Debt Covenant Policies and Corporate Governance - Literature review Example

Debt Covenant Policies and Corporate Governance

2. Discuss the effects of debt covenants in various corporate finance outcomes by providing theoretical and empirical evidence to support your case.

There are a diverse number of potential effects of debt covenants on corporate finance outcomes. To begin with, the existence of covenants in financial contracts is inspired, and indeed rationalized through their capability to mitigate the problems of agency, and assists in securing financing through the promising of the state contingent control rights. Therefore, the covenant violations identify a particular mechanism, the control rights transfer through which the misalignment of incentives can influence the investment (Chava and Roberts, 2008, p. 2087). Secondly, the covenants are pervasive in financial contracts, for example, public debt, private equity and private debt. The covenants and the possibility for violation are appropriate for a big number of companies existing in the economy. Lastly, the covenant violations frequently take place beyond of financial distress and infrequently results in acceleration or default of the loan. Therefore, the potential effect of covenant violations on investment is not restricted to a small portion of companies facing distinct situations.

The credit derivatives growth raises the potential for a decrease in the debt governance as the lenders depends on the instruments in lieu of monitoring to their management of credit risk. The covenant levels may decrease when the purchasers of a loan are not able to purchase at low cost or perhaps they have low incentive to monitor the compliance of the borrower with its loan obligations, and to renegotiate a loan after its breach (Whitehead, 2009, p. 30). The transfer of credit risk by the loan originators may augment the risk of moral hazard. As the public bonds, the results may mirror a trade-off with the lower cost of managing credit risk through loan sales and hedging balanced against the augmented cost arising from weaker covenants and less creditor oversight.

The Effects of Debt Covenants Violation on the Corporate Capital Expenditures

Corporate capital expenditures deteriorate in response to a covenant violation by roughly one percent of capital per quarter to a thirteen percent decrease relative to investment before the violation. This is due to measures of investment opportunities, firm and year quarter fixed effects, measures of financial health, and measures of debt overhang. Further, it is owing to the measures of other contractual aspects, for instance, other covenant provisions, measures of probable earnings manipulation, for example, abnormal accruals, and smooth functions such as polynomials of the distance to the threshold of the covenant (Chava and Roberts, 2008, p. 2092). Additionally, utilising the subsample of observations that are near to the covenant threshold generates almost identical outcomes to those found in the wider sample. Therefore, steady with the intuition provided through control centered theories, the control rights transfer associated with a covenant violation results in a noteworthy decrease in investment undertaking, as creditors intervene to thwart ineffective investment or chastise managers for perceived misconduct.

The debt purchasers offer the finance in return for a pledged stream of recompenses and a range of other covenants linking to corporate behaviour, for instance, the risk and value of the corporate assets. When the corporation defaults on the payments or violates the covenants, then the debt holders naturally get the rights to repossess the collateral, throw the corporation into proceedings of bankruptcy, vote on removing managers and vote in the decision to reorganise (Whitehead, 2009, p. 27). The creditors do not require coordinating to take action against a delinquent corporation because the legal obligation of the corporation is to every debt holder. It will have the tendency to make debt renegotiation much more problematic; thus, the corporate governance may be more austere with diffuse debt holdings as compared to the concentrated debt. Obviously, the effective effort of corporate control with diffuse debt relies on the efficiency of the bankruptcy and legal systems.

The current evidence indicates that corporate policies change considerably after the financial covenant violations. The changes are attributed to augmented creditor influence over borrowing companies in ways that benefit both debtholders and shareholders (Sweeney, 1994, p. 290). The investment response to covenant violations differs systematically with numerous distinct ex-ante substitutes for the misalignment of information asymmetry and incentives amongst the lenders and borrowers (Nini et al., 2009, p. 409). Amongst the borrowers wherein agency and information glitches are comparatively more austere, the decrease in investment accompanying the covenant violations is statistically and economically considerably bigger than that found amongst the borrowers wherein the frictions are severe to a less extent. Indeed, amongst borrowers where information and agency hitches are rather mild, the decline in investment associated with the covenant violations is usually not distinct from zero.

