520005

The University of ChicagoThe Booth School of Business of the University of ChicagoThe University of Chicago Law School

State Laws and Debt CovenantsAuthor(s): Yaxuan Qi and John WaldSource: Journal of Law and Economics, Vol. 51, No. 1 (February 2008), pp. 179-207Published by: The University of Chicago Press for The Booth School of Business of the University ofChicago and The University of Chicago Law SchoolStable URL: http://www.jstor.org/stable/10.1086/520005 .

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179

[Journal of Law and Economics, vol. 51 (February 2008)]� 2008 by The University of Chicago. All rights reserved. 0022-2186/2008/5101-0007$10.00

State Laws and Debt Covenants

Yaxuan Qi Concordia University

John Wald University of Texas at San Antonio

Abstract

We examine whether state laws impact the use of debt covenants by using asample of U.S. public bond issues from 1987 to 2004. We consider variationin state laws with respect to the minimum asset-to-debt ratio necessary for apayout and with respect to antitakeover statutes. We find that firms incorporatedin states with stricter restrictions on distributions are less likely to include debtcovenants that constrain payouts, limit additional debt, or restrict the sale ofassets. Thus, state payout restrictions appear to be a substitute for the use ofthese debt covenants. On the other hand, firms incorporated in states withstronger antitakeover statutes are somewhat more likely to use debt covenants.This finding is consistent with the notion that firms with antitakeover protectionare more likely to suffer from agency problems and, thus, are more likely touse debt covenants to minimize agency costs.

1. Introduction

The Coase Theorem suggests that, in a world of rational agents and no transactioncosts, an optimal contract will be derived from free bargaining and, hence, thatthe legal environment should function only to facilitate such contracts. Thus, iftransaction costs are low, highly restrictive laws could hinder the creation of anoptimal contract. Alternatively, if transaction costs are significant, corporate lawscould substitute for or complement the potentially costly negotiations inherentin writing contracts.1

A variety of empirical research has suggested that legal systems have a sig-nificant impact on corporate policies. For instance, La Porta et al. (1997, 1998,2000), Doidge, Karolyi, and Stultz (2007), and others have studied the influenceof legal protection on corporate ownership structures and corporate valuationin an international context. In contrast, we examine the interaction betweencreditors’ legal protection resulting from U.S. laws and the covenants in nego-

We thank Mike Lockerbie for excellent research assistance and Dhammika Dharmapala, MichaelLong, Lucas Roth, and an anonymous referee for comments on earlier drafts of this paper.

1 Smith and Warner (1979) suggest that, although the negotiation of covenants can be costly, thesecovenants can increase the value of a firm. See, for example, Cooter (1982) for a general discussionof the Coase Theorem.



180 The Journal of LAW& ECONOMICS

tiated debt agreements. Instead of looking at contract differences across countries,we examine contract differences across states. By focusing only on U.S. firms,we control for the general level of economic development, the function of capitalmarkets, and federal regulations, which are the same for all U.S. firms. We focusour attention on two types of statutory restrictions—namely, restrictions on theminimum asset-to-debt ratio necessary to make a distribution and restrictionson hostile takeovers. These two types of restrictions are designed to protectcreditors from expropriation by shareholders and are adopted widely in U.S.debt agreements. We examine whether firms incorporated in states with stricterstatutory restrictions are more or less likely to use additional restrictions of eitherthe same type or other types in their debt covenants.

We find that firms incorporated in states with stricter restrictions regardingpayouts are less likely to add debt covenants that constrain distributions, limitadditional debt, or restrict the sale of assets. Thus, state payout restrictions appearto substitute for the use of these bond covenants. Since these covenants are costlyto negotiate, firms have an incentive not to include them if state laws alreadyprovide similar protection, which is consistent with the costly contracting hy-pothesis of Smith and Warner (1979). This finding suggests that state laws providesufficient protection for creditors with regard to some dimensions.

