Covenant Violations Research Articles

Creditor Control Rights, State of Nature Verification, and Financial Reporting Conservatism

I examine the impact of state-contingent allocation of creditor control rights on financial reporting. Using a discontinuity analysis, I find that firms’ financial reporting becomes more conservative immediately after covenant violations and this effect persists for at least eight quarters. The conservatism effect is more pronounced when creditors possess greater bargaining power, when firms’ operations are more volatile, and when creditors put Chief Restructuring Officers in place. My findings identify a specific channel through which debt financing shapes corporate financial reporting and provide direct evidence supporting the debt contracting explanation for conservatism posited in Watts (2003).

Market Timing and Wealth Transfer in Debt Repurchases: The Decision between Tender Offers and Open Market Bond Repurchases

This study investigates how the firm’s objective of the bond repurchase affects its choice of whether to repurchase on the open market or via a tender offer. Unlike tender offers, open market repurchases are not pre-announced and the identity of the buyer is unknown to the seller. We provide evidence that firms are likely to repurchase on the open market when they seek to exploit mispricing of their bonds and when they seek to manage their financial reports, either in order to meet earnings targets or avert debt covenant violations. When firms seek to amend indenture terms they are likely to choose a tender offer over an open market repurchase. We also find that mispricing exploitation is mitigated when the information quality available to bondholders is higher and that insiders take advantage of the likely wealth transfer from bondholders to shareholders achieved in open market repurchases.

Does Shareholder Litigation Affect Financial Reporting Choices?

This paper investigates the effects on financial reporting practices of a court ruling that made it easier for public corporations to defend against class-action litigation filed under securities laws. I find an increase in restatements and discretionary revenues for firms affected by the ruling relative to unaffected firms. Further, within affected firms, these results were concentrated among those most likely to face litigation. I also find a decline in debt covenant violations and an increase in investment levels. These results suggest that the threat of shareholder litigation can discipline managerial reporting practices.

CEO Compensation and Covenant Violations

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.

Creditor Control Rights and Financial Reporting Conservatism

Covenant violations transfer control rights from shareholders/managers to creditors and provide a clear mechanism through which creditors can impose their preference on corporate financial reporting policies. Consistent with creditors using their control rights to demand more conservative financial reporting, we find significant evidence that firms exhibit a higher level of accounting conservatism after covenant violations. Results from quasi-discontinuity regressions show that the effect of covenant violations on accounting conservatism is beyond that of deteriorating firm performance that triggers covenant violations. In addition, the post-violation increase in accounting conservatism is more pronounced in firms with higher expected agency costs of debt and firms experiencing more severe violations, and is more evident in the years immediately following covenant violations. Our findings provide direct support for debtholder demand for accounting conservatism (Watts (2003)) and highlight the importance of creditor control rights and shareholder-debtholder conflicts in shaping corporate financial reporting policies.

Covenant Violations, Loan Contracting, and Default Risk of Bank Borrowers

Covenants are repeatedly violated in private debt contracts by the same borrower. We use covenant violations to test predictions from the incomplete contracting literature and provide supporting evidence that lenders act as “tough principals” to address borrower moral hazard in subsequent new loans increasing loan spreads and implementing a tougher covenant structure. Alternative hypotheses related to (i) credit risk, (ii) disciplining of managers, (iii) bad luck, (iv) hold-up or (v) corporate governance cannot explain our findings. Our results suggest that covenants are important to address informational and agency problems between lenders and firms in dynamic loan contracting.

The Supply-Side Determinants of Loan Contract Strictness

Using a novel measure of contract strictness based on the ex-ante probability of a covenant violation, I investigate how lender-specific shocks impact the strictness of the loan contract that a borrower receives. Exploiting between-bank variation in recent portfolio performance, I find evidence that banks write tighter contracts than their peers after suffering payment defaults to their own loan portfolios, even when defaulting borrowers are in different industries and geographic regions than the current borrower. The effects of recent defaults persist after controlling for bank capitalization, although compression in bank equity is also strongly associated with tighter contracts. The evidence is most consistent with lenders using their default experience to make inference about their screening ability and adjusting contracts accordingly. Finally, contract tightening is most pronounced for borrowers who are dependent on a relatively small circle of lenders, with a one standard deviation increase in lender defaults implying covenant tightening nearly equivalent to that of a two-notch downgrade in the borrower's own credit rating.

