Strategic Disclosure and Debt Covenant Violation

53 Pages Posted: 8 Dec 2017 Last revised: 3 Dec 2020

See all articles by Thomas Bourveau

Thomas Bourveau

Columbia Business School - Accounting, Business Law & Taxation

Derrald Stice

University of Hong Kong - HKU Business School

Rencheng Wang

Singapore Management University - School of Accountancy

Date Written: November 30, 2020

Abstract

This study examines how managers change their forecasting behavior as a debt covenant violation (DCV) approaches. We posit that managers strategically use earnings forecasts in order to delay the costs associated with DCVs. Consistent with this, we find that management forecasts are more optimistic in the quarter before a DCV, and this result is stronger when firms have a higher risk of losing control rights in the event of a DCV. Furthermore, we find that managers combine their forecast optimism with actions that are favorable to shareholders but would likely be curtailed by lenders after the DCV. Specifically, we find that managers who are more optimistic in their forecasts also increase R&D, take on more risk, and increase dividend payouts before violations, actions which would be opposed once control rights shift to debtholders after a DCV. Lastly, we find managers who are more optimistic in their forecasts are less likely to be replaced (i.e., lower CEO turnover) after a DCV. Overall, our results are consistent with managers changing their disclosure behavior in an attempt to reduce lenders' awareness of an impending DCV, and thus, buy themselves time to take actions favorable to equity investors. These actions, though likely opposed by debtholders ex ante, improve, on average, firms' prospects, which in turn improves managers' job security following a DCV.

Keywords: Debt Covenant Violation, Strategic Disclosure, Risk-Shifting

Suggested Citation

Bourveau, Thomas and Stice, Derrald and Wang, Rencheng, Strategic Disclosure and Debt Covenant Violation (November 30, 2020). Singapore Management University School of Accountancy Research Paper No. 2019-95, Available at SSRN: https://ssrn.com/abstract=3082058 or http://dx.doi.org/10.2139/ssrn.3082058

Thomas Bourveau

Columbia Business School - Accounting, Business Law & Taxation ( email )

3022 Broadway
New York, NY 10027
United States

Derrald Stice (Contact Author)

University of Hong Kong - HKU Business School ( email )

Hong Kong, HK
China

Rencheng Wang

Singapore Management University - School of Accountancy ( email )

60 Stamford Road
Singapore 178900
Singapore

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