Design and Renegotiation of Debt Covenants
University of California, Berkeley - Haas School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)
Stanford Graduate School of Business
AFA 2004 San Diego Meetings
EFA 2005 Moscow Meetings Paper
We analyze the design and renegotiation of covenants in debt contracts as a particular example of the contractual assignment of property rights under asymmetric information. In particular, we consider a setting where future firm investments are efficient in some states, but also involve a transfer from the lender(s) to shareholders. While there is symmetric information regarding investment efficiency, managers are better informed about any potential transfer than the lender. The lender can learn this information, but at a cost. In this setting, we show that the simple adverse selection problem leads to the allocation of greater ex-ante decision rights to the uninformed party than would follow under symmetric (in particular, full) information. Consequently, ex-post renegotiation is in turn biased towards the uninformed party giving up these excessive rights. In many settings, this result yields the opposite implication from standard Property Rights results regarding contracting under incomplete contracts and ex-ante investments, whereby rights should be allocated to minimize inefficiencies due to distortions in ex-ante investments. Indeed, for debt contracts as well as other settings, the uninformed party, who receives strong decision rights in our setting, is likely to have few significant ex-ante investments to undertake relative to the informed party.
Number of Pages in PDF File: 36
Date posted: July 10, 2005