Corporate finance journal midland

Francis J. Kerins, Jr. [*]

I examine corporate call policy for nonrefundable debt. Nonrefundable bonds purportedly cannot be called with funds from lower-interest-cost debt. However, firms tend to call nonrefundable debt following interest rate decreases. The calling firms typically issue lower-interest-cost debt around the time of the call and do not identify the source of funds used to call the debt. These actions show the weakness of the constraints imposed by the nonrefunding provision on firms' call policies and may have led to the abandonment of the provision in the early 1990s and the adoption of potentially superior contracting mechanisms.

During the high-interest-rate periods of the 1970s and 1980s, many corporations issued debt with a form of call protection known as a nonrefunding provision. The offering circulars and bond indentures of nonrefundable debt issues usually specified that the bonds could not be called for early redemption if the source of call funds was the proceeds of borrowing at a similar or lower interest cost.

Although the nonrefunding provision appeared to protect investors against interest rate declines, the extent of that protection is not clear. For example, between February 1992 and February 1993, Kroger Company called $501 million of outstanding 12.785% and 13.125% nonrefundable debt issues, repurchased over $400 million of these issues in open-market transactions, and issued $1.6 billion of lower-interest-cost debt. Kroger announced that one of the purposes of the lower interest cost issues was "to refinance the company's higher cost debt" (Wall Street Journal, 1992). Kroger also issued $212.8 million of new equity following the calls of the nonrefundable issues. Although Kroger might not have violated the specifics of the nonrefunding provision, investors who purchased the nonrefundable debt to protect themselves against calls in periods of declining interest rates might have been disappointed with Kroger's actions.

Several court cases have addressed the legality of calls of nonrefundable debt by firms that are issuing lower-cost-debt. In 1978, the Franklin Life Insurance Company sued Commonwealth Edison Company for redeeming an issue of 9.44% nonrefundable preferred shares while at the same time borrowing funds at a lower rate. Commonwealth Edison identified the source of funds for the redemption as an equity issue. The court found in favor of Commonwealth Edison, because the nonrefunding provision requires an examination of only the source of the funds actually used to achieve redemption.

In 1983, Morgan Stanley & Company sued the Archer Daniels Midland Company (ADM) for calling a nonrefundable 16% issue while twice borrowing money at a lower interest rate. ADM identified two equity offerings as the source of the funds for the redemption. Morgan Stanley, a large holder of the nonrefundable issue, indicated that for ADM to identify the equity issues as the source was juggling funds. Morgan Stanley saw this action as aimed at circumventing the provision, since ADM had issued two lower-cost debt issues during the time between the issue of the nonrefundable debt and the call announcement. The court upheld the redemption, based on the source test precedent of the Franklin Life case.

The source test precedent seems to hold that a call of nonrefundable debt by a firm issuing lower-interest-cost debt is legal as long as the specific funds from the new issue are not used for the call. If a firm has sufficient cash from sources other than new debt, then the firm can sell a new issue and effectively achieve a refunding and still pass the scrutiny of the source test.

In another variation on redeeming nonrefundable debt, during the late 1980s and early 1990s, a number of firms used STACs (Simultaneous Tender and Call). With a STAC, the firm tenders for the debt and announces that all bonds not tendered will be called at a lower call price. Funds from new, lower-cost debt are used for the tender, and not the call. This approach led to civil litigation in several cases against firms that used STAGs (Dhillon, Noe, and Ramirez, 1998).

In practice, although some firms identify funds from common or preferred share issuance or asset sales for calls of nonrefundable debt, most announcements include very general descriptions of the sources of funds. The Wall Street Journal and press release announcements for the calls include descriptions of the sources of funds such as: "cash on hand," "excess cash currently available to the company," "general corporate funds," or "funds segregated and available for this redemption."

The way in which the nonrefunding provision functions as a financing choice depends on the effectiveness of the provision to constrain firms' ability to redeem bond issues. If the nonrefunding constraints hold, then bondholders should benefit in periods of declining interest rates. If the nonrefunding provision does not constrain at least some firms, then the provision can serve another purpose or persist as a "neutral mutation" that causes no harm. If the provision is a neutral mutation and future conditions show that the provision provides only limited protection, then the provision might disappear from use. [1] The use of nonrefunding provisions has declined dramatically since the peak in 1986. Only one corporate bond issued since 1994 (in 1996) has included the nonrefunding provision.

In this paper, I examine the practices of firms that call nonrefundable debt and consider the implications of these practices on the choice of the nonrefunding provision in the corporate debt contract. I find that although nonrefundable bonds are called at a lower rate than are bonds that do not have the provision, calls of nonrefundable debt are common and often occur in periods of declining interest rates. Firms that call during the nonrefunding period often do not report the source of funds used to call the bonds. Frequently, these calls occur at the same time that the company is issuing lower-interest-cost debt. Companies also use a variety of strategies to limit the effectiveness of the nonrefunding provision.

My evidence suggests limited protection against calls following interest rate decreases, particularly for investment-grade issues. These events are consistent with the abandonment in the early 1990s of the use of the nonrefunding provision, which identifies actions firms cannot take to call debt, and the adoption of prescriptive covenants, like make-whole and clawback provisions, which identify actions that firms must take to call debt.

In Section I, I discuss the background for this study and describe the data. In Section II, I discuss the reasons firms call debt. I develop variables to measure these incentives and the refunding constraints. In Section III, I develop hypotheses on the nature of the constraints imposed by the nonrefunding provision and describe my method for testing the hypotheses. In Section IV, I test the hypotheses. Section V summarizes and concludes.

I. Background and Data Description

Bond covenants are the terms on which bondholders and the firm contract. Because covenants are designed to restrict issuing firms from engaging in specific actions that might shift wealth from bondholders to stockholders (or other stakeholders) after the bonds are sold, covenants are intended to reduce the costs associated with the bondholder-stockholder conflict. The choice of which covenants are included in a particular debt contract should be those that most efficiently control the conflict.

The call provision is a covenant that is common in one form or another to all debt contracts. In the cases in which it allows the firm to call the debt, the call provision provides a schedule of prices for calling the debt and a description of the terms under which the debt can or cannot be called. [2]

Bonds with call provisions give the issuing firm the option to call the debt prior to maturity. Callable debt issues usually provide investors with call protection that lasts for several years, followed by a period during which the bonds are freely callable. This call protection can be either absolute, as with standard call protection, or conditional, as with nonrefunding protection. Standard call protection is more constraining than nonrefunding protection. Except for sinking fund calls, a bond with standard call protection cannot be called during the protection period.

In contrast, nonrefundable bonds are freely callable, but nonrefundable during the protection period. Some debt issues contain both call and refunding protection. Such issues are noncallable for a specified period. After that, they are callable but nonrefundable for an additional period. Thatcher (1985) calls these "two-tiered" bonds. Thus, it appears that nonrefundable debt affords investors some degree of protection against calls in response to interest rate declines, but not against calls for other purposes.