In syndicated loan contracts, a borrower’s failure to comply with a covenant restriction triggers a default, and as such the lender’s right to terminate the loan (or foreclose on assets which are serving as collateral). The likelihood that such a covenant violation would occur depends on the loan covenant strictness, which measures how stringent covenant restrictions are on the borrower. Rationales for creditors to demand strict covenants include the pricing of default risk and the allocation of bargaining power in more frequently triggered renegotiations.
In this paper, we propose a new determinant of covenant strictness: the degree of creditor friendliness in Chapter 11 bankruptcy practices. This new determinant dictates that the more debtor(creditor)-friendly the bankruptcy practice is, the more creditors will seek to increase (decrease) their level of loan monitoring outside of bankruptcy through an adjustment in covenant strictness. Borrowers would agree on stricter covenants in exchange for a lower loan spread, and vice-versa. We demonstrate that covenants are not only included in order to shift the governance from debtors to creditors once they are breached, but to also potentially address the concern creditors might have about how the bankruptcy law is practiced if the borrowing firm goes bankrupt. To illustrate our new determinant, we first provide a stylized model linking creditor control inside and outside of bankruptcy. This link emerges from the introduction of a legal component in the creditor’s demand function for loan covenants. Next, from the sample of all large US manufacturing firms that filed for Chapter 11 bankruptcy between 1990 and 2013, we collect the frequencies of occurrence of several bankruptcy provisions that we categorize as being creditor or debtor-friendly. We interpret these frequencies as bankruptcy practice proxies, and use them as instruments in order to isolate our legal channel. Our identification strategy relies on the result that judicial discretion is the primary driver of our bankruptcy practice proxies, which ensures that no link exists between the financial contracting process and the potential bankruptcy outcome. On a sample of US manufacturing syndicated loans that were negotiated between 1993 and 2012, we find that our legal determinant significantly impacts the strictness of the contracts, in addition to the spread charged on the borrower.
This paper finally relates to the recent recommendations of the US American Bankruptcy Institute (ABI) Commission to Study the Reform of Chapter 11, which has investigated the creditor friendliness of the corporate bankruptcy practice. Our results imply that any amendment to the Code that would limit the creditors’ rights during bankruptcy would have an impact on the pricing of syndicated debt through a modification of the covenant structure of loan contracts.
Garence Staraci is a PhD Student in Finance at the Yale School of Management.
Meradj Pouraghdam is a PhD Student at Institut d'Etudes Politiques de Paris (Sciences Po).