THE ECONOMICS OF THE PRIVATE MARKET
Asymmetric Information, Contracting, and the Theory of Covenants
Two imperfections of capital markets are at the heart of many of the contracting problems that shape debt markets. 76 First, the interests of bondholders and stockholders of borrowing firms are not always aligned; second, parties to financial contracts are not likely to be equally informed about the characteristics of the issuing firm. 77 The informational advantage borrowers have over lenders leads to two kinds of bondholder-stockholder conflict. First, once a debt contract is signed, borrowers have incentives to expropriate wealth from lenders (moral hazard). Second, before a contract is signed, potential borrowers have incentives to understate the risks they will pose for lenders, including moral hazard risks. A simple example of moral hazard risk is provided by Black (1976), who noted that ''there is no easier way for a company to escape the burden of a debt than to pay out all of its assets in the form of a dividend, and leave the creditors holding an empty shell'' (p. 7). In the absence of sufficiently powerful constraints or capacity for lender monitoring and enforcement capacity, such actions may be either unobservable by the firm's bondholders or beyond their control. Smith and Warner (1979) identify four major kinds of moral hazard that lenders must control:
If a firm issues bonds and the bonds are priced assuming the firm will maintain its dividend policy, the value of the bonds is reduced by raising the dividend rate and financing the increase by reducing investment. At the limit, if the firm sells all its assets and pays a liquidating dividend to the stockholders, the bondholders are left with worthless claims.
If the firm sells bonds, and the bonds are priced assuming that no additional debt will be issued, the value of the bondholders' claims is reduced by issuing additional debt of the same or higher priority.
If a firm sells bonds for the stated purpose of engaging in low variance projects and the bonds are valued at prices commensurate with that low risk, the value of the stockholders' equity rises and the value of the bondholders' claim is reduced by substituting projects which increase the firm's variance rate.
Myers (1977) suggests that a substantial portion of the value of the firm is composed of intangible assets in the form of future investment opportunities. A firm with outstanding bonds can have incentives to reject projects which have a positive net present value if the benefit from accepting the project accrues to the bondholders. 78
Covenants may alter the relationship between bondholders and stockholders in two fundamental ways. First, covenants affect the relationship when the borrowing firm is in financial distress by providing lenders with a mechanism for early intervention. This intervention may take one of several forms: forced bankruptcy, a renegotiated restrucEagleTraders.comg, or the imposition of additional constraints on firm behavior. This can be viewed as the role of covenants ex post, which is to permit these interventions after the consequences of the firm's actions have been revealed.
Second, and possibly more important, is the role of covenants ex ante. Debt contracts that include covenants can effectively constrain the ability of stockholders to engage in strategies designed to expropriate wealth from bondholders or otherwise to engage in actions that are detrimental to bondholders. Smith and Warner document that covenants of the kind observed in private placements and bank loan contracts can mitigate bondholder-stockholder conflicts. They also demonstrate that contracting is not a zero-sum game. Terms of contracts affect not only the distribution of wealth between the bondholders and the stockholders but also the total value of the firm. Covenants can increase a firm's value (relative to value under a contract without covenants) by providing disincentives to, or restrictions on, exploitive stockholder behavior. For example, asset substitution incentives may be so powerful that under a contract without constraints stockholders are willing to substitute an asset with a lower expected return so long as it has a sufficiently higher risk than the existing asset. Such a substitution increases stockholder wealth even though it decreases the firm's total value because the bondholders lose more than the stockholders gain. Rational bondholders, however, anticipate that some of their claim will be expropriated through asset substitution and price their bonds accordingly (that is, they demand a higher rate). Thus, in the absence of constraints on asset substitution, equilibriums involving debt financings have two features: First, firms will take more risks than in the presence of constraints (the incentive to substitute assets does not disappear just because the bondholders' anticipation of asset substitution is reflected in the interest rate). 79 Second, a firm's stockholders will absorb the loss in the firm's value that results from the asset substitution. Consequently, any covenant that restricts asset substitution (for example, a requirement to stay in the same business, a restriction on asset sales, or restrictions on investments, mergers, and acquisitions) can increase firm value. Because ultimately the stockholders gain from such restrictions in equilibrium, they will agree to covenants in debt contracts.
The theory of covenants and renegotiation emphasizes that covenants must be based on mutually observable and verifiable characteristics, actions, or events (see, for example, Berlin and Mester, 1992, and Huberman and Kahn, 1988). Covenants cannot, for example, be written on characteristics, actions, or events that are observable only by the stockholders and not by the bondholders. Covenants also need to be observable and verifiable by third parties, such as a court of law. 80 Characteristics, actions, or events that are observable but not verifiable cannot be included in covenants; however, they may still significantly affect an optimal debt contract. For example, a bank can refuse to renew a one-year loan on the basis of a mutually observable but nonverifiable characteristic but would have difficulty legally declaring a two-year loan in default at the end of the first year because of a violation of a covenant written on that same characteristic. This example suggests that, in many cases, a short-term loan without a covenant may dominate a longer-term loan with a covenant (see Berlin, 1991, and Hart and Moore, 1989).
Although covenants can be written only on observable and verifiable characteristics, they may be related to nonverifiable and even unobservable characteristics. This relation greatly increases the power of covenants for mitigating bondholder-stockholder conflicts. A relation between observables and unobservables may exist for two reasons. First, observable, verifiable actions or events may be correlated with nonverifiable or unobservable actions or events. For example, the true risk of a firm, that is, the volatility of its returns, may not be observable. However, its current ratio may be correlated with this volatility and, therefore, serve as a proxy for risk. Second, an observable characteristic, action, or event may be related to an unobservable characteristic, action, or event through either self-selection or incentive effects. For example, a firm's ability to take unobservable risks may be much greater in industry A than in industry B. Consequently, a covenant that restricts a firm to industry B limits the ability of a firm to alter its (unobservable) risk profile. A financial covenant may have the same effect. For example, a minimum current ratio requirement may constrain a borrower from selling on account to slow-paying customers. 81 Selling to such customers necessarily increases the observed liquidity risk of the firm because its current ratio deteriorates. It may also create an incentive to increase the firm's unobservable risk, to the extent that the firm has more ability to sell to unobservably (to the lender) riskier customers if it is permitted to extend trade credit on longer terms. 82
Collateral can also be used to mitigate bondholder-stockholder conflict. For example, a lien on firm assets (inside collateral) prevents borrowers from selling those assets without lender approval. 83 This limits the firm's ability to expropriate lender wealth through asset substitution (see Smith and Warner, 1979). Owners' pledging personal assets as collateral for a corporate loan (outside collateral) effectively increases their equity exposure. Such increased exposure may have important incentive effects depending on the owner's level of risk aversion. Outside collateral may also be useful in solving adverse selection problems because a borrowing firm's willingness to pledge collateral may reveal its true quality (see Chan and Kanatas, 1985), or it may be useful in solving incentive problems because it may alter the marginal return to risk shifting (that is, asset substitution) (see Boot, Thakor and Udell, 1991).