State Contract Law and the Use of Accounting Information in Debt Contracts

Abstract

We study the relation between state contract law and the use of balance-sheet and income-statement based covenants in debt contracts. Incomplete contract theory suggests that balance-sheet based covenants ex ante resolve debtholder-shareholder conflicts, whereas income-statement based covenants serve as trip wires that trigger the switch of control rights ex post. Importantly, it is more difficult for lenders to exert their control rights ex post if the contract law is more favorable to debtors (i.e., the law is pro-debtor). We therefore ask whether lenders using pro-debtor law are more likely to rely on balance-sheet based covenants, and our evidence provides an affirmative answer to this question. Pro-debtor state contract law is positively associated with the weight given to balance-sheet based covenants (vs. income-statement based covenants) in the debt contract. Moreover, we extend our inquiry beyond financial covenants and find additional evidence that lenders using the law of pro-debtor states are more likely to rely on contractual features that align cash flow rights ex ante, rather than allocating control rights ex post through enforcement. In particular, we document that borrowing base restrictions, which limit the amount a lender provides to the borrower based on the borrower’s working capital assets, are more common in contracts that are governed by pro-debtor state contract law.