Creditor control rights and firm investment policy☆

Abstract

We present novel empirical evidence that conflicts of interest between creditors and their borrowers have a significant impact on firm investment policy. We examine a large sample of private credit agreements between banks and public firms and find that 32% of the agreements contain an explicit restriction on the firm's capital expenditures. Creditors are more likely to impose a capital expenditure restriction as a borrower's credit quality deteriorates, and the use of a restriction appears at least as sensitive to borrower credit quality as other contractual terms, such as interest rates, collateral requirements, or the use of financial covenants. We find that capital expenditure restrictions cause a reduction in firm investment and that firms obtaining contracts with a new restriction experience subsequent increases in their market value and operating performance. AbstractWe provide novel empirical evidence of a direct contracting channel through which firm financial policy affects firm investment policy. We examine a large sample of private credit agreements between banks and publicly traded U.S. corporations and find that 32% of the agreements contain an explicit restriction on the firm's capital expenditures. Creditors are more likely to impose a restriction following negative borrower performance, and the effect of negative performance on the likelihood of facing a capital expenditure restriction is larger than the effect of negative performance on other loan terms such as the interest spread or pledging of collateral. We also demonstrate that the restrictions affect firm investment policy. For example, we show that most of the actual capital expenditures of borrowers with restrictions cluster just below their restricted amount, while in the year prior to the contract, the same borrowers' capital expenditures are distributed evenly above and below the restriction. Our results are consistent with control-based theories of financing in which creditors retain control rights over investment policy as a second-best solution to agency conflicts.

The confounding effect of cost stickiness on conservatism estimates

“…Debt contracts often include restrictions on capital investment(Nini et al, 2009;Nikolaev, 2010), which can reduce cost stickiness by restraining resource expansion during sales increases. To deter excessive cost stickiness (i.e., overspending on unused resources), creditors might also set tighter limits on earnings when the observed earnings asymmetry primarily arises from cost stickiness rather than conservatism.…”

The choice between public and private debt: A survey

“…Nini, Smith, and Sufi (2009) andRoberts and Sufi (2009a) investigate the extent of the impact of incentive conflicts between lenders and borrowers on investment and financial policies respectively.…”

Default clauses in debt contracts

“…Second, we add to the extensive literature on the drivers and role of covenants in debt contracts (e.g., Billett et al 2004;Bradley and Roberts 2004;Christensen and Nikolaev 2012;Nash et al 2003;Nini et al 2009). We document that default clauses cover a wide set of events that trigger the transfer of control rights to lenders, not just covenant breaches.…”