Covenant Violations and Dynamic Loan Contracting

Covenants are repeatedly violated in private debt contracts by the same borrower. We use covenant violations to test predictions from the incomplete contracting literature and provide supporting evidence that lenders act as “tough principals” to address borrower moral hazard in subsequent new loans increasing loan spreads and implementing a tougher covenant structure. Alternative hypotheses related to (i) credit risk, (ii) disciplining of managers, (iii) bad luck, (iv) hold-up or (v) corporate governance cannot explain our findings. Our results suggest that covenants are important to address informational and agency problems between lenders and firms in dynamic loan contracting.