Debt Contract Design Research Articles

The Price of Power: How Managerial Taxes Affect Debt Contract Provisions

We examine how income taxes—both managerial and corporate—influence the design of firms’ debt contracts and their use of financial covenants in particular. Both levels of taxation have the potential to exacerbate conflicts of interest among creditors, shareholders, and managers and, consequently, should influence the design of their debt contracts. Specifically, a decrease in corporate and an increase in managerial taxes encourage managers to take more risk, accordingly, we predict and find that loans issued following such changes in taxation are more likely to include performance rather than capital covenants. A series of cross-sectional tests provide further insight into the effect of both levels of taxation, and corroborate our main inferences. Overall, our study demonstrates how debt contract layouts change in response to arguably exogenous changes in income taxes—and, in turn, managers’ preferences—for risk.

Unemployment Risk and Debt Contract Design

ABSTRACT We examine how firms’ contractual relationships with their employees affect the design of their debt contracts, and the use of financial covenants in particular. Viewing the firm as the nexus of both explicit and implicit contractual relationships, we argue that managers cater to their employees’ preferences when negotiating contractual terms with creditors. We argue that an increase in unemployment-insurance benefits reduces employees’ cost of job loss, which, in turn, allows managers to take more risk. First, we show that more generous benefits are associated with a higher operating leverage, operating cash flow volatility, and product-development frequency. We then find that loans initiated following an increase in unemployment-insurance benefits include a higher proportion of performance, rather than capital covenants. Overall, our study demonstrates how the design of debt contracts changes in response to arguably exogenous changes in employees’ collective tolerance—and, in turn, managers’ preferences—for risk. JEL Classifications: M41; G32; J60.

Skilled labor and bank loan contracting

AbstractThis paper examines the credit risk implications of a firm's reliance on skilled labor and provides an empirical analysis of the effect of skilled labor on loan contracting outcomes. Using a sample of listed US firms from 1998 to 2017, we predict and find that banks charge higher interest rates to firms relying on high‐skill workers than low‐skill workers. This effect is stronger for firms with higher asset‐based operating leverage, higher probabilities of employee turnover and severer conflicts of interest between equity holders and debt holders. In addition, consistent with the idea that banks consider the specific costs and benefits associated with skilled labor, we show that a firm's reliance on skilled labor is positively (negatively) associated with the relative usage of capital (performance) covenants. Our results hold when applying different matching methods, fixed‐effect models or exogenous shocks from two quasi‐natural experiments. Overall, our study demonstrates the impact of skilled labor, an important labor‐force heterogeneity, on debt contract design and contributes to the understanding of the interaction between labor and capital, that is, the two primary inputs of a firm.

The effect of bond market transparency on bank loan contracting

We find that bond issuers receive bank loans with 12% fewer covenants when the secondary corporate bond market becomes more transparent. The treatment effect is more pronounced when bond trades are more informative, when stock prices are less informative, and when the likelihood of future debt-equity agency conflicts is higher. The evidence suggests that bond prices reflect forward-looking information that mitigates banks’ information risk in debt contracting. As such, banks impose fewer contractual restrictions on bond issuers when bond transactions become publicly observable. We find consistent results using a hand-collected dataset of negative covenants. Treatment firms are also less likely to subsequently renegotiate borrowing terms. Finally, we find corroborating evidence from new primary bond issues. Taken together, our findings suggest that public bond market frictions affect private debt contract design.

Transitory and Permanent Cash Flow Shocks in Debt Contract Design

Transitory and Permanent Cash Flow Shocks in Debt Contract Design

Strategic Debt Restructuring and Asset Substitution

This paper examines whether debt renegotiation mitigates the agency costs of asset substitution. Inspired by the studies of Mella-Barral and Perraudin (1997) and Leland (1998), we have developed an analytical continuous time model of a firm that has the option to switch to a higher risk activity and renegotiate the terms of the debt. Our model creates a trade-off between increasing firm volatility and decreasing growth rate which characterizes the potential for asset substitution. Our findings indicate that, in most cases, debt renegotiation substantially reduces agency costs of asset substitution, whereas non-renegotiable debt is optimal when equity holders have a weak bargaining position and the opportunity cost of their risk-taking incentives is high. Several testable empirical implications regarding the design of debt contracts are developed.

