The Defeasance of Control Rights
Abstract: Renegotiations of positive covenants in loan contracts and their impact on corporate financing and investment decisions received a lot of attention in the finance literature recently. Action-limiting covenants in bonds, which are different in nature but no less important in impact, have been much less researched possibly because they are very difficult to renegotiate. This paper shows that an option granted to the issuer to remove the covenants upon exercise can effectively substitute for renegotiation and can implement endogenous control right allocation when no verifiable signal is available. Our model predicts and our empirical analysis documents that (1) with the option to remove covenants, issuers are willing to accept more action-limiting covenants ex ante; (2) the exercise price is set high enough so that the option is only exercised in the good state; (3)financially constrained firms with high growth opportunities and higher degree of uncertainty are more likely to include this option; (4) investors trade o_ the yield for reduced risk upon exercise in the good state and higher number of covenants in the bad state; (5) investors accept a lower yield on bonds with the option to remove covenants even after controlling for the number of covenants.
