Debt covenant violations and risk shifting behavior

Purpose The study has three inter-related goals: first, to examine empirically the transfer of wealth from creditors to shareholders that occurs when firms default on debt covenants, second, to develop a framework for measuring the impact of overinvestment by firms in covenant default and, third, to provide an estimate of the cost to creditors of managerial risk-shifting. Design/methodology/approach The paper examines the relationship between market volatility and investment of financially distressed firms in a real options framework. The debt is taken to be exogenously determined. Numerical methods are employed to assess the impact of volatility on investment. Findings The study finds that the risk-shifting motivations of shareholders offset the anticipated negative relationship between investment and volatility as firms violate covenants and become financially distressed. Research limitations/implications The debt violation data in this study are extracted from filings by SEC registrants posted on the EDGAR website. The laws and regulations affecting firms in other jurisdictions may differ, possibly affecting the options open to firms in financial distress. Practical implications Prior research has found that covenant violations rarely lead to accelerated payment or bankruptcy. The present study suggests that monitoring should include investment scrutiny procedures to minimize risk-shifting behavior. Social implications The results offer a cautionary tale for creditors about the negative value created by risk-shifting when firms are in financial distress. They indicate a need for close monitoring of a firm's investment decisions post-violation. Originality/value This study appears to be the first to provide evidence of changes in the relationship between investment and volatility as a firm violates debt covenants and become financially distressed.