Agency costs and misrepresentation in leveraged firms.

• Author: Hannes, Sharon

1. INTRODUCTION II. INCENTIVES FOR MISREPRESENTATION AND MANIPULATION III. AGENCY COSTS BETWEEN SHAREHOLDERS AND BONDHOLDERS IN LEVERAGED FIRMS A. The Asset-Substitution, Risk-Shifting, Overinvestment Problem B. The Debt-Overhang, Underinvestment Problem. C. Optional View: Shareholders as Holders of a Call Option on the Firm's Asset D. Shareholders, Bondholders and Managers. IV. THE EFFECTS OF MANIPULATION ON AGENCY COSTS IN LEVERAGED FIRMS A. Manipulation and the Risk-Shifting Problem B. Manipulation and the Debt-Overhang Problem V. DISCUSSION, NORMATIVE CONCLUSIONS, AND THE TEST CASE OF THE FINANCIAL SYSTEM'S COLLAPSE VI. SUMMARY MATHEMATICAL APPENDIX I. INTRODUCTION

   The financial crisis that began in the United States in 2007 and spread into a deep worldwide recession focused attention on leveraged firms and their agency costs. Prior to the recession, financial companies in the United States broke all leverage records. (1) The five largest U.S. investment banks--Goldman Sachs, Merrill Lynch, Bear Sterns, Lehman Brothers, and Morgan Stanley--attained a leverage ratio of 40 to one. (2) For example, at the end of 2007 Bear Sterns had $11.8 billion in shareholders capital while its debts amounted to $383.6 billion, of which $70 billion were short-term debts that had to be repaid or renewed on a daily basis. As the congressional committee that investigated the economic crisis explained, this situation was equivalent to a small business owner investing a minimal sum of $50,000 in his business and taking gigantic loans totaling $1.6 million, of which $296,750 would be due daily. (3)

   In this Article, we investigate the unexplored interaction among different agency costs in leveraged firms and financial misrepresentation problems. Each of these issues has been individually analyzed quite extensively in the literature. This Article, however, is uniquely significant as the first to investigate the interaction among the different problems.

   To begin, firms with excessive leverage face two significant agency costs between shareholders and bondholders. (4) One such problem is the incentive for shareholders (and the executives acting on their behalf) to channel a company's capital into risky assets and projects, known in finance literature as the "risk-shifting," "asset-substitution," or "overinvestment problem" (throughout this Article we will use these terms interchangeably). (5) The intuition is quite straight-forward. In the case of business success, the shareholders--as holders of the residual rights to the firm's profits--enjoy its fruits. In contrast, in case of business failure, part of the loss is borne by bondholders, and the more leveraged the firm is, the larger the share of the loss that bondholders have to bear. This convex structure of shareholders' payoffs in a leveraged firm--that is, the asymmetry between success and failure--therefore induces shareholders to take risks they would not have otherwise assumed.

   Another agency cost in the sphere of relations between shareholders and bondholders is a mirror image of the over-investment problem. Shareholders in a leveraged firm have inadequate incentive to invest in beneficial or "positive net present value" (NPV) projects. This is known in finance literature as the "debt-overhang" or "underinvestment problem" (throughout the Article we will use these terms interchangeably). (6) When a firm's debts are greater than its assets, its shareholders may lack proper incentive to invest in certain positive NPV projects that require additional investment because the fruits of that investment will fall in whole or in part into the hands of the bondholders, who are the first in line to receive the firm's assets. (7) This lack of adequate incentive drives shareholders and potential investors away and makes it difficult for a firm to recover from its distress.

