The Market Response to Implied Debt Covenant Violations

Previous research documents a negative stock price reaction to the announcement of debt covenant violations. However, not all covenant violations are disclosed because firms are able to obtain covenant violation waivers and renegotiate debt contracts with their lenders before being required to disclose a violation in the financial statements. Exploiting the fact that over half of all private debt contracts contain a debt covenant based on some variation of accounting earnings, I construct a sample of firms with debt contracts that contain at least one earnings-based covenant. Combining earnings-based-covenant contract values with information publicly available, I construct a measure of implied debt covenant violation and find evidence that investors are able to price the likelihood of an earnings-based debt covenant violation on the earnings announcement date. Furthermore, I find no evidence of a negative stock price reaction to the disclosure of a debt covenant violation when there was a high likelihood of such a violation implied by previously-reported earnings. These results suggest that the total cost of debt covenant violations in the cross-section is higher than estimated in the previous literature