on the same date, we included the bond with the longest time to
maturity in our sample. Our results are qualitatively similar when we exclude such bonds from the analysis.

                                                                                                                 8
countries with fewer than four convertible issues. We collect financial statement data from the
Worldscope database. We obtain stock price data from Datastream International for non-US
issues and Center of Research for Security Prices (CRSP) for US issues. We collect data on the
corporate ownership structure from the annual reports of the companies9. We remove firms with
missing data to compute determinants of convertible debt financing (discussed below). Our final
sample consists of 936 firm-year observations from 19 countries for 1995-2005. The sample
covers convertibles issued by non-financial firms in 19 countries: Australia, Canada, Finland,
France, Germany, Hong Kong, India, Italy, Japan, Malaysia, Netherlands, Philippines,
Singapore, South Korea, Switzerland, Taiwan, Thailand, United Kingdom and United States.


3.2. Expected probability of conversion
        Our main dependent variable is the expected probability of conversion of convertible debt
offerings. Following Lewis, Rogalski and Seward (2003), we estimate the probability that a
convertible debt issue is converted into equity at maturity based on observable characteristics at
the time of issue. This probability is estimated using Black-Scholes option pricing as N(d2)
where N(.) is the cumulative probability under a standard normal distribution, and
d2= ln (S/X) + (r – div – σ2/2) T                                                              (1)
                   σT 0.5
where
S = current price of the underlying stock
X = conversion price
r = interest rate yield on a 5-year government bond
div = issuing firm’s dividend yield for the fiscal year before the convertible issue date
σ = standard deviation of the common equity return estimated over 200 days prior to issue date
T = number of years until maturity of the convertible debt.



8
  Mandatory convertibles are convertibles that must be converted to equity at maturity.
9
  The specific procedures for selecting US and Japan convertible bonds are as follows. The intersection between
SDC and Worldscope databases yields a reduced sample of 735 convertible debt issues in Japan and 766 convertible
bond issues in US. In view of the costs associated with manual collection of the corporate ownership structure and to
ensure that our results are not dominated by convertibles in Japan and US, we randomly select 20% of the firms
from this reduced sample to collect data on corporate ownership of firms in Japan and US from the annual reports.
This criterion yields a sample of 147 firms in Japan and 153 firms in United States. Our results are qualitatively
similar when we exclude US and Japan from our analysis.

                                                                                                                   9
        For the convertible debt issuer, the dependent variable is a continuous variable between
zero and one that measures the expected probability of conversion based on equation (1). We
label the expected probability of conversion as PROBCON. Thus, as the dependent variable
(PROBCON) approaches one (zero), the more (less) likely the convertible debt issue will be
converted from debt to equity at maturity.
        Following Lewis, Rogalski and Seward (2003), we sort the convertible debt issues into
three groups based on conversion probabilities on the issue date. We classify a convertible debt
as ‘‘debt-like’’ if the probability of conversion is less than 40%; as ‘‘hedge-like’’ if the
probability of conversion is between 40% and 60%; and as ‘‘equity-like’’ if the probability is
greater than 60%10.      The cutoffs chosen here reflect the simple observation that a higher
conversion probability is more likely to be interpreted as an equity-like security by investors.


3.3. Expected time to conversion
        As an alternative measure to the expected probability of conversion at maturity, we
employ the expected time for conversion to equity. For a geometric Brownian motion with a
drift, Yaksick (1995) shows that the optimal exercise time of an American call option is the ratio
of the exercise stopping boundary to the drift of stock price process. In Yaksick’s model, the
exercise stopping boundary equals the product of the inverse of stock price volatility times the
logarithm of the ratio of exercise price to the initial (time zero) stock price. Specifically, Yaksick
defines the optimal exercise time as
E(T) = (1/ σ) * log (X/S0)                                                                     (2)
               μ
where
E(T) = optimal exercise time
σ = stock volatility
μ = drift of the stock price process
X = exercise price
S0 = initial stock price at time zero




10
  Using alternative 45%-55% and 35%-65% cutoffs to partition the convertible debt issuer sample, we obtain
qualitatively similar results.

                                                                                                       10
         We extend Yaksick’s (1995) model to incorporate the time to first call. Specifically, we
compute the expected first passage time as the maximum of the optimal exercise time (per
equation 2) or the time to first call11. Thus,
T = MAXIMUM [ (1/ σ) * log (X/S0)                 , FIRSTCALL]                                               (3)
                     μ
where
FIRSTCALL = Time to first call.
         Empirically, we estimate equation (3) above as follows
TIMECON1 = MAXIMUM [ (1/ σ) * log (X/S0)                        , FIRSTCALL ]                                (4)
                               μ
where
TIMECON1 = Expected first passage of time to conversion.
σ = Stock volatility in the period 300 days to 60 days prior to the announcement of convertible
debt offering.
μ = Change in the stock price in the period 300 days to 60 days prior to the announcement of
convertible debt offering.
X = Exercise price.
S0 = Initial stock price at the announcement of the convertible debt offering.
FIRSTCALL = Time to first call.
         As a robustness check, we also employ Davidson, Glascock and Schwarz’s (1995) model
as an alternative measure of the expected conversion period. In their model, the expected stock
price E(ST), at a future time T, is expressed as
E(ST) = S0euT                                                                                                   (5)
where
S0 = current stock price
e = exponential function
U = drift
T = time
A convertible becomes equity at the time of conversion and it becomes in-the-money when the
stock price exceeds the conversion price (CP). By setting equation (5) equal to the conversion
price and estimating the future rate of stock price appreciation (i.e. the drift variable), we can

11
  We thank the referee for providing this insightful suggestion on estimating the expected first passage of time to
conversion.

                                                                                                                      11
solve for the expected time until profitable conversion. Thus, the shorter (longer) the expected
conversion time, the more (less) equity-like the convertible is deemed at the time of issue. We
employ the Institutional Brokers Estimate System (IBES) forecast 5-year median earnings
growth rate to estimate the expected growth rate12.Using the annualized growth estimates, we
compute the expected time to conversion by setting the conversion price (CP), equal to the
expected future stock price in equation (5),
CP = S0euT                                                                                           (6)
and then solving for expected time for conversion (TIMECON2),
TIMECON2 = T = log(CP)-log(S0)                                                                        (7)
                    U

3.4. Model
        We extend Lewis, Rogalski and Seward (2003) model on the determinants of convertible
debt issues. To test the association between investor protection and probability of conversion at
maturity, we employ the following model: -
PROBCONit = ß0 + ß1 SHRIGHTit + ß2 SHRIGHTit * VOTEit + ß3 SHRIGHTit * BLOCKit
+ ß4 CRRIGHTit + ß5 CRRIGHTit * VOTEit + ß6 CRRIGHTit * BLOCKit + ß7 VOTEit
+ ß8 BLOCKit + ß9 ENFORCEit + ß10 EXTCAPit + ß11 PCREDITit + ß12 CCRATEit
+ ß13 MKTBOOKit + ß14 CHGASSETit + ß15 ROAit + ß16 LTDit + ß17 LOGMVEit + ß18 SLACKit
+ ß19 RUNUPit + ß20VOLATILEit + eit                                                                  (8)
where subscript it refer to firm i in year t and e is the error term.
The dependent variable (PROBCON) is the expected probability of conversion at maturity.


