Managerial Moral Hazard and Bond Covenants

57 Pages Posted: 29 May 2007  

Sudheer Chava

Georgia Institute of Technology - Scheller College of Business

Praveen Kumar

University of Houston - Department of Finance

Arthur Warga

University of Houston - Department of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: May 26, 2007

Abstract

Based on an analysis of the agency risk for bondholders from managerial entrenchment and fraud, and using an efficient contracting framework, we derive and test refutable hypotheses about the influence of managerial moral hazard on the use of bond covenants. Entrenched managers can both exacerbate and ameliorate bondholder agency risk, and the influence of fraud risk on bond covenants is determined by the quality of information on the firms' net assets and economic prospects. Our empirical analysis indicates that managerial entrenchment and the risk of managerial fraud significantly influence the use of covenants, in the direction predicted by our agency-theoretic analysis. Moreover, the use of covenants responds to cross-sectional variations in the firms' informational environment that influence the risk of managerial fraud. We also find that the Sarbanes-Oxley Act (SOX) has not significantly influenced the overall use of bond covenants; however, the passage of SOX appears to have reduced the agency risk to bondholders from managerial moral hazard with respect to investment.

Keywords: Managerial entrenchment, Fraud, Bond covenants, Contracting efficiency

JEL Classification: G32, G34, D82

Suggested Citation

Chava, Sudheer and Kumar, Praveen and Warga, Arthur, Managerial Moral Hazard and Bond Covenants (May 26, 2007). Available at SSRN: https://ssrn.com/abstract=989342 or http://dx.doi.org/10.2139/ssrn.989342

Sudheer Chava

Georgia Institute of Technology - Scheller College of Business ( email )

800 West Peachtree St.
Atlanta, GA 30308
United States

HOME PAGE: http://www.prism.gatech.edu/~schava6/

Praveen Kumar (Contact Author)

University of Houston - Department of Finance ( email )

Houston, TX 77204
United States
713-743-4770 (Phone)
713-743-4789 (Fax)

Arthur Warga

University of Houston - Department of Finance ( email )

Houston, TX 77204
United States
713-743-4779 (Phone)
713-743-4789 (Fax)

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