Financial covenants have gone in and out of style over the last 30 years. They serve to transfer control rights to lenders when a borrower’s financial metrics breach pre-set contractual thresholds and so provide an interesting laboratory to study debtholder-shareholder conflicts and how they are potentially resolved. First, covenants can enhance efficiency by making contracts between lenders and their borrowers more complete. Second, through the contingent transfer of control during the term of the loan, they provide scope for renegotiation and wealth transfers that are primarily at the discretion of the lender.

In practice, covenant violations are associated with a … Read more