Debt Covenants , Expected Default Costs , and the Implicit Cost of Financial Reporting Manipulation ∗

The transfer of control rights to lenders makes debt covenant violations costly to equityholders and managers, and provides managers with an incentive to manipulate covenant ratios and amounts. We find that the information contained in changes in the probability of covenant violations is priced by the stock market, incremental to changes in firm fundamentals. This relation is stronger when firms are near thresholds, and stock returns are more sensitive to movements toward thresholds relative to movements away. These findings suggest that the stock market conditions on the likelihood of a costly covenant violation, but that it does so differently when the likelihood of manipulation is high. By averting selection bias associated with ex post covenant violation analysis, our tests provide an ex ante, large-sample estimates of the expected cost of technical default of 8.40% of equity value and the cost of financial reporting manipulation of 1.68% of equity value. Furthermore, these estimates imply that equityholders systematically overweight the conditional probability of bankruptcy given default by a factor of 1.67. ∗We are grateful to Nick Barberis, Andrew Bird, Gary Gorton, Peter Kelly, Kalin Kolev, Ken Lehn, Justin Murfin, Tom Ruchti, Shyam Sunder, Jake Thomas, Frank Zhang, and seminar participants at Carnegie Mellon University and Yale University for helpful comments. Contact Information: Aytekin Ertan, London Business School, Regent’s Park, London NW14SA, UK, Email: [email protected]; Stephen A. Karolyi, Tepper School of Business, Carnegie Mellon University, 254A Posner Hall, 5000 Forbes Avenue, Pittsburgh, PA, 15213, Email: [email protected].