The market response to implied debt covenant violations

Abstract

Previous research documents a negative stock price reaction to the announcement of a debt covenant violation (DCV). However, managers of firms that violate a covenant often obtain waivers and renegotiate debt contracts with lenders before the SEC requires them to disclose a violation. Firms therefore may not report some covenant violations, and prior research has not documented their cost to shareholders. Exploiting the fact that over half of all private debt contracts contain a debt covenant reliant on some variation of accounting earnings, I construct a sample of firms with debt contracts that contain at least one earnings‐based covenant. Combining earnings‐based‐covenant contract values from debt agreements with information publicly available at the earnings announcement date, I predict firms in violation of a debt covenant and provide evidence that equity investors react negatively to these implied violations, regardless of whether managers ever disclose that a violation occurred. In additional tests, I find no evidence of a negative stock price reaction to a firm disclosure of a DCV that market participants could infer from previously reported earnings, but I demonstrate that equity investors do react to the disclosure of a violation of a balance‐sheet covenant that would not have been inferable. This study complements previous research on DCVs by documenting the costliness to shareholders of violations subsequently resolved with lenders but not disclosed.

Debt Covenant Violations, Firm Financial Distress, and Auditor Actions

“…For example, research finds that unanticipated going-concern reports, such as those issued to seemingly viable companies, result in larger negative stock price reactions than when reports are anticipated (Blay and Geiger 2001;Fleak and Wilson 1994;Jones 1996;Loudder et al 1992). Likewise, Stice (2014) finds no evidence of a negative stock price reaction to the disclosure of a debt covenant violation when previously reported earnings imply a high likelihood of a violation.…”

“…). Likewise, Stice () finds no evidence of a negative stock price reaction to the disclosure of a debt covenant violation when previously reported earnings imply a high likelihood of a violation.…”

What's my style? Supply‐side determinants of debt covenant inclusion

“…Significant consequences arise when firms violate covenants and trigger a renegotiated agreement between violating firms and their creditors, such as negative stock market reactions (Beneish & Press, 1993; Stice, 2018), reduced investments (Chava & Roberts, 2008), impaired access to financing (Roberts & Sufi, 2009), employment cuts (Falato & Liang, 2016) and increased CEO turnover and independent director appointments (Ferreira et al., 2018; Nini et al., 2012). Even though covenants provide lenders with the valuable option to renegotiate contracts and covenant violations serve as tripwires that allow creditors to step in and influence firm policies, they also bring cost to banks.…”

Does fiduciary duty to creditors reduce debt covenant violation avoidance behavior?

“…Consistent with the contract-based argument (e.g., Ball et al, 2008;Holthausen & Watts, 2001;10 Covenant violations increase the cost of debt (Beneish & Press, 1993). Stock prices also decrease upon disclosure of violations, or when investors suspect covenant violation is imminent (Stice, 2018). Moreover, managers personally lose a significant part of their compensation or even their job following covenant violation (Eckbo et al, 2015;Ozelge & Saunders, 2012), and therefore have incentives to avoid covenant violation.…”