Dynamic Financial Covenant Thresholds

52 Pages Posted: 23 Jan 2012 Last revised: 16 Jun 2020

See all articles by Sudheer Chava

Sudheer Chava

Georgia Institute of Technology - Scheller College of Business

Shunlan Fang

Kent State University

Saumya Prabhat

Indian School of Business (ISB), Hyderabad

Date Written: June 7, 2015

Abstract

Among loan contracts originated during 1996 – 2015 with covenants, 37% have financial covenant thresholds that automatically tighten according to a predetermined schedule. Firms that accept dynamic covenant thresholds improve their creditworthiness, but they are more likely to violate covenants relative to matched control firms. In the event of a covenant violation, these firms are less likely to receive a waiver. They also tend to pay higher waiver fees, experience greater investment cuts, reclassify more debt as callable within one year, and they are more likely to switch lead lenders. Overall, our findings suggest that, on average, signaling through dynamic thresholds in covenants is credible but costly to borrowers should they fail to deliver the signaled performance.

Keywords: Loan contract design, signaling, adverse selection, covenant thresholds, covenant violations, creditor control

JEL Classification: G14, G21, G32, M41

Suggested Citation

Chava, Sudheer and Fang, Shunlan and Prabhat, Saumya, Dynamic Financial Covenant Thresholds (June 7, 2015). Available at SSRN: https://ssrn.com/abstract=1983456 or http://dx.doi.org/10.2139/ssrn.1983456

Sudheer Chava

Georgia Institute of Technology - Scheller College of Business ( email )

800 West Peachtree St.
Atlanta, GA 30308
United States

HOME PAGE: http://https://fintech.gatech.edu

Shunlan Fang (Contact Author)

Kent State University ( email )

Kent, OH 44242
United States

Saumya Prabhat

Indian School of Business (ISB), Hyderabad ( email )

Hyderabad, Gachibowli 500 019
India

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