Monitoring is an important feature of many corporate finance theories, and the recent empirical literature on debt covenants has shown that monitoring is a vital feature of debt. As a firm experiences losses, it triggers covenants, and management finds itself increasingly restricted in what corporate policies it can use. Covenants can alleviate agency problems but they are potentially costly to the firm exactly because they restrict the set of management choices. Despite this, the role of monitoring has remained relatively unexamined in dynamic settings, including the dynamic theory of security design. The primary obstacle has been the lack of a parsimonious monitoring model.

Our paper makes three contributions. First, we present a parsimonious dynamic principal agent model with monitoring, and we characterize the optimal contract. Second, we show that this contract can be implemented with debt and equity, where debt covenants implment monitoring choices and equity issuance implements changes in performance sensitivity allowed by monitoring. In doing so, we can explain patterns in both the use of debt covenants and equity issuance, and we make new testable predictions. Third, we show that the optimal equity issuance policy arises in a game with strategic actions by equity holders and management. After we present the model in the main text and describe its properties, we will discuss our empirical predictions in the conclusion (Section 7).