Junk issuers more likely to add poison put covenants; use soars in 2012

By Susanna Moon

Chicago, Sept. 29 – Investor Responsibility Research Center Institute said new research finds an increased use of so-called poison puts in bond agreements, especially for high yield issues.

The use of poison puts soared in 2012, with 57% of bonds issued that year containing poison put provisions, compared to about 8% to 27% of debt issued in the 1990s, according to a press release by the institute on findings in the report, “Poison Puts: Corporate Governance Structure or Mechanism for Shifting Risk?” by Frederick L. Bereskin, assistant professor, Lerner College of Business & Economics University of Delaware, and Helen Bowers, associate professor, Lerner College.

Poison puts allow bondholders to redeem the bonds before maturity in the event of a change of control, the authors noted.

Poison puts are used by lenders to protect against increases in risk resulting from highly levered deals or from acquisitions by firms with lower debt ratings. Poison puts can also “entrench management or thwart shareholder activists and hostile takeovers,” the release said.

The institute said the research also shows that “firms with bonds that feature the indentures have higher levels of institutional ownership and are less likely to have poison pills and are equally likely to have classified boards.”

Also, the research found other bond features that “would be consistent with the efficient contracting theory including shorter maturities, higher interest costs spread to treasuries and other covenants that are consistent with lenders exhibiting concern and attempting to minimize risk.”

“However, the authors note the de facto entrenchment power of poison puts: firms which issue bonds with poison puts are less likely to be either acquirers or targets, even though those firms are more likely to be in industries with acquisition activity,” the release said.

Change-of-control provisions are most common in lower-rated bonds, the authors noted.

More research results

Some key findings:

• The use of poison puts varies significantly by industry: Change-of-control provisions were included in only 10% of bond issues in the financial industry, but in 76% of health care firms’ issues;

• Poison puts began gaining ground in 2007: From 1990 to 2006, up to 25% of bond issues featured the indentures; from 1995 to 2005, between 7% and 17% had them; and beginning in 2007, they ranged from 47% to 57%;

• Firms with credit ratings of A or higher included poison puts in their bonds only 10% of the time; whereas firms with credit ratings of BB+, BB or BB- included poison puts in 73% of their bond issues; and

• Companies tend to exclusively include poison puts in their bonds or not. Only 17% of studied firms sometimes issued bonds with poison puts. Most firms either never issue bonds with poison puts (42%) or always include poison puts in their bond indentures after the first issue with a poison put (42%).

Poison puts also are referred to as proxy puts, change-of-control provisions or event risk covenants, the authors said.

Typically, the covenants give bondholders a put option requiring the issuer to offer to purchase all of the bonds, usually at 101% of par, if any of the following occurs:

• Any person or group acquires 50% or more of the issuer’s voting stock;

• Any time the majority of the board of directors ceases to be those who were directors at the time of issue or directors whose election was approved by a majority of the continuing directors;

• The merger or consolidation of the company into another entity;

• The sale, in one or a series of related transactions, of all or substantially all of the company’s assets; or

• The adoption of a plan to dissolve or liquidate the company.

Some poison put covenants include a “double trigger” where the change-of-control event must be associated with a ratings downgrade.

“It is important to examine how poison puts relate to firms’ underlying governance structure given their increasing use and prominence, as well as the unique way that poison puts have the ability to entrench management through contractual arrangements,” Bereskin said.

“Our finding that these firms typically do not have weaker governance can be interpreted either as a sign that poison puts substitute for other means of entrenchment, or that they are less related to governance than bondholders’ contracting concerns.”

“Much of our evidence is consistent with poison puts – as with other covenants – being largely driven by the unique contracting environment of these firms,” Bowers continued.

“It is not surprising that firms more vulnerable to potential risk-shifting, for example, are particularly likely to use poison puts.”

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