Do Creditor Rights Increase Employment Risk? Evidence from Loan Covenants

Abstract

Using a regression discontinuity design, we provide evidence that there are sharp and substantial employment cuts following loan covenant violations, when creditors gain rights to accelerate, restructure, or terminate a loan. The cuts are larger at firms with higher financing frictions and with weaker employee bargaining power, and during industry and macroeconomic downturns, when employees have fewer job opportunities. Union elections that create new labor bargaining units lead to higher loan spreads, consistent with creditors requiring compensation when employees gain bargaining power. Overall, binding financial contracts have a large impact on employees and are an amplification mechanism of economic downturns.

Creditor Control Rights and Board Independence

“…Our paper makes several contributions to the literature. Our results are complementary to the literature on the effect of loan covenant violations on firm outcomes (Chava and Roberts (), Roberts and Sufi (), Nini, Smith, and Sufi (, ), Falato and Liang ()). Our work shows that credit agreements have long‐lasting effects on how firm decisions are made.…”

“…We confirm the irrelevance of these firm characteristics by replicating the regression in column (1) using firm characteristics as dependent variables. These are “balancing tests,” as in Falato and Liang (). Table IA.VIII in the Internet Appendix summarizes these results.…”

“…As in Chava and Roberts () and Falato and Liang (), we infer violations from threshold and accounting data. This procedure may lead to coding and other errors, as well as possible overstatement of the actual number of violations because we do not consider covenant threshold renegotiations.…”

“…In practice, creditors rarely need to carry out such threats; most covenant violations lead to contract renegotiation (Roberts ()). Covenant violations enhance creditors' bargaining position in renegotiations, as shown by the empirical literature on the impact of violations on firm policies (e.g., Chava and Roberts (), Roberts and Sufi (), Nini, Smith, and Sufi (, ), Falato and Liang ()). This literature describes such an improvement in creditors' bargaining power as an increase in “creditor control rights.”…”

Financial Stability Monitoring

“…As highly indebted households and nonfinancial businesses are less able to withstand negative shocks to incomes or asset values, they may have to sharply curtail spending in ways that can reinforce the effects of the shocks. For example, in the nonfinancial business sector, leverage, debt defaults, bankruptcy, or covenant violations force firms to cut back on investment or employees, potentially amplifying the initial declines in spending if cutbacks are widespread (Opler and Titman, 1994;Chava and Roberts, 2008;Falato and Liang, 2012;Sharpe, 1994). For households, more highly-levered households are less able to absorb the shock of a house price decline (see Mian and Sufi (2009) who use county-level household data and show the rise in household leverage was a strong predictor of recession severity during 2007 to 2009).…”