The corporations with no earlier dealings with their existing lender; thus, a little reputational capital, experience a sharp decrease in capital expenditures comparative to their capital stock of about 1.7% following violating a covenant, contrary to the negligible alteration of approximately 0.2% happening amongst corporations violating a covenant with their long duration lenders. Likewise, the corporations with loans from a one lender experience a considerably larger decrease in investment of approximately 2.3% relative to corporations borrowing from a big lending syndicate of roughly 0.3%, constant with bigger lending syndicates lessening the moral hazard hitch existing in the borrowers (Chava & Roberts, 2008, p. 2108). Moreover, the companies with relatively bigger stockpiles of cash experience a bigger decrease in investment of about 2.2% in comparison to the companies with smaller cash holdings of roughly 0.25%, steady with the free cash flow glitch and the capability of creditors to mitigate the glitch.

The Debt Covenant Renegotiations and the Creditor Control Rights

The allocation of state contingent of the control rights plays an important role in mitigating distortions of investment emerging from financing frictions and shaping investment distribution (Denis & Jing Wang, 2014, p. 353). The control rights transfer empowers the creditors to interpose in management and influence the investment to guarantee a reasonable return on their investment after a lowly performance in corporations wherein agency and information hitches are somewhat severe.

A previous research on the accruals information has displayed that high accruals are linked to the declining in the forthcoming performance. The earnings consisting mainly of accounting accruals are less tenacious as compared earnings chiefly consisting of cash flows. The performances of companies with extreme accruals have the tendency to mean revert faster as compared to the companies having moderate levels of the accruals (DeFond & Jiambalvo, 1994, p. 146). The companies with high accruals have the possibility of experiencing lower earnings performance in the future. Besides, the high accruals have been associated with the efforts of the management to manipulate earnings to elude glitches, for example, debt covenant violations.

Some research studies show that the borrowers have the incentive and the capability to move wealth from lenders to the shareholders of the company. To facilitate lending, the borrower, and the lender write covenants into the debt contract that limit the borrower's actions and establish monitoring to make sure that the debt contract' terms are being met. The debt covenants are utilised by the commercial lenders as early cautionary systems to signal the imminent financial hitches amongst the borrowers (DeFond & Jiambalvo, 1994, p. 163). The violation of a covenant makes the lenders have an alternative to require instant loan repayment. The lender waives the violation and reorganizes the covenant underneath the present level most of the time; nonetheless, after reassessing the situation of the borrower (Vashishtha, 2014, p. 185). There is no additional problem when the performance of the borrower enhances. When the performance of the borrower continues to decline, the covenant is once more violated, and the lender all over again has the chance to assess the performance of the borrower.

The Role of Debt in Interactive Corporate Governance

The majority of literature on corporate governance reposes on a premise that the interests of numerous stakeholder groups conflict, and that the loyalty of the managerial is more probable to be captured by shareholders in comparison any other population. Nevertheless, the stakeholder interests do meet in the controlling managerial slack objective, and non-equity constituents have a considerable effect on company decisions (Triantis & Ronald, 1995, p. 1079). Even though the study of governance has taken initial phases to abandon its preoccupation with equity centered solutions and pinpoint interdependencies existing amongst an extensive array of stakeholders, the governance specialists have missed a significant interactivity component. A stakeholder may react to the actions of others; thus, it adds to the shared interest in the slack control.