   In addition to these agency costs between bondholders and shareholders, another problem in leveraged firms is the incentive of existing shareholders to present the financial status and business results in an artificially rosy light. This is a manifestation of a more general problem regarding owners of assets who often have an interest in misrepresenting the true value of their assets. This problem exists whether assets are held by individuals or by firms and regardless of leverage, but it is aggravated by debt financing. A misrepresentation of a firm's financial status and business performance may artificially inflate its value. This inflated market value enables existing shareholders to sell their stock at an exaggerated price or to attract additional capital with little dilution of their share in the firm. (8) In this way, value is transferred from the firm's future shareholders to its existing shareholders, whether they intend to sell their stock during the fraudulent period or to keep it for the long run even after the fraud is discovered. The incentive to manipulate and inflate the share value may be even stronger when a firm is leveraged. The artificial increase in the value of a firm's assets and in its business results brings about a transfer of value from bondholders to shareholders in a number of ways. Under a mistaken impression, bondholders are likely to agree to a lower return on their debt, and it will also be easier for the company to meet restrictive financial conditions and perform a distribution of dividends. This is the misrepresentation problem in its aggravated form in a leveraged firm.

   In this Article we do not dispute the existing arguments regarding the agency costs between shareholders and bondholders in leveraged firms. Likewise, we do not deny the incentive for shareholders to inflate the value of their firm artificially. To the contrary, as we shall demonstrate, these are indeed real and significant problems. Our aim in this Article is to analyze the influence of the misrepresentation problem on the classical agency costs between shareholders and bondholders in leveraged firms. The interaction between the various agency costs and the misrepresentation problem has not yet been discussed in the literature. For example, it is clear that a leveraged firm that can conceal the risk level of its business activities from the market in general, and from its bondholders in particular, has an increased incentive both to take excessive risks and then to hide those risks. In this case the misrepresentation problem and the overinvestment problem fuel each other. It is easy to relate this phenomenon to the last financial crisis where risk-taking took the form of investing in especially complex financial instruments. In retrospect, at least, these instruments were so complex that few players in the market actually understood what they meant, (9) and many bodies--including the credit rating agencies--participated in hiding their potential risks. (10)

   But what about misrepresentation that does not conceal the risk level of a firm's business dealings but rather artificially inflates the value of its assets or business results? Herein lie the two central innovations of this Article. First, as we shall argue, misrepresentation tends to restrain excessive risk-taking in leveraged firms. On the other hand, we will show that the manipulation does not circumvent the motivation of shareholders to take beneficial risks that are desirable from the viewpoint of the firm as a whole. Second, as we shall argue, the possibility of manipulating the value of a firm's assets moderates the tendency of shareholders in leveraged firms not to choose positive net present value projects that require additional investment.

   The following examples demonstrate the gist of our arguments. In all the examples we will ignore the time value of money and risk-adjusted returns by assuming both are equal to zero, although we correct these assumptions in the mathematical appendix to the paper. We shall also temporarily assume that the managers act solely in the interests of existing shareholders.

   Example A: Overinvestment in Risky Projects

   Assume that a leveraged firm has total assets (net working capital and fixed assets) worth $50 million and outstanding debts of $50 million due next year. In this situation, without further action, the firm will be bankrupt next year. In liquidation, the $50 million debt to the bondholders will be repaid in full, and shareholders will get nothing (see Table 1).

   Assume further that shareholders face two alternatives. The first is to invest in a conservative, safe project that will, with certainty, raise the value of the company's assets from $50 million to $60 million. The second alternative is to invest in an excessively risky project that has a 50% chance of raising the company's assets' value to $75 million, but also a 50% chance of reducing their value to $15 million, so in expectation the firm value would decline to $45 million. In other words, the conservative project has a net present value of $10 million, whereas the risky project has a negative net present value (minus $5 million).

   From the overall viewpoint of all the stakeholders in the firm--and therefore from that of the economy as well--the safe project is the superior one. Nevertheless, shareholders will prefer the inferior risky project. That is because the shareholders of a leveraged firm would enjoy the profits, if any, of the risky project, but not be injured by its failure, which would fall on the bondholders' shoulders. In the above example, the average profit to shareholders from taking the risky project amounts to $12.5 million (50%*(7550)), whereas the safe project would yield a profit of only $10 million. (11) This bad outcome--the shifting of risk onto the bondholders--is demonstrated in Tables 2 and 3.

   This classic example regarding the influence of leverage on risk-taking does not take into account the possible effect of manipulation and misrepresentation. If the managers, on behalf of the existing shareholders...