Does Institutional Ownership Exacerbate Debt-Equity Conflicts? Evidence from the Auditor Certificate of Debt Covenant Compliance

Abstract

We study the effect of borrowing firms’ institutional ownership on lenders’ monitoring demand. Using the data on a covenant-monitoring mechanism known as auditor’s certificate of covenant compliance (ACC), we show that the likelihood that a loan contract includes the ACC provision increases with a borrower’s institutional ownership. Consistent with the debt-equity conflict hypothesis, this result is driven by indexed and transient institutions, which are either ineffective or unmotivated in monitoring portfolio firms. The effect is more pronounced among the borrowers with poorer accounting quality, suggesting that firms’ accounting discretion is the key mechanism in play. We further support the causal interpretation by exploiting Russell index reconstitutions. Our evidence suggests that lenders expect borrowers’ earnings-management incentive to grow with indexed and transient ownership and thus take a preemptive action to ensure the effectiveness of covenants as the control-allocation rule.

Keywords: institutional investors, debt contract, covenant compliance, debt equity conflict

JEL Classification: G30, G23, M40