When examining antitakeover statutes, we find evidence that firms incorpo-rated in states with greater antitakeover restrictions are more likely to includeadditional covenants that limit hostile takeovers. This finding is consistent withthe notion that certain firms most at risk of a hostile takeover seek protectionboth from state law and from debt covenants. The positive correlation betweenantitakeover laws and event-risk covenants also may be due to entrenched man-agers more easily including debt covenants that further consolidate their po-sitions.2

We also find some evidence of cross effects. Specifically, firms incorporatedin states with stricter statutory payout restrictions are less likely to include othertypes of covenants, such as event-risk or asset-substitution restrictions. Thus,these state laws may provide some protection from other types of firms’ actionsthat could decrease bond value. In addition, firms incorporated in states withstrong antitakeover protection are more likely to use some payout, financing, orasset-substitution restrictions. Incorporation in a state with more antitakeoverprovisions is regarded as a measure of weak governance because these protectionsisolate managers from the pressures of financial markets (see, for example, Gom-pers, Ishii, and Metrick 2003). Therefore, antitakeover laws may indicate a greaterpossibility of agency problems and, thus, more of a need for the use of covenantsto mitigate agency issues (see related discussions in Gompers and Lerner 1996;Begley and Feltham 1999; Chava, Kumar, and Warga 2005). This finding is alsoconsistent with the notion that adding one type of covenant lowers the costs of

2 Kahan and Klausner (1993) argue that covenants that deter takeovers are used primarily toentrench managers and not to benefit bondholders.



Debt Covenants 181

adding other covenants. Lehn and Poulsen (1991) show that debt issues thatinclude covenants regarding dividends or additional debt are more likely toinclude event-risk protection. If there are fixed costs to adding covenants of anytype, a reduction in one type of covenant may imply a relatively higher cost ofincluding other covenants. Thus, a reduction in the use of one covenant becauseof substitution with state payout restrictions would imply fewer other covenants,whereas an increase in the use of one covenant that is complementary to an-titakeover laws would imply more other covenants.

Our findings complement those of previous studies on the interaction betweenthe legal system and corporation policies. Statutory legal protections for investorscan function as either a substitute or a complement to contract-specific protec-tions, depending on the impact of the legal system on the relative costs andbenefits of such additional contracts. For instance, using a large sample of firmsacross 49 countries, La Porta et al. (1998) find a significant negative correlationbetween the quality of investor legal protection and the concentration of own-ership. Gore, Sachs, and Trzcinka (2004) examine whether public finance dis-closures and bond insurance are substitutes. They find that, when disclosure isrequired by state law, issuers use less insurance. Thus, legal protection and firm-level adaptive mechanisms can work as substitutes. Consistent with these results,we find that state laws that restrict payouts substitute for issue-specific covenants.On the other hand, Doidge, Karolyi, and Stultz (2007) use a model of the interactionbetween a country’s investor protection and firm-level governance mechanisms toshow that these elements function as complements in countries with low levels ofinvestor protection. Cumming and Johan (2006) examine covenants for inter-national venture capital funds. They find that funds located in countries with betterdeveloped legal systems are more likely to use additional covenants. Consistentwith these results, we find that state antitakeover laws appear to increase the need(or managers’ ability) to add entrenching debt covenants.

A considerable portion of the prior literature examines which firms use cov-enants and how they function to increase a firm’s value (see Smith and Warner1979; Malitz 1986; Asquith and Wizman 1990; Lehn and Poulsen 1991; Nash,Netter, and Poulsen 2003). The more recent literature examines the degree towhich covenants are priced (see Bradley and Roberts 2004; Riesel 2004; Wei,2005). In this paper, we instead focus on the relationship between state laws andbond covenants, while controlling for the determinants of covenant choice sug-gested in the existing literature.

Section 2 discusses our hypotheses in greater detail. Section 3 details our data.Section 4 presents our empirical results, and Section 5 summarizes our con-clusions.

2. Discussion and Hypotheses

The conflict between shareholders and bondholders has been extensively stud-ied in the finance literature (see, for example, Jensen and Meckling 1976; Myers




1977). Bond covenants provide one way to mitigate this conflict. As Smith andWarner (1979) discuss, management can use bond covenants to bind themselvesfrom later expropriating creditors’ investments; covenant use can therefore lowerfinancing costs and increase firm value. The number and type of covenantsdepend on the probability of expropriation (see, for instance, Malitz 1986), thecosts of the firm’s decreased flexibility (Nash, Netter, and Poulsen 2003), andthe costs of the negotiation of covenants. As we demonstrate, the use of covenantsalso depends on state laws, which either may provide alternative mechanismsfor creditor protection or may increase the possibility of agency problems. Wefocus our attention on two types of statutory restrictions: restrictions on theminimum asset-to-debt ratio necessary to make a distribution to shareholdersand restrictions on hostile takeovers.