        SHRIGHT is the shareholder rights index from by LaPorta, Lopez, Shleifer and Vishny
(1998), which ranges from zero to five13. We predict the coefficient on SHRIGHT to be positive.
VOTE is the ratio of voting rights to cash flow rights of the controlling shareholder of the firms.
BLOCK is the proportion of common equity owned by a non-management shareholder who
holds at least 5% of the firm’s common equity. The interaction term SHRIGHT * VOTE,

12
   About 38% of our sample is not covered by IBES. As alternative proxy for the growth rate, we also employ the
historical earnings growth rate of the firm for the past five years. Our results are qualitatively similar.
13
   The shareholder rights essentially measures the rights of shareholders to call extraordinary meetings and their
rights to have board representation. The index ranges from zero to five with higher scores denoting stronger
shareholders’ rights.


                                                                                                               12
capturing the incremental effect of the separation of voting rights and cash flow rights on
shareholder rights in affecting the expected probability of conversion, is expected to be negative.
Similarly, we predict the interaction term SHRIGHT * BLOCK - capturing how large non-
management block-holders affect the association between shareholder rights and the expected
probability of conversion – to be positive. CRRIGHT is the creditor rights index from by
LaPorta, Lopez, Shleifer and Vishny (1998), which ranges from zero to four14. We predict the
coefficient on CRRIGHT to be negative. We also expect the coefficient on the interaction term
CRRIGHT * VOTE to be negative and that on the interaction term CRRIGHT * BLOCK to be
positive.
        We briefly discuss the motivation for our control variables. We include a control for the
enforcement of investor rights (ENFORCE). We measure ENFORCE as the average score across
three legal variables used in LaPorta, Lopez and Shleifer (2006): (1) efficiency of the judicial
system, (2) assessment of rule of law, and (3) the corruption index. We expect the probability of
conversion to be positively associated with the enforcement of investor rights. Demirguc-Kunt
and Maksimovic (1999) and Booth, Aivazian, Demirguc-Kunt and Maksimovic (2001) find that
country-specific factors such as stock market development and the importance of the debt market
may affect capital structure decisions. We control for the level of capital market development
with the ratio of stock market capitalization to gross domestic product (EXTCAP) and the ratio
of private credit by deposit money banks and other financial institutions to gross domestic
product (PCREDIT). Following Esty and Megginson (2003), to control for sovereign risk, we
employ the Institutional Investor country credit rating (CCRATE), which ranges from zero (high
risk) to 100 (low risk). If costs of external financing are lower in well-developed capital markets
and in countries with lower sovereign risk, then convertibles are more likely to be converted
equity in countries with high EXTCAP, high PCREDIT and high CCRATE.
        We also include firm-level determinants of convertible debt. Following Green (1984),
convertible debt mitigates agency costs associated with asset substitution, especially for firms
with high growth opportunities. Our proxies for growth opportunities are MKTBOOK, which is
the market value of common equity divided by value of book equity and CHGASSET which is


14
  The creditor rights index essentially measures the legal rights of creditors in corporate reorganization such as
whether secured creditors are paid first in bankruptcy proceedings. The index ranges from zero to four with higher
scores denoting stronger creditor rights. Galai et al. (2007) develop a model that shows recent or severe distress
events have greater impact on the liquidation trigger.

                                                                                                               13
the difference between total assets at the end of the fiscal year immediately following the offer
date minus total assets in the fiscal year immediately preceding the offer date. We expect the
probability of conversion to be positively associated with MKTBOOK and CHGASSET. To
control for the firm’s profitability, we use ROA, defined as profit before tax divided by total
assets. If greater profits imply higher availability of internal funds to finance future investments,
the probability of converting convertibles to equity should be lower. An increase in financial risk
increases the costs of financial distress (Deng et al., 2007; Myers, 1977; Niu, 2008). We use
long-term debt divided by total assets (LTD) as a proxy for financial risk and we expect high
debt firms are more likely to convert their convertibles to equity to reduce costs of financial
distress. To control for firm size on capital structure, we employ the natural logarithm of
common equity at the year preceding the convertible issue (LOGMVE). If large firms have
greater external financing needs, we expect the probability of conversion to be positively
associated with firm size.
        Myers and Majluf (1984) argue that in the presence of information asymmetries and
adverse selection costs associated with external financing, firms with large financial slack tend to
finance new projects with internal funds. We measure financial slack (SLACK) as cash divided
by total assets. Firms with higher financial slack have more flexibility to finance projects from
internal sources and hence, they are less likely to convert their convertibles to equity. Lucas and
McDonald (1990) and Jung, Kim and Stulz (1996) find that firms are more likely to issue equity
when pre-issue stock returns is high, suggesting that firms time equity issues during periods of
low information asymmetry. To control for pre-issue run-up in stock prices, we compute the
issuer’s raw return over the 75 days preceding the announcement date (RUNUP). Finally, we
control for overall firm risk by including the standard deviation of the issuer’s raw return over
the 75 days preceding the announcement date (VOLATILE). Lewis, Rogalski and Seward (2003)
find that firms with high pre-issue run-up in stock prices and high risk firms are more likely to
issue equity-like convertibles to reduce equity-related financing costs.


4. Results
4.1. Descriptive statistics
        Table 1 contains the descriptive statistics for the sample. There is substantial variation in
the probability of conversion of convertible issues. In general, firms in countries with stronger

                                                                                                  14
shareholder (creditor) rights issue convertibles with higher (lower) probability of conversion at
maturity.
        Table 2 presents the convertibles sorted by debt-like (column 1), hedge-like (column 2)
and equity-like (column 3) convertibles respectively. Column (4) presents the tests of differences
in means between the debt-like and equity-like convertibles. We find that equity-like convertible
issues are concentrated in countries with stronger shareholder rights, stronger enforcement of
investor rights, better developed stock markets and higher country credit ratings. Furthermore,
equity-like convertible issues are more prevalent in firms with controlling shareholders
possessing lower voting rights relative to cash flow rights, higher growth opportunities, lower
long-term debt, larger market capitalization, higher adverse selection costs (measured by stock
price run-up and stock returns volatility preceding the issue).