The Effect of Bond Market Transparency on Bank Loan Contracting

We find that bond issuers receive bank loans with 12% fewer covenants when the secondary corporate bond market becomes more transparent. The treatment effect is more pronounced when bond trades are more informative, when stock prices are less informative, and when the likelihood of future debt-equity agency conflicts is higher. The evidence suggests that bond prices in a transparent secondary bond market reflect forward-looking information that mitigates banks’ information risk when entering into loan contracts. As such, banks impose fewer contractual restrictions in lending agreements. Treatment firms are also less likely to employ gradually tightening dynamic-threshold covenants as a signaling device. Finally, we find corroborating evidence from primary bond issues. Taken together, our findings suggest that secondary bond market frictions affect debt contract design.

State contract law and the use of accounting information in debt contracts

This paper examines the relation between state contract law and the use of accounting information in debt contracts. Contract theory suggests that balance sheet based covenants resolve debtholder-shareholder conflicts ex ante, whereas income statement based covenants serve as trip- wires that trigger the switch of control rights ex post. 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), suggesting that balance sheet based covenants are more efficient in these jurisdictions. We therefore test and find evidence that lenders using pro-debtor (pro-lender) law are more (less) likely to rely on balance sheet based covenants. We measure reliance using both the weight of balance sheet covenants relative to income statement covenants and the covenant strictness. Our analysis further shows that contracts with performance pricing grids are less likely to include interest increasing grids when the law is more favorable to debtors. The results provide initial evidence that contract law is an important determinant for the design of debt contracts.

Does social trust affect international contracting? Evidence from foreign bond covenants

Building on rational choice institutionalism theory and Williamson’s (J Econ Lit 38(3): 595–613, 2000) four-level social analysis framework, we investigate the influence of the informal institution of social trust on debt contract design in an international setting. Using a sample of non-U.S. firms that issue bonds in the U.S. debt market, we find that Yankee bond creditors impose fewer covenants on bond issuers domiciled in countries with a high degree of social trust. We further show that the inverse relationship between debt covenants and the informal institution of social trust is more pronounced for firms from countries with weak formal institutions, as well as for firms with poor corporate governance and greater information opacity. These findings are robust to endogeneity tests, within-country analysis, various empirical models and measures of trust, and alternative hypotheses. We also show that, while a lower level of informal social trust is associated with higher borrowing costs, this relationship weakens when formal covenants are added to the debt contract (i.e., a substitution effect). Our paper contributes to the international business literature by providing new insights into the role of informal institutions (social trust) in cross-border debt contracting.

Determinants of the Usefulness of Inside Debt in Debt Contract Design

Evidence shows that managers’ debt-like compensation (i.e., inside debt) aligns their incentives with lenders’, reducing the agency cost of debt. We examine how changes in the contracting environment affect the use of inside debt in debt contracting. We find evidence of reduced reliance on inside debt for debt contracting when borrowers have credit constraints, consistent with a shift in bargaining power to lenders, and when firms experience financial distress, consistent with increased agency costs when bankruptcy is more probable. We detect reduced reliance on inside debt for debt contracting during the financial crisis and during shocks to industry demand, two plausibly exogenous shocks to firms’ contracting environments. In total, the results suggest that the role of inside debt changes predictably with the contracting environment.

Managerial Biases and Debt Contract Design: The Case of Syndicated Loans

We examine whether managerial overconfidence impacts the use of performance-pricing provisions in loan contracts (performance-sensitive debt [PSD]). Managers with biased views may issue PSD because they consider this form of debt to be mispriced. Our evidence shows that overconfident managers are more likely to issue rate-increasing PSD than regular debt. They choose PSD with steeper performance-pricing schedules than those chosen by rational managers. We reject the possibility that overconfident managers have (persistent) positive private information and use PSD for signaling. Finally, firms seem to benefit less from using PSD ex post if they are managed by overconfident rather than rational managers. This paper was accepted by Gustavo Manso, finance.

Auditor Reporting and Corporate Debt Structure

This paper examines whether auditor reporting is associated with corporate debt structure. Specifically, it examines whether modified audit opinions are related to debt conversion privilege, which is a significant debt contract term. I hypothesize a positive link between the presence of qualified audit reports and the likelihood of issuing convertible bonds. Modified opinions deliver warning signals about firms’ financial statement quality. Debtholders are likely to demand conversion provision to protect themselves against shareholders-debtholders agency conflicts when lenders seem to have high information asymmetry. The results confirm the hypothesis, demonstrating the economic role of audit reports in debt contract design.

