Debt covenant violations and risk shifting behavior

Umar Butt and Trevor William Chamberlain

International Journal of Managerial Finance, 2025, vol. 22, issue 1, 1-24

Abstract: PurposeThe study has three inter-related goals: first, to examine empirically the transfer of wealth from creditors to shareholders that occurs when firms default on debt covenants, second, to develop a framework for measuring the impact of overinvestment by firms in covenant default and, third, to provide an estimate of the cost to creditors of managerial risk-shifting.Design/methodology/approachThe paper examines the relationship between market volatility and investment of financially distressed firms in a real options framework. The debt is taken to be exogenously determined. Numerical methods are employed to assess the impact of volatility on investment.FindingsThe study finds that the risk-shifting motivations of shareholders offset the anticipated negative relationship between investment and volatility as firms violate covenants and become financially distressed.Research limitations/implicationsThe debt violation data in this study are extracted from filings by SEC registrants posted on the EDGAR website. The laws and regulations affecting firms in other jurisdictions may differ, possibly affecting the options open to firms in financial distress.Practical implicationsPrior research has found that covenant violations rarely lead to accelerated payment or bankruptcy. The present study suggests that monitoring should include investment scrutiny procedures to minimize risk-shifting behavior.Social implicationsThe results offer a cautionary tale for creditors about the negative value created by risk-shifting when firms are in financial distress. They indicate a need for close monitoring of a firm's investment decisions post-violation.Originality/valueThis study appears to be the first to provide evidence of changes in the relationship between investment and volatility as a firm violates debt covenants and become financially distressed.

Keywords: Risk shifting; Covenant violation; Financial distress; Investment (search for similar items in EconPapers)
Date: 2025
References: Add references at CitEc
Citations:

Downloads: (external link)
https://www.emerald.com/ijmf/article/22/1/1/131647 ... ns-and-risk-shifting (text/html)
https://www.emerald.com/ijmf/article-pdf/22/1/1/10765221/ijmf-04-2025-0165en.pdf (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:eme:ijmfpp:ijmf-04-2025-0165

DOI: 10.1108/IJMF-04-2025-0165

Access Statistics for this article

International Journal of Managerial Finance is currently edited by Dr Alfred Yawson

More articles in International Journal of Managerial Finance from Emerald Group Publishing Limited
Bibliographic data for series maintained by Emerald Support ().