Waiving Technical Default: The Role of Agency Costs and Bank Regulations

Hassabelnaby, Hassan R.

doi:10.1111/j.1468-5957.2006.00633.x

Cited by 14 publications

(5 citation statements)

References 38 publications

(41 reference statements)

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“…Prior research shows that assessing the severity of the covenant violation is based upon the borrower's financial condition. Still, lenders also consider loan features, regulatory environment, and overall liquidity risk the bank presents, among others (HassabElnaby, 2006).…”

Section: Page60 Page60mentioning

confidence: 99%

The Potential for Biases in Resolving Loan Problems

Brody¹,

Sokolowski²,

White³

2021

IJFBS

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This paper describes how behavioral biases influence the resolution of financial covenant violations. Prior literature documents that violation waivers are common; however, there is a lack of discussion on the determinants that lead loan officers to waive covenant violations. We rely on the escalation of commitment bias (or the sunk cost phenomenon) to discuss how loan officers may become attached to a selected course of action and fail to incorporate new information, increasing the likelihood of covenant waivers. We explain the implications of this bias on bank financial reports by detailing how accounting links loan quality to bank financial statements. We further draw on the psychology literature to offer potential solutions to mitigate overcommitment in the context of loan officers. Future research can examine the extent to which loan officers knowingly or unknowingly steer away from rational decision-making. This study has practical implications as users of bank financial reports, including investors, auditors, examiners, and bank managers, learn about processes and challenges on how accounting mechanics link bank loan portfolios to financial statements.

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Section: Page60 Page60mentioning

confidence: 99%

The Potential for Biases in Resolving Loan Problems

Brody¹,

Sokolowski²,

White³

2021

IJFBS

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“…Once a debt covenant is triggered, lenders can choose to accelerate the loan, renegotiate the contract, or grant a waiver (HassabElnaby, ). Renegotiation can be costly – Beneish and Press () estimate that the average costs of DCV attributable to increased interest rates and renegotiation fees are between 1% and 2% of the market value of equity for their sample of firms .…”

Section: Background and Hypothesis Developmentmentioning

confidence: 99%

The market response to implied debt covenant violations

Stice

2018

Business Fin & Account

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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.

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“…Creditors face a higher level of uncertainty about firms’ future prospects after a misstatement becomes publicly known and the revelation of the intentional misstatement decreases a firm's creditworthiness. An increase in information asymmetry and higher default probability reduces creditors’ willingness to waive the right of accelerated repayment (Chen and Wei, ; HassabElnaby, ; and Chava and Roberts, ). In cases in which creditors are willing to waive this right, they will often renegotiate the terms of the facility and will, for instance, require additional collateral, stricter covenants, or shorter maturity, which restricts firms’ financial leeway under the existing facilities (see Beneish and Press, ; and Chava and Roberts, ).Another consequence of misstatement‐related covenant violations was that a number of firms were prevented from drawing on existing credit facilities.…”

Section: Content Analysis Of Rating Reportsmentioning

confidence: 99%

“…In addition, the misstatement becoming publicly known might have a more pronounced effect on firm's creditworthiness if the firm is close to default. For instance, creditors are less willing to waive covenant violations in cases in which the firm's creditworthiness is low (HassabElnaby, ).…”

Section: Multivariate Analysismentioning

confidence: 99%

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What Drives the Consequences of Intentional Misstatements? Evidence from Rating Analysts’ Reactions

Bierey¹,

Schmidt

2016

Business Fin & Account

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This paper aims to identify the mechanisms through which intentional misstatements adversely affect firms by analyzing rating analysts’ reaction to misstatements. In order to identify the mechanisms through which the misstatement affects firms’ credit ratings, we analyze the content of rating reports. Rating analysts are concerned about seven different mechanisms. They are most concerned about misstatement‐related violations of debt covenants that increase a firm's liquidity risk. We find that, subsequent to an intentional misstatement becoming publicly known, credit ratings of misreporting firms are adversely affected for up to seven years. The adverse impact of an intentional misstatement on a firm's credit rating is most pronounced in cases in which rating analysts mention concerns about misstatement‐related violations of covenants. Our results suggest that these covenant violations are the most severe mechanism through which misstatements adversely affect firms’ creditworthiness.

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Waiving Technical Default: The Role of Agency Costs and Bank Regulations

Cited by 14 publications

References 38 publications

The Potential for Biases in Resolving Loan Problems

The Potential for Biases in Resolving Loan Problems

The market response to implied debt covenant violations

What Drives the Consequences of Intentional Misstatements? Evidence from Rating Analysts’ Reactions

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