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Covenant Violations and Dynamic Loan Contracting

74 Pages Posted: 20 Nov 2011 Last revised: 24 May 2017

Felix Freudenberg

Goethe University Frankfurt - Department of Finance

Björn Imbierowicz

Copenhagen Business School

Anthony Saunders

New York University - Leonard N. Stern School of Business

Sascha Steffen

Frankfurt School of Finance & Management

Multiple version iconThere are 2 versions of this paper

Date Written: May 19, 2017

Abstract

This paper examines the dynamic allocation of control rights in private debt contracts of firms that repeatedly borrow in the syndicated loan market. We show that a covenant violation in the prior loan contract provides a signal to creditors which results in stricter contract terms for the subsequent new loan. This signal is neither related to unobservable nor to observable firm characteristics at the initiation of the new loan, such as for example credit risk. It also does not reflect agency problems between the lender and firm management, shareholders or public debtholders. After covenant violations in the prior contract, new loans have on average 18bps higher spreads and include more of those covenant types which also have been violated in the prior contract, with tighter thresholds. Our findings reveal that a prior covenant violation is a stigma for borrowers which results in stricter loan contract terms in subsequent new loan contracts.

Keywords: Control Rights, Covenant Violation, Dynamic Loan Contracting, Stigma

JEL Classification: G21, G32, L14

Suggested Citation

Freudenberg, Felix and Imbierowicz, Björn and Saunders, Anthony and Steffen, Sascha, Covenant Violations and Dynamic Loan Contracting (May 19, 2017). Journal of Corporate Finance, Forthcoming; AFA 2013 San Diego Meetings Paper; NYU Working Paper No. FIN-11-042. Available at SSRN: https://ssrn.com/abstract=1961980 or http://dx.doi.org/10.2139/ssrn.1961980

Felix Freudenberg

Goethe University Frankfurt - Department of Finance ( email )

House of Finance
Grueneburgplatz 1
Frankfurt am Main, Hessen 60323
Germany

Björn Imbierowicz

Copenhagen Business School ( email )

Solbjerg Plads 3
Frederiksberg C, DK - 2000
Denmark
+4538153736 (Phone)

Anthony Saunders

New York University - Leonard N. Stern School of Business ( email )

44 West 4th Street
9-190, MEC
New York, NY 10012-1126
United States
212-998-0711 (Phone)
212-995-4220 (Fax)

Sascha Steffen (Contact Author)

Frankfurt School of Finance & Management ( email )

Sonnemannstr. 9 -11
Frankfurt, 60314
Germany

HOME PAGE: http://www.sascha-steffen.de

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