Abstract
This chapter discusses aspects of the role of debt contracts and covenants in corporate governance. It reviews evidence on types and incidence of debt covenants in both public and private debt and discusses evidence on contemporary developments in debt contracting practice and newly emerging debt covenants, placing debt covenant practice in historical context, and stressing the evolutionary nature of covenants. We observe patterns in empirical evidence on covenant types and usage, noting that covenants lose and gain popularity or relevance, with some new covenants appearing. Traditional explanations of choice in debt contracting associated with agency costs and contracting costs provide only partial explanations of change and we explain covenant evolution using the literature on financial innovation. Influences on covenant evolution include changing law and regulation, new opportunities to manage risk, exogenous shocks and crises, the influence of cyclical and structural economic factors, and advances in theory. We conclude that it is important to extend existing research on innovation in debt contracting and covenants to include studies of the development of specific covenants, agents of change and costs and benefits of innovation. Such research will help ensure modelling of debt covenants in empirical research in accounting and finance is sensitive to institutional realities.
This chapter includes the paper originally titled “Debt Contracting costs, corporate governance and accounting choice: reflections on the Positive Accounting Theory model” and discussed at the First International Workshop on Accounting and Regulation in 1998.
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- 1.
Covenants are agreements between two or more legal personalities, entered into in writing and under seal, whereby either party stipulates the truth of certain facts, or promises to perform or give something to the other, or to abstain from the performance of certain things.
- 2.
In this chapter although we focus on the evolution of one aspect of debt contracting practice, namely changes in types and incidence of accounting-based covenants, this is not to say that other aspects of debt contracting relevant to corporate governance do not also evolve. Analysis of the nature and implications of inter-temporal change in lenders’ and borrowers’ responses to covenant violation, lenders’ monitoring practices, measurement practices and other aspects of debt contracting must await further research.
- 3.
In its legal sense “boilerplate” refers to standard and often predetermined contract provisions.
- 4.
The outline structure of standard form debt contracts is discussed in Day and Taylor (1998) pp 174–175.
- 5.
Two further companies, whilst not having actual cash flow covenants, had covenants in contracts applicable to US loans which were similar to cash flow covenants. In addition, two companies had contracts which required the provision of cash flow forecasts and two others had contracts which identified cash flow shortfalls as events of default.
- 6.
As reported in Accountancy Age (2010), a US corporation included the following in a debt contract: “Audited consolidated balance sheets of the group members … [must be] reported on by and accompanied by an unqualified report from a Big Four accounting firm”.
- 7.
See also Wojnilower (1980) on the role of credit crunches in financial history which emphasises that new financial products are designed to sustain financing flexibility for the firm.
- 8.
Miller (1986) also provides an interesting and rare example of a case study of the origin and development of a financial innovation, in this case financial futures. His history includes identification of the inventor and main actors in the innovation and the stimulus to it, floating exchange rates, which he describes as the “sand in the oyster”.
- 9.
Merton cites Bernstein (1992) for a detailed description of the interaction between theory and practice in generating major innovations. Many areas of knowledge have periods of vibrant theoretical development but theoretical advances do not necessarily convert to practice as effectively and swiftly as in finance, leaving the question of how innovation takes place open. Perhaps vibrant theory is best viewed as a necessary but not sufficient condition for innovation.
- 10.
Heffernan et al. also observed regional and sectoral variations; stock broking, fund management and related activities being most innovative.
- 11.
A well-known case of the legal protection of financial proprietary knowledge is Stern Stewart. The intellectual property section of its website lists five proprietary measures and one other: Economic Value Added (EVA)®, Current Operations Value®, Future Growth Value®, Wealth Added Index™, and Relative Wealth Added™, and Market Value Added (see http://www.sternstewart.com/?content=intellectualprop). EVA® has been subjected to significant academic use and some academic analysis (see Mouritsen 1998; O’Hanlon and Peasnell 1988).
- 12.
Finnerty (1988) also provides an extensive listing of financial innovations to the date of his paper, together with an analysis of the influence of the factors driving each innovation; see also Finnerty (1992). Other analytical studies of drivers of particular financial innovations are Tufano (1995), which documents financial innovations in the nineteenth and early twentieth centuries and Mason et al. (1995). For case studies of particular innovations see Brown and Smith (1988), Briys and Crouhy (1988), and McConnell and Schwartz (1992), who provide a case study of the origin of the liquid yield option note.
- 13.
Other institutional factors explain international differences in the incidence of dividend covenants, for example the risk of lenders who restrict borrowers’ dividend policy being deemed in UK law “shadow directors” under Section 251 of the 2006 Companies Act and insolvency legislation; see Day and Taylor (1998) for a further discussion. In considering the two cases of dividend covenants identified in their sample Ramsay and Sidhu (1998) note the similarity of the private definitions and the legal restrictions of dividend payments under then Australian law.
- 14.
Dichev and Skinner (2002) identify a range of cash flow covenants, including debt to cash flow, as the most common in the specialist area of management buy-outs and buy-ins in the US.
- 15.
We may add to these two influences the role of influential individuals as the focus of innovation. Although not directly concerned with financial innovation Ramirez (1995) and others discuss the influential individual in finance.
- 16.
Other innovations included preferred stocks and deferred coupon debt instruments.
- 17.
Tufano reports evidence of earnings manipulation by management to avoid the terms of such covenants through opportunistic redefinition of “capital improvements” as “maintenance expenses” [Tufano’s italics], the latter allowing a reduction in earnings and hence interest expense. He also quotes Stetson (1917), a contemporary legal authority on corporate finance on the difficulties of earnings definition and hence legal enforcement of covenant terms in income contingent debt securities by borrowers.
- 18.
Examples are court permission for issue of receivers' certificates (short-term debt notes issued to provide liquidity to distressed firms which were secured against the firm’s assets irrespective of pre-existing collateralisations) and the reversal of established rules giving secured creditors priority over unsecured creditors.
- 19.
According to Jones (2011) both the Enron and WorldCom failures were clearly associated with failures of external audit (see p. 476).
- 20.
The FASB issued SFAS95, Statement of Cash Flows, in the US in November 1987, followed by the ASB’s FRS1, Cash Flow Statements, in the UK in September 1991, and the IASC’s revision of IAS7 in 1992.
- 21.
Anti-takeover provisions bring into sharp focus the corporate governance role of covenants in mediating relations between bondholders, managers, and shareholders (see Day and Sigfrid 2001).
- 22.
Their research shows that sovereign bond contracts with modification provisions requiring unanimous consent by bondholders became vulnerable to change with less than unanimous approval through the unexpected use of existing exit consents. After this shock, borrowers and investors did not initially react with a significant shift in contract terms. In time the value of allowing modification of payment terms with less than unanimous consent was accepted and substantial changes in contract terms followed, moving bond contracts even further away from unanimous action clauses toward collective action clauses.
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Day, J., Taylor, P. (2014). The Role of Debt Contracts and Debt Covenants in Corporate Governance: Reflections on Evolution and Innovation. In: Di Pietra, R., McLeay, S., Ronen, J. (eds) Accounting and Regulation. Springer, New York, NY. https://doi.org/10.1007/978-1-4614-8097-6_8
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