4.2. Expected probability of conversion
        Table 3 presents the estimation results of regressions of the probability of conversion to
equity. The dependent variable (PROBCON) is a continuous variable that ranges from zero to
one capturing the expected probability of conversion to equity at maturity. In column (1), the
estimated coefficient on shareholder rights (SHRIGHT) is positive and significant at the 1%
level, indicating that the probability of conversion is positively associated with shareholder
rights. Thus, firms in countries with stronger shareholder rights issue convertibles that are more
likely to be converted to equity at maturity.              The estimated coefficient on creditor rights
(CRRIGHT) is negative and significant at the 1% level, indicating that the probability of
conversion is negatively associated with creditor rights. Hence, firms in countries with strong
creditor rights issue convertibles that are less likely to be converted to equity at maturity15. The
probability of conversion at maturity is negatively associated with the separation of voting rights
and cash flow rights of the controlling shareholder, indicating that convertible holders are less
likely to convert their claims to equity in firms with high expected expropriation of minority
shareholders by controlling shareholders. The probability of conversion at maturity is positively
associated with the equity ownership by large non-management block-holders, indicating that
convertible holders are more likely to convert to equity in firms subjected to more effective

15
   In terms of economic significance, a rise in shareholder rights index from one (weakest) to five (strongest)
increases probability of conversion by 39%. Conversely, a rise in creditor rights index from one (weakest) to four
(strongest) reduces probability of conversion by 25%.

                                                                                                               15
monitoring by large non-management shareholders. Firms with higher market-to-book, higher
leverage, higher market capitalization, higher pre-issue stock price run-up, and higher stock
return volatility, issue convertibles with higher probability of conversion. In general, consistent
with prior literature, the control variables suggest that firms that issue convertibles have higher
growth opportunities, higher adverse selection costs and higher financial distress.
         In column (2), we examine the interaction between country-level investor protection and
expected agency costs associated with firm-level ownership structure in affecting the probability
of conversion. The coefficient of -0.0782 on the interaction term SHRIGHT*VOTE is negative
and significant at the 1% level. This result suggests that the positive association between the
probability of conversion and shareholder rights is mitigated by the separation of voting rights
from cash flow rights.
         Furthermore, the coefficient of 0.0465 on the interaction term SHRIGHT*BLOCK is
positive and significant at the 1% level. This result indicates that the positive association
between the probability of conversion and country-level shareholder rights is more pronounced
when the proportion of equity held by large non-management shareholders is larger. Our results
suggest a complementary effect between country-level shareholder rights and firm-level
corporate governance structure in affecting the design of convertibles.                                  More effective
monitoring by large non-management shareholders at the firm level reinforces the positive
association between country-level shareholder rights and the probability of conversion16.
         The coefficient of -0.0612 on the interaction term CRRIGHT*VOTE is negative and
significant at the 1% level. This result suggests that the negative association between the
probability of conversion and creditor rights is strengthened by the separation of voting rights
from cash flow rights of the controlling shareholder17. Thus, when the expected agency costs
between the controlling shareholder and minority shareholders are higher, investors are less
likely to convert their convertibles to equity in countries with stronger creditor rights.
         It is possible that strong investor rights may be of limited use if enforcement of those
rights is weak. Thus, as a robustness test, in table 3 column (3), we interact the enforcement of

16
   If a firm is in a country with shareholder rights of 3, a rise in the ratio of voting rights to cash flow rights from the
25th percentile to the 75th percentile reduces the probability of conversion to equity by 18%. In contrast, if a firm is
in a country with shareholder rights of 3, a rise in the proportion of equity ownership by large non-management
shareholder from the 25th percentile to the 75th percentile increases the probability of conversion to equity by 9%.
17
   If a firm is in a country with creditor rights of 2, a rise in the ratio of voting rights to cash flow rights from the 25th
percentile to the 75th percentile reduces the probability of conversion to equity by 26%.

                                                                                                                          16
investor rights with shareholder rights and creditor rights respectively. The interaction term
SHRIGHT*ENFORCE is positive and significant, indicating the probability of conversion is
higher when shareholder rights and enforcement are stronger. The interaction term
CRRIGHT*ENFORCE is negative and significant, indicating the probability of conversion is
lower when creditor rights and enforcement are stronger. More importantly, our primary results
are qualitatively similar.


4.3. Expected time to conversion
         As an alternative measure to the expected probability of conversion at maturity, we
examine the expected time to conversion (see section 3.3). The shorter (longer) the expected
time to conversion, the more (less) equity-like the convertible is deemed at the time of issue.
Table 4 presents regressions of the expected time to conversion of convertibles. In column (1),
the dependent variable is estimated time to conversion based on the expected first passage time
as the maximum of the optimal exercise time or the time to first call (see equation (4) in section
3.3). The estimated coefficient on shareholder rights is negative and significant at the 1% level,
indicating that firms in countries with stronger shareholder rights issue convertibles with shorter
expected time to conversion. The interaction term SHRIGHT*VOTE is positive and significant
at the 1% level. Hence, in countries with stronger shareholder rights, firms in which the
controlling shareholders’ voting rights exceed their cash flow rights are more likely to issue
convertibles with longer expected time to conversion. The coefficient on the interaction term
SHRIGHT*BLOCK is negative and significant at the 1% level. Hence, in countries with stronger
shareholder rights, firms with large non-management block-holdings issue convertibles with
lower expected time to conversion18.
         We also find that expected time to conversion is positively associated with stronger
creditor rights. Furthermore, the estimated coefficient on the interaction term CRRIGHT *
VOTE is positive and significant at the 1% level. Thus, in countries with stronger creditor rights,
firms in which the controlling shareholder’s voting rights exceeds its cash flow rights are more
likely to issue convertible debt with longer expected time to conversion.

18
  An increase in shareholder rights from 1 (weakest) to 5 (strongest) reduces expected time to conversion by 1.26
years. If a firm is in a country with shareholder rights of 3, a rise in the ratio of voting rights to cash flow rights from
the 25th percentile to the 75th percentile increases the time to conversion by 1.14 years. In contrast, if a firm is in a
country with shareholder rights of 3, a rise in the proportion of equity ownership by large non-management
shareholder from the 25th percentile to the 75th percentile reduces the time to conversion by 0.87 years.

                                                                                                                        17
         As a robustness test, Table 4 column (2) reports the results of estimating time to
conversion based on the Davidson, Glascock, and Schwartz’s (1995) methodology (see equation
(7) in section 3.3). Here, the dependent variable (TIMECON2) is the expected time (in years)
for the convertible to be at-the-money so that it is profitable to convert the convertibles to equity.
Our results are qualitatively similar19.


