The market response to implied debt covenant violations

Derrald Stice

Journal of Business Finance & Accounting, 2018, vol. 45, issue 9-10, 1195-1223

Abstract: Previous research documents a negative stock price reaction to the announcement of a debt covenant violation (DCV). However, managers of firms that violate a covenant often obtain waivers and renegotiate debt contracts with lenders before the SEC requires them to disclose a violation. Firms therefore may not report some covenant violations, and prior research has not documented their cost to shareholders. Exploiting the fact that over half of all private debt contracts contain a debt covenant reliant on some variation of accounting earnings, I construct a sample of firms with debt contracts that contain at least one earnings‐based covenant. Combining earnings‐based‐covenant contract values from debt agreements with information publicly available at the earnings announcement date, I predict firms in violation of a debt covenant and provide evidence that equity investors react negatively to these implied violations, regardless of whether managers ever disclose that a violation occurred. In additional tests, I find no evidence of a negative stock price reaction to a firm disclosure of a DCV that market participants could infer from previously reported earnings, but I demonstrate that equity investors do react to the disclosure of a violation of a balance‐sheet covenant that would not have been inferable. This study complements previous research on DCVs by documenting the costliness to shareholders of violations subsequently resolved with lenders but not disclosed.

Date: 2018
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