Design and Renegotiation of Debt Covenants

Nicolae Garleanu and Jeffrey Zwiebel

The Review of Financial Studies, 2009, vol. 22, issue 2, 749-781

Abstract: We analyze the design and renegotiation of covenants in debt contracts as a specific example of the contractual assignment of property rights under asymmetric information. Specifically, we consider a setting where managers are better informed than lenders regarding potential transfers from debt to equity associated with future investments. This simple adverse-selection problem leads to the allocation of greater ex ante decision rights to the creditor (the uninformed party), i.e., tighter covenants, than would follow under symmetric information. This corresponds well to empirical evidence indicating that covenants are very tight upon inception and are frequently waived (and never tightened) upon renegotiation. The Author 2008. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org., Oxford University Press.

Date: 2009
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