4.4. Investor reaction to convertible issuance
         This section examines the association between investor reaction to convertible debt issues
and investor protection. We follow standard event study methodology and measure the share
price response to the financing event over a three-day period using the market model as the
pricing benchmark. Excess returns (XS) are computed as the actual return minus the market
model predicted return:
XSit = Rit - ai – bi Rmt
where Rit is the rate of return on stock i over day t and Rmt is the corresponding rate of return on
the market index for each economy over day t. The market model parameters are estimated over
140 trading days for the period 200 days to 61 days before the announcement20.
         Table 5 presents regressions of cumulative abnormal returns over a three-day window
surrounding the issue date of the convertibles. Column (1) presents the results on the full issuer
sample21. Investor reaction is positively associated with shareholder rights, enforcement and
market-to-book ratio. The finding that investor reactions are largely unrelated to firm-specific
performance measures in the full sample regression analysis is similar to the results reported in
Lewis, Rogalski and Seward (2003), who suggest that issuers offer convertible debt for different
reasons, and therefore analysis of the full sample may obscure the role of issuance motives on



19
   As an additional test, in table 4 column (3), we interact the enforcement of investor rights with shareholder rights
and creditor rights respectively. The interaction term SHRIGHT*ENFORCE is negative and significant, indicating
the expected time to conversion is shorter in countries with stronger shareholder rights and stronger enforcement of
investor rights. The interaction term CRRIGHT*ENFORCE is positive and significant, indicating in countries with
stronger creditor rights, the expected time to conversion when the enforcement of investor rights is stronger. More
importantly, our main inferences are similar.
20
   Following Lewis, Rogalski and Seward (2003), we adjust all the firm-specific variables in two ways. First, we
calculate the difference between the issuer’s variables and the industry median to adjust for performance differences
across industries. Second, we divide the difference by the standard deviation of the performance measure in each
industry to control for performance variation across industries.
21
   Following prior studies that examined determinants of investor reaction to convertible debt issues (Lewis et al.,
2003; Dutordoir and Van de Gucht, 2007), we include similar control variables in Table 5.

                                                                                                                   18
investor reactions. We explore this issue in more detail below where we investigate share price
reactions to convertible debt offers by debt-like, hedge-like and equity-like issuers separately.
       Column (2) presents the results of investor reactions to debt-like convertibles.
Cumulative abnormal returns are higher for debt-like convertibles issued by firms in stronger
creditor rights. This result is intuitive because when the expected probability of conversion is
low, convertible investors are less likely to convert their claims to equity because they are better
protected in countries with stronger creditor rights. The negative coefficient on the interaction
term CRRIGHT * VOTE, suggests that for convertibles issued in countries with stronger creditor
rights, investor reaction is lower in firms with higher separation of voting rights from cash flow
rights. Firms with higher leverage have more positive abnormal returns when they offer debt-like
convertibles. The greater the pre-issue stock price run-up, the lower the abnormal returns.
       Column (3) presents the results of investor reactions to hedge-like convertibles.
Cumulative abnormal returns are higher for issues in countries with stronger shareholder rights.
Firms with higher growth opportunities and firms with larger market capitalization tend to have
more positive abnormal returns.
       Column (4) presents the results of investor reactions to equity-like convertibles. Investors
react more positively to announcements of equity-like convertibles issued by firms in countries
with stronger shareholder rights. If expected probability of conversion is high, investors are more
concerned of their expected post-conversion rights as shareholders and thus, shareholder
protection is important. The interaction term SHRIGHT*VOTE is negative and significant,
indicating that for equity-like convertibles issued in countries with stronger shareholder rights,
investors recognize misaligned managerial incentives and discount firms with a greater
separation of control rights and cash flow rights. In addition, the interaction term
SHRIGHT*BLOCK is positive and significant, indicating that investors reacting more positively
when better monitoring by non-management block-holders reinforces the strong shareholder
protection environment.


5. Conclusions
       We find that firms in countries with stronger shareholder rights issue convertible debt
with a higher expected probability of conversion. The positive association between the expected
probability of conversion and shareholder rights is mitigated in firms for which ownership

                                                                                                    19
structures create potentially high managerial agency costs. Specifically, in countries with
stronger shareholder rights, firms in which the controlling shareholders have higher separation of
control rights and cash flow rights, are more likely to issue convertible debt with lower
probability of conversion. Furthermore, we find that equity ownership by large non-management
shareholders strengthens the propensity of firms to issue convertibles with higher probability of
conversion in countries with stronger shareholder rights. Our results suggest convertible debt
holders are more likely to convert their claims to equity in countries with stronger shareholder
rights. Stronger country-level shareholder rights combined with lower expected agency problems
between controlling shareholders and minority shareholders at the firm-level reduce the risk of
expropriation of minority shareholders and encourage investors to hold convertibles with higher
probability of conversion. Furthermore, strong country-level shareholder rights facilitate large
non-management shareholders to increase monitoring effectiveness and efficiency. In contrast,
firms in countries with stronger creditor rights issue convertibles with a lower expected
probability of converting to equity at maturity. The negative association between creditor rights
and the probability conversion is more pronounced in firms with higher separation of control
rights and ownership rights. Our results suggest that convertible debt holders are less likely to
convert their claims to equity in countries with stronger creditor rights. Moreover, in firms with
higher expected agency problems between controlling shareholders and minority shareholders,
convertible debt holders are less likely to convert to equity.




                                                                                               20
References
Alderson, M., Betker, B., Stock, D., 2006. Investment and financing activity following calls of
convertible bonds. Journal of Banking and Finance 30, 895-914.

Aggarwal, R. Klapper, L., Wysocki, P., 2005. Portfolio preferences of foreign institutional investors.
Journal of Banking and Finance 29, 2919–2946.

Boot, L., Aivazian, V., Demirguc-Kunt, K., Maksimovic, M., 2001. Capital structures in developing
countries. Journal of Finance 56, 87-130.

Brennan, M., Schwartz, E., 1988. The case for convertibles. Journal of Applied Corporate Finance, 55–
64.

Davidson , W., Glascock, J., Schwartz, T., 1995. Signaling with convertible debt. Journal of Financial and
Quantitative Analysis 30, 425–440.

Demirguc-Kunt, A., Maksimovic, V., 1999. Institutions, financial markets and firms' choice of debt
maturity. Journal of Financial Economics 54, 295-336.

Deng, S., Elyasiani, E., Mao, C., 2007. Diversification and the cost of debt of bank holding companies.
Journal of Banking and Finance 31, 2453-2473.

Dutordoir, M., Van de Gucht, L., 2007. Are there windows of opportunity for convertible debt issuance?
Evidence for Western Europe. Journal of Banking and Finance 31, 2828-2846.

Esty, B., Megginson, W., 2003. Creditor rights, enforcement, and debt ownership structure: Evidence
from the global syndicated loan market. Journal of Financial and Quantitative Analysis 38, 37-60.

Galai, D., Raviv, A., Wiener, Z., 2007. Liquidation triggers and the valuation of equity and debt
Journal of Banking and Finance 31, 3604-3620.

Gelos, G., Wei, S., 2005. Transparency and international portfolio holdings. Journal of Finance 60,
2987–3020.

Giannetti, M., 2003. Do better institutions mitigate agency problems? Evidence from corporate finance
choices. Journal of Financial and Quantitative Analysis 38, 185-212.

Green, R., 1984. Investment incentives, debt and warrants. Journal of Financial Economics 13, 115–136.

Jung, K., Kim, Y., Stulz, R., 1996. Timing, investment opportunities, managerial discretion, and the
security issue decision. Journal of Financial Economics 42, 159–185.

Korkeamaki, T., 2005. Effect of law on corporate financing practices - international evidence on
convertible bond issues. Journal of Corporate Finance 11, 809-831.

La Porta, R., Lopez-de-Silanes, F., Shleifer, A., Vishny, R., 1997. Legal determinants of external finance.
Journal of Finance 52, 1131-1150.

