Do Creditor Rights Increase Employment Risk? Evidence from Loan Covenants
54 Pages Posted: 31 Aug 2014 Last revised: 25 Mar 2015
Date Written: December 1, 2014
Financial contracts that mitigate incentive conflicts between firms and their creditors have a large impact on employees. Using a regression discontinuity design, we provide evidence that there are sharp and substantial employment cuts following loan covenant violations, when creditors gain rights to accelerate, restructure, or terminate a loan. The employment cuts following violations are larger at firms with higher financing frictions and when employees have weaker bargaining power. The cuts are also much larger in industry and macroeconomic downturns, when employees have fewer alternative job opportunities. In addition, union elections that create new labor bargaining units lead to higher loan spreads, consistent with creditors requiring compensation when employees have more bargaining power. Our analysis identifies a specific channel -- loan covenants -- through which financing frictions impact employment and offers direct evidence that binding financial contracts are an amplification mechanism of economic downturns.
Keywords: real effects of financing, labor and finance, financial frictions over the business cycle
JEL Classification: G30
Suggested Citation: Suggested Citation