Losing Control? The Two-Decade Decline in Loan Covenant Violations

The annual proportion of U.S. public firms that reported a financial covenant violation fell roughly 70% between 1997 and 2019. To understand this trend, we develop an estimable model of covenant design that depends on the ability to differentiate between distressed and non-distressed borrowers and the relative costs associated with screening incorrectly. We find the drop in violations is best explained by an increased willingness to forego early detection of distressed borrowers in exchange for fewer inconsequential violations, which we attribute mostly to a shift in the composition of public borrowers and partly to heightened investor sentiment during the 2010s.

Keywords: financial contracting, control rights, financial covenants, credit agreements

JEL Classification: G21, G23, G32, G34

Suggested Citation: Suggested Citation

Griffin, Thomas and Nini, Gregory and Smith, David Carl, Losing Control? The Two-Decade Decline in Loan Covenant Violations (July 30, 2024). Journal of Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3277570 or http://dx.doi.org/10.2139/ssrn.3277570