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ABSTRACT

Building on contract theory, we argue that financial covenants control the conflicts of interest between lenders and borrowers via two different mechanisms. Capital covenants control agency problems by aligning debt holder–shareholder interests. Performance covenants serve as trip wires that limit agency problems via the transfer of control to lenders in states where the value of their claim is at risk. Companies trade off these mechanisms. Capital covenants impose costly restrictions on the capital structure, while performance covenants require contractible accounting information to be available. Consistent with these arguments, we find that the use of performance covenants relative to capital covenants is positively associated with (1) the financial constraints of the borrower, (2) the extent to which accounting information portrays credit risk, (3) the likelihood of contract renegotiation, and (4) the presence of contractual restrictions on managerial actions. Our findings suggest that accounting-based covenants can improve contracting efficiency in two different ways.