Shareholder Rights Do Affect the Cost of Bank Loan Available to Purchase

Gaul et al. (2018) (GJU) argue that our finding in Chava et al. (2008) (CLP)—that firms with lower takeover defenses pay significantly higher spread on their bank loans—is driven by an omitted variable, namely the unobserved asset volatility of the firm. We argue against GJU’s conclusions based on their own findings, conceptual flaws in their underlying economic arguments, serious limitations of their empirical work, and the findings of other published papers in the literature. GJU’s results show that our findings are robust both when they replicate our main results and also when they include equity volatility as an additional control variable in lieu of unobserved asset volatility. The only specification where GJU question our main findings is when they model equity volatility as a mis-measured value of unobserved asset volatility and use an instrumental variable regression model with the volatility of firm’s accounting earnings as an instrument. We disagree with the underlying economic logic behind this approach: equity volatility is a meaningful economic transformation of asset volatility, not its mis-measured value. Further, we find it implausible that their accounting earnings based instrument satisfies the exclusion restriction because a firm’s accounting earnings itself depends on its governance, managerial incentives, and a host of other factors. Despite these limitations, even for this specification GJU’s results show that CLP’s main claim remains strong for firms in extreme portfolios of takeover defense. Finally, other papers in the literature, including at least one published paper that explicitly controls for a measure of accounting volatility, reaches the same conclusion as CLP. Overall, we show that GJU’s paper is based on flawed economic and econometric arguments. Our critique also applies to the earlier work of Gaul and Uysal (2013, Review of Financial Studies) on which GJU base their critique.