La Porta, R., Lopez-de-Silanes, F., Shleifer, A., Vishny, R., 1998. Law and finance. Journal of Political
Economy 106, 1113-1150.


                                                                                                        21
La Porta, R., Lopez-de-Silanes, F., Shleifer, A., Vishny, R., 2002. Investor protection and corporate
valuation. Journal of Finance 57, 1147-1170.

La Porta, R., Lopez-de-Silanes, F., Shleifer, A., 2006. What works in securities laws? Journal of Finance
61, 1–32.

Lewis, C., Rogalski, R., Seward, J., 1999. Is convertible debt a substitute for straight debt or common
equity? Financial Management, 5-27.

Lewis, M., Rogalski, R., Seward, J., 2003. Industry conditions, growth opportunities and market
reactions to convertible debt financing decisions. Journal of Banking and Finance 27, 153–181.

Li, D., Moshirian, F., Pham, K., Zein, J., 2006. When financial institutions are large shareholders: The
role of macro corporate governance environment. Journal of Finance 66, 2975-3007.

Lins, K., 2003. Equity ownership and firm value in emerging markets. Journal of Financial and
Quantitative Analysis 38, 159-184.

Lucas D., McDonald, R., 1990. Equity issues and stock price dynamics. Journal of Finance 57, 1019-
1145.

Mayers, D., 1998. Why firms issue convertible bonds: The matching of financial and real investment
options. Journal of Financial Economics 47, 83–102.

Myers, S., 1977. Determinants of corporate borrowing. Journal of Financial Economics 5, 147–175.

Myers, S., Majluf, N., 1984. Corporate financing and investment decisions when firms have information
that investors do not have. Journal of Financial Economics 13, 187–221.

Niu, J., 2008. Can subordinated debt constrain banks’ risk taking? Journal of Banking and Finance 32,
1110-1119.

Stein, J., 1992. Convertible bonds as backdoor equity financing. Journal of Financial Economics 32, 3–
21.

Yaksick, R., 1995. Expected optimal exercise time of a perpetual American option: A closed form
solution. Journal of Financial Engineering 4, 55-73.




                                                                                                      22
Table 1
Descriptive statistics
PROBCON is the expected probability of converting the convertibles to equity at maturity. TIMECON is the expected time (in years) for the convertible to be at-the-money so that
it is profitable to convert the convertibles to equity. SHRIGHT is the anti-director rights index from LaPorta, Lopez, Shleifer and Vishny (1998), which ranges from zero to five.
CRRIGHT is the creditor rights index from LaPorta, Lopez, Shleifer and Vishny (1998), which ranges from zero to four. ENFORCE is the average score across three legal
variables used in LaPorta, Lopez and Shleifer (2006): (1) efficiency of the judicial system, (2) assessment of rule of law, and (3) the corruption index. EXTCAP is the stock market
capitalization divided by gross domestic product. PCREDIT is the credit provided by deposit money banks and other financial institutions to non government owned firms divided
by gross domestic product. CCRATE is the Institutional Investor country credit rating, which ranges from zero (high risk) to 100 (low risk). VOTE is the ratio of voting rights to
cash flow rights of the ultimate controlling shareholder of the firms. BLOCK is the proportion of common equity owned by a non-management shareholder who holds at least 5%
of the firm’s common equity. MKTBOOK is the market value of common stock at the fiscal year-end immediately preceding the announcement date divided by the book value of
common equity. ROA is net income after tax divided by total assets. CHGASSET is the difference between total assets at the end of the fiscal year immediately following the offer
date minus total assets in the fiscal year immediately preceding the offer date. LTD is the book value of the firm’s long-term debt divided by total assets. LOGMVE is the natural
logarithm of the market value of common stock. SLACK is equal to cash divided by total assets. RUNUP is the issuer’s raw return over the 75 days preceding the announcement
date. VOLATILE is the standard deviation of the issuer’s raw return over the 75 days preceding the announcement date.
Panel A
Country                N        SHRIGHT         CRRIGHT         ENFORCE         EXTCAP         PCREDIT         CCRATE          PROBCON         TIMECON
Australia              33       4               3               4.683           0.631          0.880           82              0.701           2.957
Canada                 32       5               1               4.52            0.608          0.810           88              0.716           3.025
Finland                5        3               1               4.890           0.931          0.580           89              0.691           2.837
France                 84       3               0               3.650           0.487          0.870           93              0.736           3.013
Germany                15       1               3               4.210           0.264          1.180           94              0.221           5.958
Hong Kong              48       5               4               4.366           1.390          1.540           68              0.745           3.926
India                  34       5               2               2.673           0.192          0.300           51              0.638           2.411
Italy                  7        1               2               2.860           0.195          0.790           84              0.226           5.914
Japan                  147      4               2               4.400           0.585          1.070           87              0.637           2.272
Malaysia               7        4               3               3.243           0.781          1.380           59              0.745           2.714
Netherlands            39       2               3               4.770           0.878          1.420           94              0.215           5.947
Philippines            5        3               1               1.253           0.276          0.410           48              0.743           3.064
Singapore              11       4               3               4.873           0.804          1.170           87              0.739           3.567
South Korea            142      2               3               2.367           0.323          0.93            63              0.216           6.002
Switzerland            18       2               1               4.813           1.443          1.640           95              0.207           5.911
Taiwan                 114      3               2               2.780           0.828          0.990           78              0.734           3.064
Thailand               7        2               2               1.113           0.178          1.00            53              0.259           6.201
United Kingdom         35       5               4               4.700           1.195          1.360           89              0.727           3.061
United States          153      5               1               4.563           1.177          1.460           92              0.723           3.044
Mean                   51       3.5             2.1             3.783           0.734          1.096           81.57           0.605           3.741




