Debt Covenants, Expected Default Costs, and the Implicit Cost of Financial Reporting Manipulation

• In Event: Financial Institutions and Debt Contracting

Abstract

The transfer of control rights to lenders makes debt covenant violations costly to equityholders
and managers, and provides managers with an incentive to manipulate covenant ratios and
amounts. We find that the information contained in changes in the probability of covenant
violations is priced by the stock market, incremental to changes in firm fundamentals. This
relation is stronger when firms are near thresholds, and stock returns are more sensitive to
movements toward thresholds relative to movements away. These findings suggest that the stock
market conditions on the likelihood of a costly covenant violation, but that it does so differently
when the likelihood of manipulation is high. By averting selection bias associated with ex post
covenant violation analyses, our tests provide ex ante, large-sample estimates of the expected
cost of technical default of 5.10% of equity value and the cost of financial reporting manipulation
of 1.05% of equity value. Further, these estimates imply that equityholders systematically
overweight the conditional probability of bankruptcy given default by a factor of 1.44.

Authors

• Aytekin Ertan, London Business School

• Stephen Adam Karolyi, Carnegie Mellon University