Strategic Disclosure and Debt Covenant Violation

Abstract

This study examines how managers change their forecasting behavior as a debt covenant violation approaches. Using a sample of firms that disclose a debt covenant violation (DCV) in their financial statements, we find that management forecasts are more optimistic in the period leading up to a DCV, and this result is not driven by managers’ unintentional forecast bias. Additionally, we find that managers who are more optimistic in their forecasts also take on more risk and increase dividend payouts before violations, consistent with managers strategically using earnings forecasts to justify their activities favorable to shareholders but likely to be curtailed by lenders in the event of a DCV. In addition, we find that managers are more likely to optimistically bias their earnings forecasts when they have a higher risk of losing control rights in the event of 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 justify actions that are favorable to equity investors but would likely be opposed by debtholders, which in turn improves their job security.

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