                                                                                                                                                                                23
Table 1 (continued)
Descriptive statistics

Panel B

Country            N     VOTE    BLOCK   MKTBOOK   ROA      CHGASSET   LTD     LOGMVE   SLACK   RUNUP   VOLATILE
Australia          33    1.198   0.121   2.468     0.070    0.605      0.112   10.901   0.089   0.204   0.072
Canada             32    1.425   0.138   3.072     0.034    0.183      0.167   13.405   0.051   0.184   0.035
Finland            5     1.246   0.093   1.398     0.011    0.016      0.442   12.506   0.033   0.379   0.056
France             84    1.492   0.118   3.657     0.025    0.302      0.193   14.521   0.057   0.217   0.078
Germany            15    1.224   0.173   2.905     -0.045   0.253      0.110   14.196   0.067   0.088   0.082
Hong Kong          48    1.195   0.149   2.725     -0.073   0.319      0.092   11.425   0.131   0.251   0.047
India              34    1.180   0.102   2.548     0.095    0.470      0.251   12.175   0.015   0.302   0.032
Italy              7     1.485   0.152   1.585     -0.014   0.322      0.232   14.804   0.074   0.196   0.044
Japan              17    1.083   0.174   2.941     0.031    0.124      0.221   15.131   0.111   0.282   0.061
Malaysia           7     1.211   0.148   6.279     0.083    0.454      0.165   14.601   0.023   0.186   0.032
Netherlands        39    1.523   0.175   5.088     0.041    0.498      0.207   14.056   0.095   0.302   0.046
Philippines        5     1.124   0.183   4.768     0.113    0.652      0.251   12.130   0.008   0.075   0.081
Singapore          11    1.273   0.160   1.843     0.006    0.248      0.092   13.491   0.047   0.208   0.032
South Korea        142   1.287   0.131   1.709     0.012    0.159      0.241   12.643   0.052   0.144   0.058
Switzerland        18    1.304   0.155   2.125     0.049    0.202      0.227   13.501   0.061   0.239   0.043
Taiwan             114   1.201   0.162   2.357     0.068    0.291      0.142   13.962   0.043   0.089
Thailand           7     1.095   0.107   3.522     0.055    0.381      0.302   13.402   0.026   0.226   0.053
United Kingdom     35    1.368   0.126   3.298     0.029    0.192      0.198   14.732   0.073   0.197   0.039
United States      153   1.065   0.094   4.140     0.057    0.471      0.226   15.908   0.057   0.183   0.029
Mean               51    1.219   0.142   3.305     0.023    0.292      0.198   13.889   0.069   0.203   0.068




                                                                                                                   24
Table 2
Summary statistics for the sample of 936 convertible debt issues partitioned by the expected
probability of conversion at maturity
SHRIGHT is the anti-director rights index from LaPorta, Lopez, Shleifer and Vishny (1998), which
ranges from zero to five. CRRIGHT is the creditor rights index from LaPorta, Lopez, Shleifer and Vishny
(1998), which ranges from zero to four. ENFORCE is the average score across three legal variables used
in LaPorta, Lopez and Shleifer (2006): (1) efficiency of the judicial system, (2) assessment of rule of law,
and (3) the corruption index. EXTCAP is the stock market capitalization divided by gross domestic
product. PCREDIT is the credit provided by deposit money banks and other financial institutions to non
government owned firms divided by gross domestic product. CCRATE is the Institutional Investor
country credit rating, which ranges from zero (high risk) to 100 (low risk). VOTE is the ratio of voting
rights to cash flow rights of the ultimate controlling shareholder of the firms. BLOCK is the proportion of
common equity owned by a non-management shareholder who holds at least 5% of the firm’s common
equity. MKTBOOK is the market value of common stock at the fiscal year-end immediately preceding
the announcement date divided by the book value of common equity. ROA is net income after tax divided
by total assets. CHGASSET is the difference between total assets at the end of the fiscal year immediately
following the offer date minus total assets in the fiscal year immediately preceding the offer date. LTD is
the book value of the firm’s long-term debt divided by total assets. LOGMVE is the natural logarithm of
the market value of common stock. SLACK is equal to cash divided by total assets. RUNUP is the
issuer’s raw return over the 75 days preceding the announcement date. VOLATILE is the standard
deviation of the issuer’s raw return over the 75 days preceding the announcement date.
*, **, *** Significant at 0.10 level, 0.05 level and 0.01 level respectively.


                            (1)                    (2)                   (3)                    (4)= (1) – (3)
                            Debt-like Issuers      Hedge-like issuers    Equity-like issuers    t-statistics

                            Mean                   Mean                  Mean
N                           222                    74                    640

SHRIGHT                     1.923                  4.027                 4.112                  -6.78***

SHRIGHT*VOTE                0.404                  0.235                 0.203                  3.19***

SHRIGHT*BLOCK               0.207                  0.404                 0.430                  -2.02**

CRRIGHT                     2.774                  2.000                 1.791                  5.82***

CRRIGHT*VOTE                0.591                  0.277                 0.224                  4.06***

CRRIGHT*BLOCK               0.708                  0.745                 0.781                  0.02

ENFORCE                     3.091                  3.967                 4.003                  -4.62***

EXTCAP                      0.494                  0.823                 0.806                  -7.11***




                                                                                                          25
Table 2 (continued)

                      (1)                 (2)                  (3)                   (4)= (1) – (3)
                      Debt-like Issuers   Hedge-like issuers   Equity-like issuers   t-statistics

                      Mean                Mean                 Mean
PCREDIT               1.082               1.137                1.096                 -0.65

CCRATE                79.843              81.38                83.145                -2.01**

VOTE                  1.213               1.227                1.161                 2.16**

BLOCK                 0.173               0.185                0.192                 2.05**

MKTBOOK               2.487               3.472                3.569                 -3.80***

CHGASSET              0.241               0.421                0.296                 -1.35

ROA                   0.017               0.029                0.025                 -0.86

LTD                   0.225               0.204                0.188                 3.66***

LOGMVE                13.167              13.948               14.297                -3.71***

SLACK                 0.061               0.074                0.072                 -2.19**

RUNUP                 0.112               0.143                0.126                 -4.01***

VOLATILE              0.034               0.042                0.039                 -2.31**




                                                                                               26
Table 3
Regressions of probability of conversion
The dependent variable is the expected probability of converting the convertibles to equity at maturity (PROBCON).
SHRIGHT is the anti-director rights index from LaPorta, Lopez, Shleifer and Vishny (1998), which ranges from
zero to five. CRRIGHT is the creditor rights index from LaPorta, Lopez, Shleifer and Vishny (1998), which ranges
from zero to four. ENFORCE is the average score across three legal variables used in LaPorta, Lopez and Shleifer
(2006): (1) efficiency of the judicial system, (2) assessment of rule of law, and (3) the corruption index. EXTCAP is
the stock market capitalization divided by gross domestic product. PCREDIT is the credit provided by deposit
money banks and other financial institutions to non government owned firms divided by gross domestic product.
CCRATE is the Institutional Investor country credit rating, which ranges from zero (high risk) to 100 (low risk).
VOTE is the ratio of voting rights to cash flow rights of the ultimate controlling shareholder of the firms. BLOCK is
the proportion of common equity owned by a non-management shareholder who holds at least 5% of the firm’s
common equity. MKTBOOK is the market value of common stock at the fiscal year-end immediately preceding the
announcement date divided by the book value of common equity. ROA is net income after tax divided by total
assets. CHGASSET is the difference between total assets at the end of the fiscal year immediately following the
offer date minus total assets in the fiscal year immediately preceding the offer date. LTD is the book value of the
firm’s long-term debt divided by total assets. LOGMVE is the natural logarithm of the market value of common
stock. SLACK is equal to cash divided by total assets. RUNUP is the issuer’s raw return over the 75 days
preceding the announcement date. VOLATILE is the standard deviation of the issuer’s raw return over the 75 days
preceding the announcement date. All regressions include countries and year dummy variables (not reported). T-
statistics adjusted for heteroscedasticity are in parentheses. *, **, *** Significant at 0.10 level, 0.05 level and 0.01
level respectively.

