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Rating Triggers, Market Risk and the Need for More Regulation

  • Federico Parmeggiani

Abstract

A rating trigger is a particular type of debt covenant that mandates the borrower to maintain its own credit rating above a certain rating threshold, requiring, in the event of a rating downgrade, the adoption of specific enforceable actions aimed at securing the lender claims from the borrower's higher risk level. Rating triggers lower the cost of borrowing capital, but when activated, they exacerbate the borrower's need for liquidity just at the moment when its credit risk is higher, making the borrower's default more likely to occur. Despite the potential threat posed by rating triggers on debt markets, these contractual devices remain almost unregulated both in the US and in Europe. The purpose of this paper is first to analyse the effects rating triggers can have on overall market risk and second to assess the proliferation of rating triggers among large US and non-US companies in order to establish whether these contractual devices need stricter regulation. The article is divided in two parts. Sections 2 to 5 provide an overview of the different types of triggers and analyse the rationale behind their use in terms of advantages and disadvantages for both issuers and investors. In sections 6 to 9, I perform an empirical analysis by assessing the rating triggers that have been used by Dow Jones Industrial Average Index companies. I then examine the correlation between the use of rating triggers and the companies' risk profiles by measuring their credit ratings and their Altman's Z-Scores in order to find out whether triggers are mostly used by risky companies, capable of being impaired by the triggers' activation and thus posing a threat to market stability. In section 10, I strengthen the analysis by examining whether such correlation also applies to non-US companies which use rating triggers. In section 11 conclusions are drawn suggesting the introduction by US and European regulators of a specific duty to disclose all the rating triggers that listed companies include in bond indentures and in financial contracts every year.

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* Research Fellow and Lecturer of Corporate Law, Università degli Studi di Modena e Reggio Emilia. Email: federico.parmeggiani@unimore.it. I would like to express my deepest gratitude to Professor Geoffrey P. Miller, who was my supervisor during my stay as Global Research Fellow at the New York University School of Law in 2011 and provided me with the best guidance regarding my research project on rating triggers; to Professor Federico M. Mucciarelli, who, for me, is an academic role model and a long-time friend; to Professor Renzo Costi, who has been constantly mentoring and wisely advising me throughout my continual discovery of corporate and securities law; to Suzanne Habraken for her valuable linguistic improvements to my original draft, and to all those who have supported me over the last years of hard work. ‘No man is a failure who has friends’. Errors are mine only.

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Rating Triggers, Market Risk and the Need for More Regulation

  • Federico Parmeggiani

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