Creditors’ Bargaining Power and Accounting Conservatism: A Debt Contracting Perspective

We examine the implications of creditors’ bargaining power, and in particular, how creditors’ bargaining power affects the role of accounting conservatism in initial debt contracting. The relative bargaining power of creditors and borrowers in our study is proxied by exogenous factors unaffected by initial contracting terms. We hypothesize that creditors’ bargaining power affects ex post renegotiation outcomes in cases of covenant violation. We find supportive evidence that higher creditors’ bargaining power is associated with less favorable renegotiation outcomes for borrowers. In addition, our proxies of creditors’ bargaining power are positively associated with loan interest rates and covenant restrictions in initial debt contracts. Since only creditors with high bargaining power can extract benefits from renegotiations, we hypothesize and find that creditors with higher bargaining power exhibit a higher demand for accounting conservatism when entering initial debt contracts. Furthermore, the negative association between conservatism and loan spreads is stronger when creditors’ bargaining power is higher.

Insightful Insiders? Insider Trading and Stock Return around Debt Covenant Violation Disclosures

This paper examines insider trading around first-time debt covenant violation disclosures in SEC filings, and is interesting from a research and regulatory standpoint for three reasons – delay and infrequency of a first-time disclosure, lack of attention to covenant disclosures by regulators, and a dearth of research. We document net insider selling in the 12 months before a debt covenant violation disclosure and net insider buying up to 12 months after disclosure. This net insider selling leads investors’ negative returns before violation disclosure. Net buying also leads investors’ positive returns after disclosure. We also show that net insider selling in a narrow (one to two month) window around the covenant violation disclosure associates predictably with investors’ price response in that same window.

Creditor Control Rights, Investment and Growth Opportunities

We show that creditors do not just ensure that inefficient investment is not undertaken, but also do not preclude efficient investment. Examining what happens following a debt covenant violation, a situation through which creditors acquire some control rights over the firm, we find that investment declines when the firm has few growth opportunities but it may increase otherwise. The results are robust to the use of different proxies for growth opportunities. The firm’s performance improves but it suffers dividend cuts and increased CEO turnover. The results suggest that creditors consider the benefits of growth opportunities as a source of future cash flows to meet outstanding debt obligations.

The Information Content of Bank Loan Covenants

This article examines the determinants of financial covenant thresholds in bank loan agreements and information conveyed through the selection of tight financial covenants. We find that riskier firms and firms with fewer investment opportunities select tighter financial covenants. We also find that selection of tight covenants is associated with improvements in the covenant variable and declines in investment spending and net debt issuance. We observe these changes also for borrowers that do not breach their covenants, suggesting that they are not simply the result of creditor influence conditional on a technical default. Furthermore, we find that violations of tightly set covenants have significantly less of an impact on the borrower's investment spending and net debt issuance than violations of loosely set covenants. Overall, our results suggest that the selection of tight covenants conveys information concerning future changes in covenant variables, investment and financial policies, and the outcome of covenant violations. The Author 2010. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org., Oxford University Press.

Price Discovery and Dissemination of Private Information by Loan Syndicate Participants

ABSTRACTWe delineate key channels through which flows of confidential information to loan syndicate participants impact the dynamics of information arrival in prices. We isolate the timing of private information flows by estimating the speed of price discovery over quarterly earnings cycles in both secondary syndicated loan and equity markets. We identify borrowers disseminating private information to lenders relatively early in the cycle with firms exhibiting relatively early price discovery in the secondary loan market, documenting that price discovery is faster for loans subject to financial covenants, particularly earnings‐based covenants; for borrowers who experience covenant violations; for borrowers with high credit risk; and for loans syndicated by relationship‐based lenders or highly reputable lead arrangers. We then ask whether early access to private information in the loan market accelerates the speed of information arrival in stock prices. We document that the stock returns of firms identified with earlier private information dissemination to lenders indeed exhibit faster price discovery in the stock market, but only when institutional investors are involved in the firm's syndicated loans. Further, the positive relation between institutional lending and the speed of stock price discovery is more pronounced in relatively weak public disclosure environments. These results are consistent with institutional lenders systematically exploiting confidential syndicate information via trading in the equity market.

