Strategic Disclosure and Debt Covenant Violation

Abstract

This study examines how managers change their forecasting behavior as a debt covenant violation (DCV) approaches. Consistent with a change, we find that management forecasts are more optimistic in the quarter before a DCV, and this result is stronger when firms face a higher risk of shifting control rights to lenders 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. Lastly, we find managers who are more optimistic in their forecasts are less likely to be replaced after a DCV. Overall, our results are consistent with managers changing their disclosure behavior in an attempt reduce lenders' awareness of an impending DCV, and thus, buy themselves time to take actions favorable to equity investors. Furthermore, our results suggest that the actions taken by managers, though likely opposed by debtholders ex ante, may improve, on average, firms' prospects, which in turn increases managers' job security following a DCV. Our results are consistent with managers working in the interest of equity holders to minimize the costs associated with an impending DCV.

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