The Ex‐Ante Monitoring Role of Accounting Covenants in Public Debt

• Author: Zahn Bozanic
• Date: 01 July 2016
• DOI: http://doi.org/10.1111/jbfa.12208
• Published date: 01 July 2016

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 43(7) & (8), 803–829, July/August 2016, 0306-686X

doi: 10.1111/jbfa.12208

The Ex-Ante Monitoring Role of

Accounting Covenants in Public Debt

ZAHN BOZANIC∗

Abstract: In contrast to what is known about accounting covenants in private debt, little

empirical evidence on the role of accounting covenants in public debt exists. Diffuse ownership,

arm’s length monitoring, and collective action problems are unique to the public debt setting

and raise the question of whether these covenants serve their intended role. As such, this study

investigates whether including covenants reliant upon accounting inputs influences borrowers’

actions to prevent adverse credit events. Accounting covenants in the public debt setting provide

firms with a disciplining mechanism to renegotiate ahead of costly technical default – a stark

contrast to the ex-post renegotiation ‘trip wire’ role covenants play in private debt. In particular,

the results show that including accounting covenants in public debt is associated with an

increased probability of ex-ante renegotiation, that is, negotiation through consent solicitations

ahead of covenant violation. This ex-ante renegotiation, in turn, is associated with decreased

adverse credit events. Cross-sectional results support these findings as the ex-ante renegotiation

role of accounting covenants varies with bondholders’ and trustees’ monitoring ability.

Keywords: public debt, bonds, covenants, consent solicitations, monitoring, renegotiation,

information environment quality, financial reporting quality

1. INTRODUCTION

Despite a growing literature on the role covenants play in private debt, the findings in

the private debt literature on covenants and renegotiation are not likely to generalize

to the public debt setting. In private debt, covenants are widespread, are set tightly,

and routinely serve as a trigger for renegotiating upon violation with a small class of

lenders informed with non-public information (Berlin and Mester, 1992; and Dichev

∗The author is at Fisher College of Business, The Ohio State University. The author would like to thank

Ane Tamayo (the editor), an anonymous referee, Anne Beatty, Sanjeev Bhojraj, Rob Bloomfield, Sam

Bonsall, Rich Frankel, Guojin Gong, Bob Libby, Valeri Nikolaev (discussant), Michael Roberts, Shyam V.

Sunder (discussant), Hal White, Helen Zhang, seminar participants at Carnegie Mellon University, Cornell

University, The Ohio State University,The Pennsylvania State University, Purdue University, The University

of Utah, and Washington University,conference participants and discussants at the 21st Annual Conference

on Financial Economics and Accounting, and the 2011 AAA Financial Accounting and Reporting Midyear

Meeting for valuable comments and discussions. As this paper is partially based upon the author’s

dissertation at Penn State, he would especially like to thank his committee – Paul Fischer, Karl Muller,

Orie Barron, Dan Givoly, and Marie Reilly – for their guidance and support. The author is also indebted to

Romano Peluso and Ronald Rose for their many discussions regarding bond indenture, bond trustee, and

bankruptcy law. (Paper received April 2014, revised revision accepted April 2016).

Address for correspondence: Zahn Bozanic, Department of Accounting and MIS, Fisher College of Business,

The Ohio State University, 2100 Neil Avenue, Columbus, OH 43210, USA

email: bozanic.1@fisher.osu.edu

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804 BOZANIC

and Skinner, 2002). In public debt, however, the option to renegotiate upon violation

is much more difficult, costly, and indicative of more dire financial conditions. First,

renegotiation of public debt is generally more difficult than private debt because

lenders must rely solely on publicly available information and must establish consensus

amongst a diffuse body of bondholders. Second, since public debt covenants are set

loosely in anticipation of coordination problems, upon covenant violation, firms are

likely too close to substantive default to allow for successful renegotiation ex-post.1As

a result, lenders may attempt to extract rents at minimum and/or hasten acceleration

in order to maximize recovery after covenant violation, which incentivizes borrowers

to ‘front run’ costly technical default through proactive renegotiation (Huberman

and Kahn, 1988; and Beneish and Press, 1993). Stated differently, previous literature

on private debt has generally shown that accounting covenants provide a trigger to

reassess the lending relationship upon violation. This paper argues that accounting

covenants in public debt serve as a renegotiation mechanism prior to violation.

In consideration of the differing institutional details outlined above, this paper ex-

amines the ex-ante monitoring role of accounting covenants in public debt.2Account-

ing covenants rely on more ‘contractible’ information inputs, that is, information that

is easier to observe and verify than other covenants (Sridhar and Magee, 1997; Douglas

2003; and Christensen and Nikolaev, 2011). Given this, and in light of the lax bond

indenture trustee monitoring specific to the public debt setting, the contractibility

of accounting covenants offers lenders an effective tool to detect covenant violation.

For example, because of its contracting specificity and observability, an accounting

covenant on net worth is easier to monitor for compliance than is a legal covenant on

transactions with affiliates. Hence, in the event of a possible breach of an accounting

covenant, firms may take action ahead of costly technical default in order to maintain

compliance and prevent a shift in control rights (Chava and Roberts, 2008; and Cohen

et al., 2012). The disciplining role played by accounting covenants may therefore have

a beneficial impact on firms’ credit risk. As such, the goal of this paper is to understand

whether accounting covenants help to facilitate the little-known ex-ante renegotiation

mechanism in public debt – the consent solicitation – in order to prevent adverse

credit events.3

The contractibility of accounting covenants makes them uniquely suited to reduce

the likelihood of adverse credit events in public debt by providing borrowers with a

disciplining mechanism to renegotiate ahead of costly technical default. As a result,

including accounting covenants helps borrowers minimize potential losses associated

with covenant violation; without such covenants, preventative actions are likely to

occur on a less timely basis as borrowers attempt to ride out a poor performance,

which may translate into a higher frequency of surprise substantive defaults. To test the

above conjectures, this paper investigates the relation between accounting covenants

and renegotiation where managerial preemption is expected to be the first-order

effect. Further, if accounting covenants serve a disciplining role that translates into an

1 Substantive default is default due to bankruptcy or non-payment of principal or interest. This is in contrast

to technical default, or default due to covenant violation.

2‘Ex-ante’ refers to the period between contract initiation and covenant violation. By contrast, private debt

renegotiation typically occurs only after a covenant has been violated or ‘ex-post’.

3 While Cohen et al. (2012) examine capital structure changes rather than consent solicitations, the

intuition is the same: ‘debt covenants impact leverage decisions not only upon violation of covenants, but

also ex-ante, due to the potential transfer of control rights’.

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