Abstract
We provide evidence that creditors play an active role in the governance of corporations well outside of payment default states. Using a large sample of covenant violations reported by U.S. public firms, we show that violations are followed immediately with an increase in CEO turnover, an increase in the incidence of corporate restructurings and hiring of turnaround specialists, a decline in acquisitions and capital expenditures, and a sharp reduction in leverage and shareholder payouts. The changes in the investment and financing behavior of violating firms coincide with amended credit agreements that contain stronger restrictions on firm decision-making. In addition, changes in the management of violating firms suggest that creditors exert considerable behind-the-scenes influence on governance in addition to contractual control. We also show that firm operating and stock price performance improve following a violation, suggesting that actions taken by creditors benefit shareholders.
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