Firm Characteristics and the Presence of Event Risk Covenants in Bond Indentures

Abstract

Event risk covenants (ERCs) became popular as a bondholder protection measure during the height of restructuring activities in the 1980s. We investigate the empirical relation between firm characteristics and the likelihood of ERCs in bond indentures. In particular, we examine whether a firm's agency costs of debt, financial distress costs, and/or takeover potential influence its decision to include ERCs. Employing bonds with and without ERCs issued during 1986-90, we provide evidence that the likelihood a firm will include ERCs is positively related to the firm's agency costs of debt and to its potential for takeover. The results, however, do not support the financial distress costs hypothesis.

Shareholder‐management Conflict and Event Risk Covenants

“…Weaker evidence suggests management ownership is negatively related to ERC probability. These results are consistent with those of Bae, Klein, and Padmaraj (1997) and the view that, as managers' interests diverge from shareholders' interests, managers are more likely to use ERCs when issuing debt. Overall, the evidence from this study supports the entrenchment view of ERCs.…”

“…Using a more traditional approach to isolate the wealth effects of ERCs, we find that shareholder losses associated with ERCs are concentrated among debt issuers with low management ownership. We provide evidence consistent with Bae, Klein, and Padmaraj (1997) that firms likely to suffer shareholder‐management conflict are more likely to use ERCs when issuing debt. Overall, the evidence supports the notion that ERCs decrease shareholder wealth and that managers use ERCs primarily to entrench.…”

“…The logit analysis in this study is similar in spirit to that of Bae, Klein, and Padmaraj (1997), who also examine factors that could influence ERC probability. However, Bae, Klein, and Padmaraj include in their sample ERCs of all types (including coupon resets), do not control for industry‐specific effects, allow firms to appear more than once in their logit sample, and measure cross‐sectional variables before the shelf registration (for shelf‐registered bonds).…”

Blocking Block-Formation: Evidence from Private Loan Contracts

“…We examine restrictions in CIC clauses. Past studies have examined the existence of CICs in bond indentures (see, e.g., Crabbe 1991;Kahan and Klausner 1992;Cook and Easterwood 1994;Bae, Klein, and Padmaraj 1997;Chava, Kumar, and Warga 2010). Our paper complements these studies by documenting the prevalence of CICs in private loans and, more importantly, by revealing the heterogeneity in equity ownership caps in CICs.…”