Abstract:

In the governance literature, the agency conflicts between shareholders and debtholders have been  extensively discussed. In  order  to  reduce  agency  problems,  i.e.  underinvestment  and asset substitution, as well as information asymmetry, prior research has focused on efficient debt contracting. This is the alignment of interests between shareholders and debtholders as well  as  the  allocation  of  control  rights  through  the  use  of  contractual  terms, especially covenants and performance pricing.
 
Covenants  attach  the  underlying  debt  to  contractual  terms  requiring  the  borrower  to  take specific actions, refrain from specific actions, or comply with financial ratios. Prior literature has focused on the latter type of covenant, as does this research. In case of covenant violation, the  lender  has  the  right  to  renegotiate  the  debt  contract  and  therefore take  control  in  the borrowing company in order to manage the credit risk. In addition to the allocation of control rights ex post, the covenant signalling-hypothesis suggests that the financial covenant design conveys  information  about  the borrower´s  characteristics,  leading  to  a  reduction  of  the information asymmetry between the borrower and the lender.