Investor Reaction to Going Concern Audit Reports

ABSTRACT: The literature provides mixed evidence on whether investors find audit reports modified for going concern reasons to be useful. Using a substantially larger sample than previous studies, we observe negative excess returns when the going concern audit report (GCAR) is disclosed. We find that the reaction is more negative if the GCAR cites a problem with obtaining financing, suggesting that the GCAR provides new information to investors. Also, the reaction is more adverse if the GCAR triggers a technical violation of a debt covenant that restricts the firm from getting a GCAR. The evidence suggests that institutional investors drive the reaction to the GCAR, since there is no detectable reaction at low levels of institutional ownership. The market reaction gets more negative as the level of institutional ownership increases, and there is a decline in institutional ownership after the GCAR is issued. We attribute these results to sophisticated investors’ awareness of the firm’s financing needs and the covenants carried by the firm’s debt.

Corporate Debt Financing and Earnings Quality

Abstract: Our study establishes linkages between two extensively researched areas, debt financing and the quality of earnings. Debt can have a ‘positive influence’on earnings quality because managers are likely to use their accounting discretion to provide private information about the firms’ future prospects to lower financing costs. For high debt, it can also have a ‘negative influence’ on earnings quality as managers use accruals aggressively to manage earnings to avoid covenant violations. Using accruals quality as a proxy for earnings quality, we document a non‐monotonic (curvilinear) relation between debt and earnings quality. The relationship is positive at low levels of debt and negative at high debt levels with an inflection point around 41%. Our results suggest that firms that rely heavily on debt financing might be willing to bear higher costs of borrowing from lower earnings quality because the benefits from avoiding potential debt covenant violations exceed the higher borrowing costs.

A Pricing Model for Bank Loans with Covenants

A covenant is a special set of clauses in a firm’s debt contract restricting business policy and allowing creditors to take specified action should the covenant terms be violated. Three main reasons for the inclusion of covenants in debt contracts are accounted for in the literature: they (1) resolve conflicts of interest between shareholders and bondholders, (2) are used as instruments of business policy and (3) are used by banks as a means of credit monitoring. If a bank decides to grant a loan with a covenant, in order to calculate the Expected Loss Rate (ELR) it must estimate the probability of covenant violation and the contribution of the covenant to the loss given default. We find that the elr of the loan may be lower compared to a loan without a covenant. Therefore through the use of covenants banks can offer firms loans with reduced spread, without requiring more collateral. We also find that the ELR function has a minimum value with respect to the limit of covenant violation, so the choice of the financial ratio used in the covenant and its value limit are found using a minimization procedure. Using empirical values for the probability of covenant violation, the model we propose can be integrated into banks’ internal models.

Creditor Control Rights, Loan Enforcement and Bankruptcy Regimes

The paper examines the actions taken by the creditor and the impact on the borrower’s firm value upon a covenant violation across jurisdictions. By analyzing 362 loan facilities concerning 259 borrowers from four jurisdictions with either a pro-creditor or pro-debtor bankruptcy regime over a period of five years (2002-2007), we find that the jurisdiction in which the borrower is incorporated plays an important factor on how its stock price will respond to a covenant violation announcement even though it may not affect the creditors’ decision to provide waivers or change covenants. In addition, contrary to prior findings, the study also shows that creditors do not always reduce allowable borrowings nor tighten existing covenants when the loan agreement is renegotiated after a covenant violation. Instead, new restrictive covenants are often imposed to control the way the borrower utilizes the funds.

