Abstract

In this paper, we examine the effect of credit defaults swap (CDS) initiation on reference firms’ cost management behavior. CDS contracts provide insurance protection for lenders, inducing a shift in bargaining power from borrowers to lenders and an excessive incidence of bankruptcy. Anticipating more intransigent lenders in debt renegotiations and higher bankruptcy risk, borrowers are more concerned about liquidity and have heightened incentive to decrease cost stickiness after CDS initiation, as cost stickiness lowers liquidity and triggers early covenant violations. Consistent with our expectations, we find that CDS initiation is associated with a decline in reference firms’ cost stickiness. This association is more pronounced for (1) financially constrained firms; (2) firms with weaker bank relationships; and (3) firms with more financial covenants in debt outstanding. Collectively, our findings suggest that the CDS-induced “empty creditor problem” causes reference firms to be excessively concerned about liquidity and covenant violation, thus reducing the effectiveness of cost stickiness as a rational resource management tool.

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