Debt Contract Terms and Creditor Control

Abstract

The law and finance literature characterizes debt covenants as a means to manage agency conflicts between creditors and shareholders. While both banks and bondholders make use of these covenants, they do so in quite different ways. Banks typically monitor their debtors closely and rely on financial maintenance covenants to protect their interests. When these covenants get triggered, banks can use the leverage of accelerating the loan to achieve their governance goals. This ability to monitor and renegotiate suggests that tailoring precise ex ante contract restrictions is not of paramount importance because a bank and a debtor can negotiate around those restrictions based on ex post contract conditions. Bondholders, in contrast, face substantial barriers to monitoring and renegotiating with their debtors because these bondholders tend to be large groups of passive investors who face substantial collective action problems. As a consequence, ex ante restrictive terms in the contract are likely to be the primary means through which bondholders can address potential conflicts with shareholders. These differences in contracting technologies suggest that the restrictions in bond contracts are more likely to respond to changes in background legal rules. This paper tests this theory by treating two Delaware decisions that limited the default duties that the directors of Delaware corporations owe to creditors as a shock to the contracting conditions for Delaware firms. Difference-in-difference and triple difference tests suggest that restrictive terms in bond contracts for Delaware firms increased in reaction to this change, while there was not a detectable shift in the strictness of loan agreements.