Managerial Overconfidence and Covenant Protection
40 Pages Posted: 4 Oct 2016
Date Written: October 2, 2016
This paper examines how managerial overconfidence affects covenant usage. We find that creditors significantly use more covenants, increase covenant intensity, and use different types of covenants such as performance-based covenants and capital-based covenants to curb the default risk emanating from managerial overconfidence. Besides, creditors tighten individual covenants such as debt to cash flow covenant and current ratio covenant in order to alleviate the risk exposure. Covenant usage is reported to be quantitatively larger in the debt contracts of firms with higher market-to-book ratios, reflecting that high-growth firms provide the opportunities for overconfident CEOs to invest more intensively. To test for robustness, we perform a natural experiment and find that the Sarbanes Oxley Acts (SOX) implemented in 2002 and beyond serves as an exogenous shock that significantly drove the overconfidence-covenant relation. In addition, we find that a change in CEO overconfidence due to a change in CEO employment leads to a significant change in covenant usage.
Keywords: managerial overconfidence, covenants, credit risk
JEL Classification: G39
Suggested Citation: Suggested Citation