State laws differ in the degree to which they restrict payouts when debt ispresent. A few states, most notably Delaware, provide few restrictions, allowingpayments to come from either surplus or net profits in a particular year. Firmsincorporated in New York, Texas, and many other states are subject to the networth or net value rule—that is, they cannot make distributions if the payoutwould decrease the net value of assets below their stated capital, which effectivelyis the book value of debt. Firms incorporated in California or Alaska are subjectto a more stringent test, with distributions allowed only if the net assets of thecorporation remain greater than 1.25 times its liabilities.3 Wald and Long (2007)describe these laws and demonstrate how they impact firms’ choice of capitalstructure, and Mansi, Maxwell, and Wald (2006) demonstrate that firms incor-porated in states with stricter payout laws have significantly lower bond yields.Mansi, Maxwell, and Wald suggest that, instead of corresponding with a race tothe top or a race to the bottom, variations in state payout laws may provide anopportunity for firms with different contracting needs to maximize their valueby choosing the most appropriate legal environment.

Firms may face similar payout constraints from debt covenants written intoparticular contracts. These covenants take a variety of forms, including dividend-related payments, restricted payments, and subsidiary dividend-related payments

3 Specifically, New York law states, “Dividends may be declared or paid and other distributionsmay be made out of surplus only, so that the net assets of the corporation remaining after suchdeclaration, payment or distribution shall at least equal the amount of its stated capital; except thata corporation engaged in the exploitation of natural resources or other wasting assets, includingpatents, or formed primarily for the liquidation of specific assets, may declare and pay dividends ormake other distributions in excess of its surplus, computed after taking due account of depletionand amortization, to the extent that the cost of the wasting or specific assets has been recovered bydepletion reserves, amortization or sale, if the net assets remaining after such dividends or distri-butions are sufficient to cover the liquidation preferences of shares having such preferences ininvoluntary liquidation” (New York CLS Business Corporations Code, sec. 510 [2003]). The morerestrictive California law states, “The distribution may be made if immediately after giving effectthereto: (1) The sum of the assets of the corporation (exclusive of goodwill, capitalized research anddevelopment expenses and deferred charges) would be at least equal to 1 1/4 times its liabilities (notincluding deferred taxes, deferred income and other deferred credits)” (California Corporate Code,sec. 166 [2004]).



Debt Covenants 183

covenants, which limit dividends, distributions, or dividends by subordinatedfirms, respectively (see Table A1 for further description of commonly used cov-enants). As with state laws, firms typically avoid getting close to these constraintsin order to preserve their financial flexibility (Kalay 1982).4 Because restrictionson distributions are typically a function of the firm’s capital structure, theserestrictions also limit the firm’s choice of capital structure (for a formal model,see Smith and Warner 1979; Wald 1999). Thus, covenants that restrict firmfinancing, such as an indebtedness covenant that limits additional debt eitherin absolute dollar amounts or as a fraction of capital, may have an impact onconstraining firm behavior that is similar to the impact of payout restrictions.The most frequently used covenants that restrict financing are the negative-pledge, indebtedness, and subsidiary debt issuance covenants.

Antitakeover laws also vary between states, and managers of firms prefer toreincorporate in states with more antitakeover provisions, which often is det-rimental to shareholders (see Heron and Lewellen 1998; Bebchuk and Cohen2003). Mansi, Maxwell, and Wald (2006) show that these antitakeover laws havelittle effect on average bond yields. Thus, these laws do not compensate otherstakeholders of the firm, such as creditors, for the losses suffered by shareholders.The primary laws that we consider are the same as those addressed by Bebchukand Cohen and include antigreenmail, control share, fair-price, freeze-out, poisonpill endorsement, and constituencies statutes.5

