Debt Covenant Design and Creditor Control Rights: Evidence from the Tightest Covenant
62 Pages Posted: 18 Jul 2019
Date Written: March 31, 2017
Within the same debt contract, some financial covenants are considerably more restrictive than others. I exploit this heterogeneity in covenant design and show that the design of the most restrictive covenant is systematically associated with covenant outcomes - compliance, violations, or renegotiations. Consistent with an alleviation of moral hazard problems, tighter capital expenditure restrictions (performance covenants) are more likely to facilitate ex post creditor control through covenant renegotiations (violations). By contrast, borrowers are more likely to comply with contracts with tighter capital covenants, suggesting that these covenants more effectively align shareholder-creditor interests ex ante to avoid adverse selection problems.
Keywords: Financial contracting, Incomplete contracts, Creditor rights, Asymmetric information, Agency problems
JEL Classification: G32, G34, D82
Suggested Citation: Suggested Citation