Tough Love: The Effects of Debt Contract Design on Firms’ Performance

Abstract I investigate whether restrictive loan covenants disrupt or improve firms’ operating performance. Using an instrumental variables approach to address the endogenous relationship between covenant strictness and firms’ efficiency, I find that stricter loan covenants lead to an increase in profitability and firm value even when firms do not violate a covenant. Stricter covenants improve performance only in firms with managerial agency conflicts: those without large shareholder ownership, facing softer competition in their product market, or with weaker shareholder rights. The evidence suggests that by designing stringent contracts ex ante, creditors create positive externalities in poorly governed firms through managerial incentives. Received December 7, 2018; editorial decision May 31, 2019 by Editor Uday Rajan. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Loan purpose and accounting based debt covenants

PurposeThe purpose of this paper is to investigate the association between the purpose of a loan and the type of debt covenants, separated into balance sheet-based and income statement-based covenants.Design/methodology/approachUsing private loan deal observations obtained from the DealScan database over the period between 1996 and 2013, the authors classify the sample loan deals into three categories based on the purpose of borrowing, namely, borrowings for corporate daily operating purposes, financing purposes and acquisition and investing purposes. The authors conduct multinomial logistic regression analysis to test the relationship between the choice of financial ratios in a debt covenant and the purpose of a loan, controlling for financing constraints and other factors that have been identified as important to debt covenant analysis in prior studies.FindingsThe results provide evidence that the purpose of the loan is significantly associated with the type of debt covenants, suggesting that the lender and the borrower have considered the loan purpose when structuring their debt agreements. More specifically, the results indicate that the loans borrowed to fund acquisitions or long-term investment projects are more likely to have income statement-based covenants and less likely to have balance sheet-based covenants. In contrast, the loans borrowed for corporate daily operating purposes or financing purposes are more likely to contain balance sheet-based covenants relative to income statement-based covenants.Research limitations/implicationsThe authors show that loan purpose is significantly associated with the choice between income statement-based and balance sheet-based covenants. This result further illustrates ways in which accounting information improves contracting efficiency. The results are limited to the US market with its institutional structure. In future studies, it would be interesting to perform similar investigations on firms in other countries.Practical implicationsThe findings contain important and economically significant implications indicating that loan lenders and borrowers agree to include different types of accounting information (that is, income statement- versus balance sheet-based financial ratios) in their loan covenants for different purpose loans.Social implicationsOverall, the results provide important evidence regarding the connection between debt covenant structure and loan purpose. In doing so, it contributes to the literature on debt contract design (Dichev and Skinner 2002; Chava and Roberts 2008; Demerjian 2011; Christensen and Nikolaev 2012). Despite much interest in debt contract design, Skinner (2011) argues that there still exists incomplete knowledge of the economic factors that structure debt contracts. Income statement-based covenants depend on measures of profitability and efficiency and act as trip wires that transfer control rights to lenders when borrowing firms’ performance deteriorates. On the other hand, balance sheet-based covenants rely on information about sources and uses of capital and align interests between borrowing firms and lenders by restricting the borrower’s capital structure. The authors show that loan purpose is significantly associated with the choice between income statement-based and balance sheet-based covenants. This result further illustrates ways in which accounting information improves contracting efficiency.Originality/valueThis study is the first to identify differences in trends over time for the use of income statement- and balance sheet-based covenants as it relates to different loan purposes. The authors build on prior research to examine the degree to which loan purpose is associated with the choice between income statement-based and balance sheet-based covenants.

Do Labor Conditions Matter in Loan Contracting? Evidence from Labor Specificity

In this paper, we offer the novel insight that debt contract design is affected by the redeployability of borrowers’ capital and labor assets. We find that borrowers with greater redeployability have enjoy favorable loan terms (i.e. a lower loan spread, fewer loan covenants, and a lower likelihood of being a secured loan). These findings suggest that redeployability mitigates lenders’ concerns about cost stickiness and financial distress, as supported by the supplementary evidence that redeployability is negatively associated with cost stickiness and financial distress risk. Further cross-sectional analyses show that lenders regard capital and labor redeployability as substitutes in setting loan terms, consistent with these two types of redeployability having similar functions in reducing post-contracting loan repayment problems. The positive effect of redeployability on favorable loan terms is also stronger for firms with more growth opportunities, consistent with lenders viewing redeployability as important for minimizing the restructuring costs should investments fail.

