The Ex‐Ante Monitoring Role of Accounting Covenants in Public Debt

Abstract

for their guidance and support. I am also indebted to Romano Peluso and Ronald Rose for their many discussions regarding bond indenture, bond trustee, and bankruptcy law. The Ex-Ante Monitoring Role of Accounting Covenants in Public Debt ABSTRACTIn contrast to what is known about accounting covenants in private debt, little empirical evidence on the role of accounting covenants in public debt exists. Diffuse ownership, arm's length monitoring, and collective action problems are unique to the public debt setting and raise the question of whether these covenants serve their intended role. As such, this study investigates whether including covenants reliant upon accounting inputs influences borrowers' actions to prevent adverse credit events. Accounting covenants in the public debt setting provide firms with a disciplining mechanism to renegotiate ahead of costly technical default-a stark contrast to the ex-post renegotiation -trip wire‖ role covenants play in private debt. In particular, the results show that including accounting covenants in public debt is associated with an increased probability of ex-ante renegotiation, that is, negotiation through consent solicitations ahead of covenant violation. This ex-ante renegotiation, in turn, is associated with decreased adverse credit events. Cross-sectional results support these findings as the ex-ante renegotiation role of accounting covenants varies with bondholders' and trustees' monitoring ability.JEL Classification: G32, L14, M41

The market response to implied debt covenant violations

“…Debt contracts include covenants to reduce lender risk by limiting managers' ability to extract rents from debt holders and by giving lenders control of the firm during periods of deteriorating financial health (see, e.g., Aghion & Bolton, 1992). 7 Covenants restrict actions by borrowers after the debt issuance, but the commitment to turn over firm control to the lender during bad states generates ex ante more favorable borrowing terms for the borrowing firm (Bozanic, 2016;Bradley & Roberts, 2015). 8 Debt covenant violation is costly to shareholders (Smith, 1993).…”

What's my style? Supply‐side determinants of debt covenant inclusion

“…In loan contracts, covenants have classically been viewed as a method of controlling agency problems by restricting managerial behavior (e.g., Jensen & Meckling, 1976;Smith, 1993;Smith & Warner, 1979). Covenants can align the interests of the contracting parties ex-ante and serve as "trip wires" and reallocate decision rights ex-post (e.g., Bozanic, 2016;Chava et al, 2010;Demerjian, 2011;Dichev & Skinner et al, 2002).…”

Managerial ability and bank‐loan pricing

“…Other relevant studies include Bierey and Schmidt () and Bozanic (). Bierey and Schmidt () identify R&D and its interplay with legal protection as a potentially important characteristic in loan contracting.…”

“…Thus, their study is at least indirectly related to ours. Bozanic () compares the role of covenants in public and private debt and contrasts the ex‐ante renegotiation opportunities in public debt versus the trip‐wire role of covenants in private debt.…”