Corporate Compliance with Debt Covenants

Abstract

In this paper, I present and test a model of corporate compliance with the debt covenant requiring payment of a current obligation. This study adds to the empirical literature on forecasting financial distress by showing conditions under which debt default may be a rational economic decision by the firm's shareholders. This analysis departs from empirical financial distress studies which are often not linked to an underlying economic theory. The focus on covenant default also extends the literature which has modeled bankruptcy (Bulow and Shoven [1978]) and liquidation decisions (Titman [1984]) but which has not considered a common first symptom of financial distress-covenant default. Briefly, the model examines the costs that influence shareholders' decision to comply with or violate a particular debt covenant: payment of a current obligation. These costs include those associated with bondholders' reaction to possible default. The model predicts that shareholders will default when, holding other factors constant, (i) interest rates have declined relative to coupon rates stated in the debt issue; (ii) the probability of paying future obligations is high; and (iii) the cost of obtaining funds to pay the obligation is high. The model also predicts when stockholders and bondholders will renegotiate the debt contract and the amount of wealth transferred in the renegotiation. Finally, the