                                          1                       2                        3
Intercept                                 0.0831                  0.2678                   0.3105
                                          (1.20)                  (3.66)***                (3.27)***

SHRIGHT                                   0.0986                  0.0931                   0.0928
                                          (5.49)***               (4.16)**                 (4.03)***

SHRIGHT*VOTE                                                      -0.0782                  -0.0775
                                                                  (-4.12)***               (4.03)***

SHRIGHT*BLOCK                                                     0.0465                   0.0441
                                                                  (3.98)***                (3.72)***

SHRIGHT*ENFORCE                                                                            0.0724
                                                                                           (2.21)**

CRRIGHT                                   -0.0637                 -0.0506                  -0.0532
                                          (-3.86)***              (-3.52)***               (-3.60)***

CRRIGHT*VOTE                                                      -0.0612                  -0.0680
                                                                  (-2.86)***               (-2.94)***

CRRIGHT*BLOCK                                                     0.0135                   0.0117
                                                                  (1.06)                   (1.29)

CRRIGHT*ENFORCE                                                                            -0.0925
                                                                                           (2.03)**




                                                                                                                    27
Table 3 (continued)

                      1            2            3

ENFORCE               0.0599       0.0462       0.0481
                      (5.66)***    (4.43)***    (3.82)***

EXTCAP                -0.0812      -0.0703      -0.0718
                      (-1.53)      (-1.37)      (-1.22)

PCREDIT               -0.1147      -0.0857      -0.1052
                      (-1.48)      (-1.39)      (-1.17)

CCRATE                0.0701       0.0591       0.0611
                      (1.80)*      (1.17)       (1.40)

VOTE                  -0.0204      -0.0282      -0.0295
                      (-2.74)***   (-2.61)***   (-2.56)***

BLOCK                 0.0112       0.0114       0.01403
                      (2.13)**     (2.01)**     (2.03)**

MKTBOOK               0.0016       0.0012       0.0013
                      (2.79)***    (2.18)**     (2.15)**

CHGASSET              -0.0031      -0.0014      -0.0019
                      (-0.33)      (-0.16)      (-0.30)

ROA                   -0.0203      -0.0268      -0.0302
                      (-0.62)      (-0.85)      (-1.04)

LTD                   0.0662       0.0649       0.0713
                      (2.17)**     (2.20)**     (2.04)**

LOGMVE                0.0074       0.0056       0.0084
                      (2.15)**     (1.83)*      (1.91)*

SLACK                 -0.0321      -0.0468      -0.0490
                      (-0.62)      (-0.94)      (-1.13)

RUNUP                 0.0023       0.0015       0.0011
                      (2.02)**     (2.14)**     (2.08)**

VOLATILE              0.0014       0.0021       0.0016
                      (1.78)*      (2.03)**     (1.82)*

N                     936          936          936

Adjusted R2           0.38         0.45         0.46




                                                             28
Table 4
Regressions of expected time to convert
In column (1), the dependent variable (TIMECON1) is the estimated time to conversion based on the expected first
passage time as the maximum of the optimal exercise time or the time to first call (equation 4 in section 3.3). In
column (2), the dependent variable (TIMECON2) is the expected time (in years) for the convertible to be at-the-
money so that it is profitable to convert the convertibles to equity (equation 7 in section 3.3). SHRIGHT is the anti-
director rights index from LaPorta, Lopez, Shleifer and Vishny (1998), which ranges from zero to five. CRRIGHT is
the creditor rights index from LaPorta, Lopez, Shleifer and Vishny (1998), which ranges from zero to four.
ENFORCE is the average score across three legal variables used in LaPorta, Lopez and Shleifer (2006): (1)
efficiency of the judicial system, (2) assessment of rule of law, and (3) the corruption index. EXTCAP is the stock
market capitalization divided by gross domestic product. PCREDIT is the credit provided by deposit money banks
and other financial institutions to non government owned firms divided by gross domestic product. CCRATE is the
Institutional Investor country credit rating, which ranges from zero (high risk) to 100 (low risk). VOTE is the ratio
of voting rights to cash flow rights of the ultimate controlling shareholder of the firms. BLOCK is the proportion of
common equity owned by a non-management shareholder who holds at least 5% of the firm’s common equity.
MKTBOOK is the market value of common stock at the fiscal year-end immediately preceding the announcement
date divided by the book value of common equity. ROA is net income after tax divided by total assets. CHGASSET
is the difference between total assets at the end of the fiscal year immediately following the offer date minus total
assets in the fiscal year immediately preceding the offer date. LTD is the book value of the firm’s long-term debt
divided by total assets. LOGMVE is the natural logarithm of the market value of common stock. SLACK is equal to
cash divided by total assets. RUNUP is the issuer’s raw return over the 75 days preceding the announcement date.
VOLATILE is the standard deviation of the issuer’s raw return over the 75 days preceding the announcement date.
All regressions include countries and year dummy variables (not reported). T-statistics adjusted for
heteroscedasticity are in parentheses. *, **, *** Significant at 0.10 level, 0.05 level and 0.01 level respectively.
                                           1                       2                        3
Dependent variable                         TIMECON1                TIMECON2                 TIMECON1

Intercept                                5.3172                  3.6637                   2.0839
                                         (3.04)***               (6.23)***                (2.97)***

SHRIGHT                                  -0.3049                 -0.2784                  -0.3281
                                         (-3.88)***              (-4.03)**                (-3.49)***

SHRIGHT*VOTE                             1.7832                  1.8798                   1.6511
                                         (4.09)***               (3.76)***                (3.53)***

SHRIGHT*BLOCK                            -1.6015                 -1.5973                  -1.6302
                                         (-2.81)***              (-3.19)***               (-2.90)***

SHRIGHT*ENFORCE                                                                           -0.1879
                                                                                          (-2.71)***

CRRIGHT                                  0.4162                  0.4894                   0.5016
                                         (3.48)***               (3.71)***                (3.02)***

CRRIGHT*VOTE                             1.8132                  1.7524                   1.7703
                                         (2.92)***               (2.86)***                (2.35)***

CRRIGHT*BLOCK                            -0.1850                 -0.0622                  -0.2709
                                         (-0.92)                 (-1.25)                  (-1.40)

CRRIGHT *ENFORCE                                                                          0.2836
                                                                                          (2.03)**




                                                                                                                  29
Table 4 (continued)

                      1           2           3

ENFORCE               -0.2731     -0.1541     -0.2190
                      (2.01)**    (3.72)***   (1.88)*

EXTCAP                0.1531      0.0688      0.2036
                      (0.64)      (0.35)      (1.05)

PCREDIT               0.1984      0.3422      0.3074
                      (1.17)      (1.46)      (0.62)

CCRATE                0.1785      0.4192      0.2104
                      (0.62)      (0.83)      (0.36)

VOTE                  0.1563      0.0148      0.0746
                      (2.91)***   (2.13)**    (2.40)***

BLOCK                 -0.1061     -0.0657     -0.0913
                      (2.12)**    (-2.08)**   (2.05)**

MKTBOOK               -0.0174     -0.0029     -0.1621
                      (-1.84)*    (-2.04)**   (-0.55)

