CEO Compensation and Covenant Violations

Abstract

Although covenant violations are common and have significant negative consequences for firm value, little is known about why firms violate covenants, especially from manager’s incentive perspective. This study examines the relationship between CEO compensation and covenant violations. Consistent with the risk-shift hypothesis developed by Carlson and Lazrak (2010), we find that firms with CEOs whose salaries constitute a higher proportion of their total compensation are more likely to violate covenants. Those CEOs also actively change their pay structure prior to a violation so as to reduce their wealth exposure to a negative event byincreasing their salaries even higher and/or reducing their share ownership. The results suggest that the likelihood of a future violation increases by 13.6% for every percentage-point increase in salary as a proportion of total compensation and by 4.9% when the salary portion increases by 1% in the year of violation. The difference-in-difference analysis shows that creditors have significant though limited impacts on CEO’s pay structure after a violation. Specifically, the favorable changes include that bonus component increases, the value of options granted reduces and CEO’s total wealth sensitivity to stock prices increases after a violation. Salary component, however, does not decrease but increase. We find that firms that fail to adjust CEO salaries after a violation are more likely to experience multiple violations. Our analysis also shows a negative relationship between the entrenchment index and the likelihood of covenant violations, which reflects the conflicts between shareholders and creditors.