Ebook Are Creditors Able to Control Managerial Risk Taking After Covenant Violations?
In their seminal article, Jensen and Meckling (1976) discuss the risk shifting problem as a source of shareholder-debtholder conflicts and argue that risk shifting tendencies of shareholders may extract wealth from debtholders by switching from safer to riskier investments. A large body of work examines the various features of debt contracts (including covenants, maturity, and optionality) to see whether they alleviate shareholder-debtholder conflicts (Johnson, 2003; Bradley and Roberts, 2004; Billett, King, and Mauer, 2007).
While these features appear to relate to firm characteristics (e.g. growth opportunities and leverage), little is known about their direct influence on firm behavior on an ongoing basis. For example, it is possible that covenants are used when the borrower expects to stay in compliance and are therefore costless. In this case, the existence of covenants does not necessarily result in a change firm behavior. On the other hand, covenants could be effective and in which case they would be used to deter decisions that would otherwise occur. Once these covenants are violated, creditors obtain the right to accelerate any outstanding principal and withhold further credit. As argued by Chava and Roberts (2008), and Roberts and Sufi (2009), the threat associated with these rights enables creditors to exert significant influence over managerial decision-making.
This paper adds to the literature on how debtholders affect firm decisions and outcomes by looking at violations of financial covenants in private credit agreements. Prior work focuses on changes in firm behavior following violations and documents a decrease in investment spending, net debt issuance, and shareholder payouts (e.g. Nini, Smith, and Sufi, 2009b). The literature has not investigated; however, whether these changes lead to outcomes that favor debtholder interests (such as a decrease in risk). If these changes, presumably imposed by the creditors are effective, then, one would expect to see a reduction in firm risk following violations. This paper investigates this hypothesis, and shows the opposite.
I run several tests to show the impact of covenant violations on managerial risk taking behavior. First, I investigate the change in firm risk following a violation. Using various measures of risk and a quasi-discontinuity? design to isolate the effect of the violation on firm risk, I show an increase in risk. The main measure is asset volatility calculated using Moody‘s KMV method (e.g. Vassalou and Xing, 2004). In the four quarters following a violation, there is a 5 percent increase in asset volatility. In order to show that these results are not sensitive to the measure of risk, I use alternative methods such as total equity risk, systematic, and unsystematic risk calculated from the market model, and asset beta.
The increase in risk following violations using these alternative measures is significant and about 8 to 15 percent. This increase in risk implies that managers may be using the firm‘s remaining funds to invest in riskier projects once they violate a covenant, suggesting risk shifting behavior. These findings are consistent with prior research. Beneish and Press (1993, 1995) and Wilkins (1997) argue that technical covenant violations are associated with an increased likelihood of financial distress, which has been shown to exacerbate risk shifting (e.g. Eisdorfer, 2008).
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