CHGASSET              0.0732      0.0175      0.1004
                      (1.47)      (0.53)      (0.83)

ROA                   -0.0813     -0.0025     -0.1302
                      (-0.75)     (-0.32)     (-1.06)

LTD                   0.1039      0.1258      0.1342
                      (0.83)      (1.13)      (1.09)

LOGMVE                -0.0122     -0.0014     -0.0419
                      (-0.73)     (-1.72)*    (-0.22)

SLACK                 -0.2853     -0.2060     -0.1692
                      (-0.64)     (-1.08)     (-1.16)

RUNUP                 -0.0179     -0.0062     -0.0205
                      (-0.28)     (-0.33)     (-0.49)

VOLATILE              0.0093      0.0052      0.0171
                      (0.76)      (0.42)      (1.20)

N                     936         936         936

Adjusted R2           0.36        0.34        0.37




                                                          30
Table 5
Regressions of three-day announcement date excess return on indicated explanatory variables for 936
convertible debt issues and sorted by security design.
The dependent variable is the three-day announcement excess return starting from one day preceding the
announcement of convertible debt issue. SHRIGHT is the anti-director rights index from LaPorta, Lopez, Shleifer
and Vishny (1998), which ranges from zero to five. CRRIGHT is the creditor rights index from LaPorta, Lopez,
Shleifer and Vishny (1998), which ranges from zero to four. ENFORCE is the average score across three legal
variables used in LaPorta, Lopez and Shleifer (2006): (1) efficiency of the judicial system, (2) assessment of rule of
law, and (3) the corruption index. EXTCAP is the stock market capitalization divided by gross domestic product.
PCREDIT is the credit provided by deposit money banks and other financial institutions to non government owned
firms divided by gross domestic product. CCRATE is the Institutional Investor country credit rating, which ranges
from zero (high risk) to 100 (low risk). VOTE is the ratio of voting rights to cash flow rights of the ultimate
controlling shareholder of the firms. BLOCK is the proportion of common equity owned by a non-management
shareholder who holds at least 5% of the firm’s common equity. MKTBOOK is the market value of common stock
at the fiscal year-end immediately preceding the announcement date divided by the book value of common equity.
ROA is net income after tax divided by total assets. CHGASSET is the difference between total assets at the end of
the fiscal year immediately following the offer date minus total assets in the fiscal year immediately preceding the
offer date. LTD is the book value of the firm’s long-term debt divided by total assets. LOGMVE is the natural
logarithm of the market value of common stock. SLACK is equal to cash divided by total assets. RUNUP is the
issuer’s raw return over the 75 days preceding the announcement date. VOLATILE is the standard deviation of the
issuer’s raw return over the 75 days preceding the announcement date. HOT is a dummy variable that equals one if
the convertible debt is issued during a hot issue period and zero otherwise. All regressions include countries and
year dummy variables (not reported). T-statistics adjusted for heteroscedasticity are in parentheses.
*, **, *** Significant at 0.10 level, 0.05 level and 0.01 level respectively.

                              (1)                      (2)                      (3)                      (4)
                              Full Sample              Debt-like Issuers        Hedge-like issuers       Equity-like issuers
Intercept                     0.1017                   0.0682                   0.1524                   0.1256
                              (1.86)*                  (1.19)                   (2.31)**                 (2.38)**

SHRIGHT                       0.0175                   -0.0021                  0.0016                   0.0126
                              (2.39)**                 (-0.25)                  (2.03)*                  (3.04)***

SHRIGHT*VOTE                  -0.0393                  0.0362                   -0.1114                  -0.0243
                              (-1.43)                  (1.49)                   (-2.08)**                (-2.17)**

SHRIGHT*BLOCK                 0.0641                   0.0154                   0.0511                   0.0855
                              (1.57)                   (0.82)                   (-1.73)                  (2.29)**

CRRIGHT                       -0.0001                  0.0677                   0.0041                   -0.0008
                              (-0.03)                  (3.19)***                (0.82)                   (-0.21)

CRRIGHT*VOTE                  -0.0152                  -0.0161                  -0.0273                  0.0071
                              (-0.71)                  (-2.13)**                (-0.99)                  (0.24)

CRRIGHT*BLOCK                 -0.0003                  0.0029                   -0.0078                  -0.0029
                              (-0.15)                  (0.36)                   (-0.53)                  (-0.23)




                                                                                                                    31
Table 5 (continued)
                      (1)           (2)                 (3)                  (4)
                      Full Sample   Debt-like Issuers   Hedge-like issuers   Equity-like issuers
ENFORCE               0.009         0.0027              0.0100               -0.0153
                      (1.96)**      (0.47)              (1.41)               (2.04)**

EXTCAP                -0.0993       0.0873              -0.0594              -0.0344
                      (-1.28)       (1.64)              (-1.52)              (-1.09)

PCREDIT               0.1019        -0.0971             0.0292               0.064
                      (1.21)        (-1.35)             (0.76)               (1.49)

CCRATE                0.0195        -0.0016             0.0192               0.0112
                      (1.13)        (-1.27)             (1.03)               (0.86)

VOTE                  -0.0003       -0.0215             -0.0121              0.0262
                      (-0.02)       (-1.37)             (-0.38)              (2.044)**

BLOCK                 -0.0013       0.0041              -0.0881              0.0112
                      (-0.05)       (0.18)              (-1.27)              (1.86)*

MKTBOOK               0.0014        0.0006              0.0012               0.0014
                      (1.89)*       (0.81)              (1.78)*              (2.01)**

CHGASSET              -0.0063       -0.0153             0.0153               0.0009
                      (-0.97)       (-0.90)             (1.02)               (0.11)

ROA                   -0.0256       0.0181              -0.018               -0.0326
                      (-1.08)       (0.57)              (-0.35)              (-1.19)

LTD                   -0.0062       0.0109              -0.0348              -0.0106
                      (-1.15)       (2.87)***           (-1.08)              (-2.01)**

LOGMVE                0.0027        0.0004              0.0018               0.0008
                      (2.06)**      (0.23)              (2.59)***            (2.01)***

SLACK                 0.0034        -0.0443             -0.0123              0.0149
                      (1.19)        (-1.14)             (-0.25)              (0.56)

RUNUP                 -0.0031       -0.0061             -0.0012              0.0059
                      (-0.81)       (-2.10)**           (-0.19)              (2.43)***

VOLATILE              0.0016        0.0008              -0.0017              0.0032
                      (0.63)        (0.31)              (-0.31)              (1.02)

HOT                   0.0273        0.0314              0.0059               0.0062
                      (1.57)        (1.22)              (0.83)               (1.13)
N                     936           222                 74                   640

Adjusted R2           0.04          0.05                0.03                 0.08




                                                                                        32

				
DOCUMENT INFO
Shared By:
Categories:
Tags:
Stats:
views:2
posted:10/31/2012
language:English
pages:32