The Ex‐Ante Monitoring Role of Accounting Covenants in Public Debt |
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| Authors: | Zahn Bozanic |
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| Institution: | 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. |
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| 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. |
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| Keywords: | public debt bonds covenants consent solicitations monitoring renegotiation information environment quality financial reporting quality |
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