Analysis of the Role and Theoretical Rationale for the Introduction of Covenants in Debt Contracting - Literature review Example

Analysis of the Role and Theoretical Rationale for the Introduction of Covenants in Debt Contracting as it is related to Corporate Governance Issues

Mitigation of Opportunist Managers

Introduction of covenants in debt contracting have been found to be very fundamental in in solving the problems associated with the creditors and the recognized in the agency theory. Accounting research in relation to financial contracting is mainly concerned with the transactions between financiers and the individuals that require those finances. For instance, if a business owner has a project with a positive NPV but his main challenge is the getting the funds to invest in the project, then how can accounting information be used to determine the creditworthiness of such an entrepreneur. Accounting information can be very challenging as well as affecting the designs of financial claims. Accounting information has a lot of relevance in debt contracting.

The concept of asset substitution, which implies that the manager of an organisation on behalf of the shareholder has the power to increase the riskiness of the organization, the power of claim dilution, as well as the power to not consider a viable and profitable investment opportunity (debt-overhang). All this can lead to agency conflict, since the shareholders might blame the manager. In this regard, borrowers have reasons for entering into contracts that limit such behaviours since creditors logically anticipate as well protect prices against any opportunism, which may lead the borrower to bear the cost. Therefore introduction of covenants in such a contract will prompt usage of accounting information that will provide incentives against any opportunistic actions, hence the interest of the creditors will be protected. This is very much achievable as a result of the introduced covenants in debt contracts. Consequently, the introduced covenant in the debt will also ensure that an opportunist management doesn’t take advantage of an opportunistic situation. Therefore, the corporate governance of the organisation is enhanced through introduction of covenants in debt contracting.

Reduction of Agency Cost

Reduction of agency coat is also a very important aspect in corporate governance. The aim of the accounting information in the contracting is mainly to enhance bonding and monitoring activities in the organisation, which is a corporate governance feature. Therefore accounting-centred covenants mitigates activities that are not functional, hence reducing the agency cost that is linked with usage of debt (Li, Tuna and Vasvari, 2012). There is no doubt that debt covenant plays an important role in the functioning of the debt markets in relation to controlling and reducing the agency costs, thus a key tool and mechanism for market-based corporate governance. Majority of private organisations in recent times are opting for private debt markets, which implies that the concept of covenant based corporate governance is vastly embraced.

Zimmerman (1986) is a researcher can explain this phenomenon perfectly, he asserts that “the contacting role of accounting allows accounting procedures to have a cash flow and an evaluation effect.” This implies that the effect of the contact on the cost of agency differs in relation to procedures used to compute the accounting numbers as stipulated in the covenants contracts, which makes the cash flow of the organisation to vary according to the accounting procedures. In a nutshell, this theoretical perspective indicate that there is a close link between the accounting and firm value developed as expressed by Watt and Zimmerman (1978). The fact that it has been empirically proven that the accounting information can be used to enhance incentives and limit occurrence of an opportunistic behaviour, which explains why the contracting should make use of the accounting numbers. It is therefore very imperative for an organisation’s corporate governance to embrace the function of corporate debt markets to ensure inter alia.

Limit the Concept of Incomplete Contract Theory

The incomplete contract theory is also another reason for introduction of debt contracting as well enhance an effective and efficient corporate governance. The theoretical rationale for this can be explained using the assertions of Coase (1937). Coase asserted that it is costly to depend on market transaction that harmonise economic activities by means of writing as well as negotiating expansively long-term contracts. The only way that long-term contracts can only realistically specify the limits of what the involved party are supposed to do in the future, which implies that the future course of action can only be executed at a later date. Therefore a demand for authority is occurs with the corporate governance of the organisation. This is an important aspect since the authority of corporate governance is enhanced. This theory was also reinforced from an opportunistic behaviour perspective that is from contractual incompleteness (Klein, Crawford, and Alchian, 1978; Williamson, 1979). Authority can also be enhanced through trade-offs, a concept that reinforced these theory (Grossman and Hart; Hart and Moore, 1990).

When it is difficult to write and enforce “complete contracts,” there are various economic benefits that arises as a result of assigning “decision rights.” The main assumption of this phenomenon is the fact that the authority (corporate governors) have the opportunity to renegotiate the contracts especially if there some aspects that are left out. This makes the contingencies of the contracts in future to mitigated, a concept that minimises any liability that may accrue corporate governance. The initial contract’s uncertainties’ may include the fact that it is difficult to foresee the any contingencies in the initial contract. The corporate governance avoids the risk of being if in future the contract becomes a liability to the organisation, the authorities have the responsibility to assess and renegotiate the contract.

