Roberts and Sufi (2009) Here the concern is financial policies. To what extent do incentive conflicts and creditor rights influence financial policies? How do incentive conflicts and creditor rights influence financial policies? As in the last paper the focus is on violations. Violations are frequent but rarely lead to payment default or bankruptcy. They are thus a potentially important concern for firms outside of distress. The focus here is ex post, my interest would be ex ante. Violation allows the debt to be accelerated. More commonly lenders reduce the size of the credit facility, increase the interest rate (spread) and require additional collateral. Think of a standard bargaining game with outside options.

Roberts/Sufi Summary Statistics 90% of credit agreements contain restrictions on the borrowers total debt (level or interest payments) Over ¼ of firms experience a violation For firms with an average leverage ratio of at least 5% the percent of violators reaches 30% Violations cluster, a firm is 20 percentage points more likely to violate a covenant if it has done so in the previous year Small firms significantly more likely to violate than large firms 1 yr probability of violating a covenant negatively related to credit rating Except for firms rated CCC or worse, probability of violating a covenant significantly larger than probability of defaulting on a payment

Roberts/Sufi Drop is large Q0 to Q2 represents an annualized decline of net flow of debt equal to 2.5% of assets. Also persistent 2 yrs later it is still low. This is actual flow of credit and does not include the reductions of lines of credit that may be even larger that that pictured.

Roberts/Sufi No statistically significant change only suggestive.

Roberts/Sufi By Q5 statistically significantly lower than Q0 – by Q8 significantly lower than Q-1 From Q1 to Q8 is a 5% drop in leverage which is a large decline relative to typical with-in firm variation in leverage.

Roberts/Sufi Empirical Strategy Primary empirical concern is that firm changes around violation would imply the policy change in the absence of the violation Goal is to show that managers would not have altered the financial policies in the same way without the violation Focus only on discontinuous changes in financial policy occurring at the covenant threshold The estimated impact of the indicator for violation is then identified as long a managerial preferences are not discontinuous exactly at the covenant threshold In negotiations with creditors these thresholds are a contentious issue. Further more covenants imply lower interest rate so lender is not likely to be lowering the interest rate just to set thresholds where managers would want them set anyway.

Roberts/Sufi Net Debt Issuance Regressions After controlling for usual suspects in capital structure, initial covenant violations associated with a significant drop in debt issuance – 50+ basis points relative to lagged assets Estimating using first differences provides similar results “Subsequent” violations do not lead to significant changes in policy Reductions in net debt issuance is larger for firms with higher leverage Firms with higher market-to-book ratios (growth opportunities or equity valuation) see less of a reduction Firms with rated debt see a much much smaller reduction in debt issuance Points to fact that the lender’s bargaining power helps determine the extent to which financial policy is affected In negotiations with creditors these thresholds are a contentious issue. Further more covenants imply lower interest rate so lender is not likely to be lowering the interest rate just to set thresholds where managers would want them set anyway.

Roberts/Sufi Long run effects Economic magnitudes Net debt issuance drops sharply and remains significantly lower for two years after violation Economic magnitudes Estimated effects moves a firm from the 65th percentile to the 40th percentile of the with-in firm distribution of debt issuance Short run impact of violation has larger effect that two standard deviation change in common explanatory variables for leverage In negotiations with creditors these thresholds are a contentious issue. Further more covenants imply lower interest rate so lender is not likely to be lowering the interest rate just to set thresholds where managers would want them set anyway.