Bondholder-Stockholder Conflict: Contractual Covenants vs. Court-Mediated Ex-Post Settling-Up

P V Viswanath and Wayne Eastman

Review of Quantitative Finance and Accounting, 2003, vol. 21, issue 2, 157-77

Abstract: Bondholders have failed to respond to corporate restructurings by demanding more protective provisions; in fact, the trend has been toward fewer rather than more restrictive covenants. In this article, we model the use of contractual covenants as a trade-off between contract implementation costs and deadweight efficiency losses. We find that the current lack of restrictive covenants is arguably consistent with rational investor behavior. The key to this conclusion is the recognition that there is an implicit ex-post settlement component to debt contracts, which is enforced by the courts. A look at the behavior of the courts and of bondholders supports our point of view. Copyright 2003 by Kluwer Academic Publishers

Date: 2003
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