Efficiency Rationale

One of the major theoretical rationale for the introduction of covenants in debt contracting is based on the fact role of efficient accounting information for purposes of achieving an optimal security design in debt contracting. Covenants become play a huge role in this case as corporate governance and performance of a firm is constrained by wealth issues, especially when seeking financing from investors as the motivation of both the firm and the investor are always at a conflict (Li et al., 2015). While the investor focuses primarily on the future cash flows, the firm derives its benefits from the monetary and non-monetary benefits including the firm’s reputation, and utility of management. In this case, covenants play a huge role in resolving the conflicts by introducing an optimal financial contract where the investor acquires more control rights in case the firm defaults on the payment (Chava, and Michael, 2008).

Covenants help solve the conflicts between firms and investors by allowing firms to allocate control rights to the investors only the extent of certain situation, such as in the event of poor financial performance. In this content, the best indicators of the firm’s accounting performance are used as the basis for the formulation of debt contracts with covenants. According to Aghion and Bolton (1992), the introduction of covenants in debt contracting acts as optimal contracts that is aimed at implementing state-contingent control allocation. When covenants are written on the accounting performance of a firm, it allows for the firm to gain rights over areas of its operation where it has optimal performance. Since such areas are the most productive financially, covenants serve to improve the corporate governance of the firm by maximizing the value of the firm as a consequence of maximizing the value of equity. On the other hand, in situations where the company is experiencing a state of low financial performance, the use of debt contracts with covenants allows the for control rights to shift to the investor, thereby balancing the rights and allowing each party to protect their interests. It is therefore prudent to conclude that the introduction of covenants in debt contracting in the context of corporate governance can serve as an optimal security design with signals like profitability. It is also worth noting that the use of sufficient accounting information in covenants used in debt contracting is crucial in corporate governance, especially in the protection of the investor’s interests (Chava, and Michael, 2008).

Covenants and Corporate Governance Issues under the Agency Perspective

Since the covenants are designed to ensure that the firms pay the amount owed to the lenders or the investors, they may be compromised by a debt contract that incentivizes the lender to take action against the firm through highly penal measures that were designed at the time of initiation. In this case, the rationale for the introduction of accounting-based covenants is based on the need to restrict such opportunistic actions by developing incentives to counter them. Some of the notable actions that covenants have been observed to effect in corporate governance include regulation of excessive capital expenditure, issuance of additional debt and payment of dividends. These covenants limit the extent to which the actions in debt contracts are restricted by relying on accounting information of a firm as a major indicator. It is also worth noting that such cases can also see covenants having motivating incentive effects on firms. For instance, in situations where the net worth in a requirement in the debt contracts, it can motivate the managers to pursue the maximization of the firm’s profits, which are in line with the theory of the firm and maximization of the shareholders’ value (Sweeney, 1994).

According to Hart, (2001), the role of the covenants can be explored by employing the agency theory where the relationship between the principal and the agent need to be manipulated to accommodate the issues of equity and debt. Nini et al., (2012) provides a rationale for the use of debt with covenants with an aim of enhancing the value of the firm and improving the relationship between the firm and the lender. Research shows that the main focus of covenants in debt contracts is on firms as it is aimed at protecting them from opportunistic lenders. The rationale for this view is based on the research by Hauswald and Marquez, (2003, 2006) which indicates that when debtors are left to control the operations of the firm, they have a greater tendency to operate at their self-interest in order to ensure that they maximize the value of their stake in the firm as opposed to maximization of shareholder’s value.

Under the agency perspective, the role of debt contracts with covenants serves to improve the efficiency of corporate governance by restricting actions that may limit the value maximization goal of a firm (Whitehead, 2009). For instance, a covenant may require that a firm maintain a specific level of interest coverage ratio so as to limit the manager from exhibiting an opportunistic attitude in his activities, thereby hurting the financial position of the creditor. It is prudent to note that, while the requirement on the interest coverage ratio may restrict the manager’s capacity to taking on excessive debt, creditors can use other means that have an enhanced capacity of directly restricting the debt levels so that they do not exceed a given threshold. Moreover, such restrictions may be used as an option in situations where the certain threshold are surpassed by accounting ratios.

The incomplete contracting perspective also provide important insights into the process of resolution of corporate governance issues. This perspective explains the application of financial covenants in debt contracts using a rather intuitive approach. This perspective posits that the allocation of control rights is influenced by the financial covenant throughout the entire contractual relationship, hence ensuring that the decision making process flows seamlessly (Tan, 2013). For instance, in the case of the application of interest coverage ratio as a covenant in the debt contract, the firm has the power of control to the extent to which the threshold specified in the contract is upheld or exceeded. However, when the covenant threshold is breached, the control rights shift from the firm to the creditor (Nini et la., 2009). In the case of a breach or violation of the threshold of the covenant, the future of the firm-creditor relationship would thus be determined by a re-negotiation process (Denis and Jing, 2014).