Does Recognition versus Disclosure Affect Debt Contract Design? Evidence from SFAS 158

We study how recognition versus disclosure affects pricing and control allocation in debt contracting. We examine whether loan spreads and the use of covenants changed around SFAS 158 adoption, which required recognition of previously disclosed pension liabilities. We find that pension underfunding is positively associated with loan spreads and negatively associated with the use of capital (i.e., balance sheet) covenants prior to the adoption of SFAS 158. This is consistent with lenders viewing disclosed accounting information as not sufficiently reliable for contracting and instead pricing the risk associated with underfunding. Post-SFAS 158, pension underfunding is associated with lower spreads and a higher likelihood of using capital covenants relative to the pre-period. Further, we find no change in the use of performance covenants or the underlying credit risk associated with pension underfunding post-SFAS 158. Collectively, this evidence is consistent with recognition improving the reliability of accounting information for debt contracting.

Unemployment Risk and Debt Contract Design

We examine how firms’ contractual relationships with their employees affect the design of their debt contracts, and their use of financial covenants and pricing grids in particular. Viewing the firm as nexus of both explicit and implicit contractual relationships, we argue that managers internalize their employees’ preferences when negotiating contractual terms with creditors. An increase in unemployment insurance benefits reduces employees’ cost of job loss which, in turn, allows managers to take more risk. We find that loans initiated following an increase in unemployment insurance benefits are more likely to include performance rather than capital covenants and are more likely to include pricing grids based on financial (i.e., profitability) ratios rather than credit ratings. Overall, our study demonstrates how the design of debt contracts changes in response to arguably exogenous changes in employees’ collective tolerance — and, in turn, managers’ preferences — for risk.

Lender Capital Adequacy and Financial Covenant Strictness

Evidence of the effect of lender capital management incentives on debt contract design is sparse. We examine whether regulatory capital adequacy, a first-order concern for banks, is associated with the strictness of financial covenants included in loan contracts. We provide evidence that lenders with lower regulatory capital issue loans with lower financial covenant strictness. This is consistent with lenders viewing borrower covenant violations as costlier to lenders when their regulatory capital is relatively low. Consistent with lenders loosening covenants that are more likely to lead to frequent transfers of control, we find that this association is concentrated in performance covenants, as opposed to capital covenants. We also find that capital management incentives extend to participant banks in a syndicate, where participants with relatively low capital adequacy take smaller loan shares when the lead bank sets high covenant strictness.

Debt and Insolvency

Legal rules play a powerful but understudied role in security design. This article presents two new theoretical results about the design of debt contracts. The results derive from the premise that firms must avoid legal insolvency when issuing new debt because insolvency at issuance would trigger severe operational limitations on the issuer. I first show that legal insolvency limits debt capacity, limiting the amount of money that a firm can raise with debt. I next show that legal insolvency limits the yield that firms can promise new creditors, helping to explain why there is no market for ultra-high-yield new issue debt. The article’s results demonstrate that legal insolvency probably has important – if largely unnoticed – effects in limiting debt capacity and debt yields. More generally, the article illustrates the usefulness of better understanding legal solvency requirements, a legal mechanism that has received too little attention in the understanding of debt and security design.

Does Social Trust Affect International Contracting? Evidence from Foreign Bond Covenants

Building on rational choice institutionalism theory and Williamson’s (2000) four-level social analysis framework, we investigate the influence of the informal institution of social trust on debt contract design in an international setting. Using a sample of non-U.S. firms that issue bonds in the U.S. debt market, we find that Yankee bond creditors impose fewer covenants on bond issuers domiciled in countries with a high degree of social trust. We further show that the inverse relation between debt covenants and the informal institution of social trust is more pronounced for firms from countries with weak formal institutions, as well as for firms with poor corporate governance and greater information opacity. These findings are robust to endogeneity tests, within-country analysis, various empirical models and measures of trust, and alternative hypotheses. We also show that while a lower level of informal social trust is associated with higher borrowing costs, this relation weakens when formal covenants are added to the debt contract (i.e., a substitution effect). Our paper contributes to the international business literature by providing new insights into the role of informal institutions (social trust) in cross-border debt contracting.