Strategic Disclosure and Debt Covenant Violation

Abstract

This study examines how managers change their forecasting behavior as a debt covenant violation (DCV) approaches. We posit that managers strategically use earnings forecasts in order to delay the costs associated with DCVs. Consistent with this, we find that management forecasts are more optimistic in the quarter before a DCV, and this result is stronger when firms have a higher risk of losing control rights in the event of a DCV. Furthermore, we find that managers combine their forecast optimism with actions that are favorable to shareholders but would likely be curtailed by lenders after the DCV. Specifically, we find that managers who are more optimistic in their forecasts also increase R&D, take on more risk, and increase dividend payouts before violations, actions which would be opposed once control rights shift to debtholders after a DCV. Lastly, we find managers who are more optimistic in their forecasts are less likely to be replaced (i.e., lower CEO turnover) after a DCV. Overall, our results are consistent with managers changing their disclosure behavior in an attempt to reduce lenders' awareness of an impending DCV, and thus, buy themselves time to take actions favorable to equity investors. These actions, though likely opposed by debtholders ex ante, improve, on average, firms' prospects, which in turn improves managers' job security following a DCV.

Keywords: Debt Covenant Violation, Strategic Disclosure, Risk-Shifting