Full research (Hebrew)​


  • Distributing
    dividends from unrealized earnings increases, by more than threefold, a
    company’s probability of encountering a debt restructuring proceeding.
  • The
    increased risk is not priced into yield spreads of corporate bonds for
    companies that distributed such dividends and is not reflected in their bond
    ratings.
  • The
    findings of the research may lend support to the proposal of the Ministry of
    Justice and the Israel Securities Authority to amend the Companies Law, with
    the goal of preventing the distribution of dividends from unrealized earnings.

Research conducted by Nadav Steinberg of the
Bank of Israel, Dr. Ilanit Gavious of Ben-Gurion University of the Negev, and
Dr. Ester Chen of the Peres Academic Center, deals with the ability to
recognize unrealized revaluation earnings—a major pillar of International
Financial Reporting Standards (IFRS)—and focuses on a topic that has not been
examined to date: does the distribution of dividends from such earnings impact
a company’s risk of default?

 

The motivation to examine this question is
related to the conflict of interest created by dividend distributions—for
shareholders it has the utmost importance, while for creditors it reduces the
firm’s value and thus increases the value of the implicit put option and the
probability of default. The literature indicates that corporate executives are
attentive to shareholders and thus seek to maintain a smooth dividend policy:
when profits are increasing, they may increase the dividends as well, in order
to maintain the same payout ratio. It also indicates that companies use their
dividends—particularly a smooth distribution policy—to signal their quality to
the market.

 

As companies strive for a smooth dividend
policy, and as the IFRS rules allow them to recognize unrealized earnings, they
are likely to pay dividends from such earnings as well. However, as unrealized
earnings are liable not be realized in the future, distribution based on them exacerbates
the conflict of interest between creditors and shareholders. The research
examines whether distributions from unrealized earnings increase default risk
above and beyond distributions of realized earnings.

 

The sample used in the study consists of Israeli
public companies that adopted the IFRS standards in 2007. As in many of the
countries that adopted them, in Israel as well the Companies Law allows a
company to distribute dividends from accounting earnings, and does not
distinguish between realized and unrealized earnings—that is, it refers to them
in the same manner. As it is impossible to ascertain the source of the
dividends distributed, the researchers used a stringent criterion to identify
the companies that distributed dividends from unrealized earnings: a company
only meets the criterion if the amount of dividends it distributed is greater
than all the realized earnings that it can distribute. (The criterion is based
on the assumption that a company distributes all realized earnings before it
distributes any unrealized earnings.) The study’s sample included 292 companies
with tradable debt (bonds), of which 75 (approximately one-quarter) distributed
dividends from unrealized earnings, and 94 of which (approximately one-third)
went through a debt restructuring proceeding at least once during the sample
period, the six years between 2008 and 2013.

 

Debt restructuring proceedings in the
economy, 2008–13

New Research: Dividends from Unrealized Earnings and Default Risk

 

 

Multivariate survival
analysis using a relative hazard model (Cox 1972) yielded a positive and very
statistically significant link between distribution of dividends from
unrealized earnings and the risk of the company defaulting in the subsequent
years: when comparing a company that distributed dividends from
unrealized earnings to a similar company that did not distribute such dividends,
it is found that the probability of the former to require a debt restructuring
is more than three times greater, ceteris paribus. Additional examinations
showed that the findings do not derive solely from ex ante riskier companies
choosing to distribute dividends from unrealized earnings before encountering perceptible
difficulties (that is, difficulties that are also reflected in financial data
controlled for in the research).

 

If creditors suspect that the company is taking
advantage of fair value accounting to increase its dividend distribution on the
basis of “paper” profits, they can reprice the debt accordingly and demand a
higher yield ex ante. However, the research finds that they do not do so:
ceteris paribus, the cost of the debt for companies that distributed dividends
from unrealized earnings—a cost reflected in bond yield spreads or in bond
ratings—is not significantly different from the cost of the debt for companies
that did not distribute such dividends.

 

As noted, the research found that the
distribution of dividends from unrealized earnings significantly increases the
probability of encountering financial distress, and that rating agencies and
investors are not pricing this correctly. These findings indicate that bond
market investors need to demand, at issuance, covenants that limit the ability
of companies to distribute dividends from unrealized earnings, or at least to demand
a higher yield on bonds of a company that distributed such dividends.
Alternatively, the relevant regulators may need to limit such distributions. The
findings of the research may lend support for the proposal of the Ministry of
Justice and the Israel Securities Authority to amend the Companies Law, with
the goal of preventing the distribution of dividends from unrealized earnings.