The Role of Covenants in Public and Private Debt

Covenants are particular clauses in debt contracts of firms that restrict business policy, giving creditors the possibility of putting precise actions into force - normally early repayment - when the covenants are violated. We refer to the Agency Theory of Covenant (ATC), which assumes that as long as the offsetting benefits exceeds the costs of the constraints imposed by the covenants, the lender will include covenants in their debt contracts. The goal of this paper is to provide a theoretical model that explains the empirical findings of research on public (bonds) and private (bank loans) debt, by highlighting the role of coordination costs among debtholders. Our study introduces two innovative aspects to the existing literature: (1) an emphasis on the covenant violation costs, and (2) the formalisation of a market equilibrium approach. In particular, we formalise the renegotiation costs of the lender, and we identify the effect of the degree of coordination on the renegotiation costs and, ultimately, on the efficiencies in the use of covenants. With regard to, the second point, as far as we know, our paper is the first to present an equilibrium market model for two types of debt contracts with covenant. For the first type, we consider a firm issuing a bond with covenant in the primary market, whereas in the second the firm borrows a syndicated bank loan with covenant. In both models we (1) find that there is a minimum coordination level which guarantees the covenant efficiency, and we (2) identify the optimal covenant threshold.

Do IFRS Reconciliations Convey Information? The Effect of Debt Contracting

ABSTRACTWe examine whether earnings reconciliation from U.K. generally accepted accounting principles (GAAP) to International Financial Reporting Standards (IFRS) convey information. As a result of debt contracting, mandatory accounting changes are expected to affect the likelihood of violating existing covenants based on rolling GAAP, leading to a redistribution of wealth between shareholders and lenders. Consistent with this prediction, we find significant market reactions to IFRS reconciliation announcements. These market reactions are more pronounced among firms that face a greater likelihood and costs of covenant violation and early announcements. While the association between later announcements and weaker market reactions is consistent with contractual implications of technical changes to earnings, which investors quickly learn to predict, it is inconsistent with IFRS forcing all firms in the sample to reveal firm‐specific information through accruals. Thus, by showing that mandatory IFRS also affects debt contracting, we expand on existing IFRS research that focuses on how accounting quality and cost of capital are impacted.

The Cost of Private Debt Covenant Violation

This study quantifies costs that firms are willing to incur to avoid violation of private debt covenants. The results indicate that as firms approach covenant violation they engage in income-increasing earnings management, which increases their tax liability. By estimating the extent of income-increasing activities and the additional tax costs incurred, this study arrives at a lower-bound estimate of the cost of violating private debt covenants. The mean (median) firm with relatively tight debt covenants increases its current tax liability by an amount equivalent to increasing the cost of debt financing by between 12.92 (10.72) and 22.72 (12.81) basis points (where firms with relatively loose debt covenants serve as the baseline). The magnitude of this estimate indicates that the expected costs of covenant violation are meaningful. Combined with recent evidence that private debt covenant violations occur frequently (Dichev and Skinner, 2002; Roberts and Sufi, 2009b), this implies debt covenants and expected violations are economically important.

Information, Monitoring, and Manipulation: The Economic Role of Covenant Measurement

I document the variation in measurement of financial covenants, focusing on three measurement rules: earnings (EBITDA vs. EBIT), firm value (including or excluding intangible assets) and inclusion of escalator clauses (provisions that increase the threshold of net worth covenants). I find that the selection of earnings and firm value measure is associated with the creditors’ demand for monitoring and that inclusion of escalators is driven by the risk of underinvestment. There is also evidence consistent with borrowers using discretion to lower depreciation and amortization and to inflate goodwill to avoid covenant violation. I draw two conclusions. First, earnings and firm value measurements are designed to aid the creditor in monitoring; however, borrowers use discretion to manipulate the reported figures. Second, escalator clauses encourage capital expenditures, and do so effectively. This evidence collectively supports an economic role for covenant measurement: the choice of measure facilitates efficient monitoring and limits underinvestment.