The current empirical corporate finance literature displays an important transformation in borrowing companies’ investment, payout and financial policies after the violation of the financial covenants in the agreements of private debt. Once the financial covenants are violated except through payment defaults, the creditors obtain the privilege to accelerate any principal outstanding and withhold additional credit (Chava & Roberts, 2008, p. 2119). Even though creditors nearly constantly waive the violation, the threat linked to the privileges empowers the creditors to exert noteworthy effect over the company (Tan, 2013, p. 17). The violations are followed by reduced investment spending, decreased net debt issuance, lower shareholder payouts, and lower leverage. The results are attributed to augmented creditor impact on the borrowing company in techniques that would benefit both the shareholders and debt holders (Nini et al., 2012, p. 1758). The change in control rights to creditors has a constructive knock-on impact that benefits the shareholders even as the creditors move to safeguard their personal claims.

The Credit Market and Corporate Financing

The trade creditors should minimise their exposure through extending less credit and strengthen their claims through directly revising the terms of the credit contract to isolate themselves from the customers’ potential delay in repayment (Whitehead, 2009, p. 15). The trade creditors are amongst the most significant creditors of a company; thus, their welfare would have vital value implications for the borrower of credit. Averagely, the trade credit accounts for a noteworthy percentage of company external financing and is debatably an alternative for bank credit. Furthermore, trade credit provides working capital financing, liquidity insurance, and savings in transaction costs for the purchasers. The senior creditors' control rights through the debt covenant violations, levy substantial costs on junior creditors. The main reason is that the control rights empower senior creditors to take hold of cash flows ahead of junior creditors more suitably, for instance, through loan acceleration and liquidating the borrower in the extreme.

Companies frequently have manifold classes of lenders with changing seniority. While in general the interests of these different lenders are aligned and delegating monitoring to a certain class of lenders can be cost effective, there are cases, for example, bankruptcy where conflicts of interest amongst senior and junior lenders arise. The junior creditors are frequently sacrificed when senior creditors with control rights pursue their own interest and make suboptimal liquidation decisions. For instance, senior creditors particularly the banks can offer debtor-in-possession financing through which they gain power against the junior creditors to safeguard their loans.

The Breach of Debt Covenants

The debt covenants ameliorate a common agency glitch. The equity holders who appoint the management may benefit through making the company business more risky to the disadvantage of its creditors (Garleanu and Zwiebel, 2009, p. 752). The debt covenant breach normally permits creditors to demand an instant refund even though it rarely occurs in practice. The debtor may not frequently be in a position to make an instantaneous refund of the debt. Thus, the breach of debt covenants usually results in a renegotiation of the debt terms (Guay, 2008, p. 175). There is the likelihood of the debt to be renegotiated on poorer terms as a tradeoff for failure to demand a quick refund (Black et al., 2004, p. 383).

To avert the companies from meeting the requirements through adjusting their accounting practices instead of through genuinely upholding the financial health required level, the debt covenants not merely stipulate the numbers that need to be met; nonetheless, it shows how they need to be computed for the debt covenant purposes (Nikolaev, 2010, p. 60). It implies that when a corporation breaches or has the possibility of breaching its debt covenants, the corporation is not financially strong, and the hitches are expected to become worse as the lenders of the debt react to the situation.

The sustained positive association among debt covenants and the debt cost implies that the debt covenants need to be priced in the marketplace (Bradley & Roberts, 2004, p. 17). The percentage of companies that are subject to the debt covenants augments as the level of debt level, and the borrowing costs increase provided the debt is on a secured basis.

Summary

In summary, the debt covenants are extensively utilised in the corporate debt issues mainly as a means to protect the lenders’ interests. The debt covenants form the basis for the monitoring and control association amongst the borrowers and the creditors. A debt covenant that is properly structured has the ability to mitigate agency glitches amongst the bondholders and the stockholders and between the equity holders and the debt holders; therefore, it lowers the borrowing costs of a company. Nevertheless, the debt covenants that are too restrictive may sternly restrain the financial and operating undertakings of the borrowing company. The theory of standard agency delineates the problem of corporate governance in terms of how debt-holders and equity holders influence the managers to operate in the best interests of the capital providers. The capital investment decreases sharply after a financial covenant violation when creditors utilise the threat of hastening the loan to intervene in the management of the company.