A parallel set of creditor or antitakeover protections is sometimes added tospecific debt covenants. The most frequently used antitakeover covenants arethe consolidation/merger covenant, which usually restricts some mergers, andspecific event-risk covenants, often called poison puts, which allow bondholdersto force repayment in the event of a hostile takeover.6 Kahan and Klausner (1993)point out that these restrictions are more effective at preventing hostile takeoversand, thus, at entrenching management than they are at protecting creditors.Kahan and Klausner suggest that more effective event-risk protection for creditorsis offered by covenants that trigger puts in the event of a rating decline (“ratingdecline triggers put” [RDTP] covenants). Although RDTP covenants are used

4 John and Kalay (1982) offer a model of optimal covenant choice.5 We consider the antigreenmail laws of Ohio and Pennsylvania, which require unsuccessful ac-

quirers to disgorge all profits on stock purchases. The control share statute requires a hostile bidderto put an offer to a vote of shareholders early in the process. The fair-price statute requires a bidderthat gains control to pay remaining minority shareholders the same price that it paid for sharesacquired in the original bid. Freeze-out and business combination statutes restrict bidders frommerging assets for a specified number of years. Poison pill endorsements are rights that entitle existingshareholders to significant value in the event of an acquisition without board approval. Constituenciesstatutes allow managers to take into account the interests of nonshareholders when defending againsta takeover. See Bebchuk and Cohen (2003) or Gartman (2000) for additional details.

6 The consolidation/merger covenant typically requires that the surviving corporation assumes alldebts; thus, this covenant is not restrictive for most acquisitions. See Asquith and Wizman (1990)or Lehn and Poulsen (1991) for a discussion. Event-risk covenants (or poison puts) allow creditorsto put the debt back to the issuer in the event of a change in control. See Lehn and Poulsen (1991)for further details and for examples of such covenants.




rarely in practice, we also consider them in our analysis of antitakeoverrestrictions.

We examine the degree to which state laws have an impact on the use of thesecovenants in public bond issues. The costly contracting hypothesis of Smith andWarner (1979) states that there exists a set of optimal contracts that maximizesthe value of a firm but that these contracts are costly to implement. Thesecontracting costs suggest a negative correlation between state-level restrictionsand the use of debt covenants. We consider the following null hypothesis:

Hypothesis 1. The payout restrictions of the firm’s state of incorporation arenot related to the use of payout or financing covenants.

Rejection of this hypothesis and the finding of a negative correlation wouldindicate that payout restrictions in state laws substitute for debt covenant re-strictions. This finding also implies that statutes provide effective protection forcreditors and that this protection is recognized by investors. Thus, reincorpor-ation in another state must be too costly for the firm to be able to easily escapefrom restrictive state statutes. Hypothesis 2 addresses the use of antitakeovercovenants.

Hypothesis 2. The antitakeover statutes of the firm’s state of incorporationare not related to the use of antitakeover covenants.

Rejection of this hypothesis and the finding of a positive correlation wouldsuggest a number of possible alternatives. For instance, certain firms may par-ticularly need protection from takeovers and will seek protection both from statelaws and from covenants. Alternatively, as Gompers, Ishii, and Metrick (2003)suggest, if the use of antitakeover devices is a measure of poor governance, thenentrenched managers may be able to further consolidate their position by addingcovenants against takeovers.

In addition, we may find cross effects in state laws and debt covenants. Lehnand Poulsen (1991) find that creditors who negotiate payout restrictions aremore likely to negotiate event-risk protection. This finding is consistent withthe existence of fixed costs for the negotiation of debt covenants; thus, oncesome covenants are negotiated, additional covenants may be less expensive toadd. Therefore, if statutory payout restrictions substitute for payout or financingcovenants, they also may substitute for event-risk covenants. On the other hand,if antitakeover statutes complement event-risk covenants, they also may com-plement payout or financing covenants. As proxies for poor governance, anti-takeover statues may signal more agency problems and, therefore, may increasethe value of additional covenants, which would mitigate these agency costs.

3. Data

We gathered data on bond issues from Mergent’s Fixed Investment SecuritiesDatabase (FISD). The version of the FISD that we used includes U.S. public



Debt Covenants 185

debt issues through the second quarter of 2004. We excluded issues before 1987because the constitutionality of antitakeover laws was clarified by the U.S. Su-preme Court in that year (CTS Corp. v. Dynamics Corp. of America, 481 U.S. 69[1987]). We restricted our sample to U.S. corporate debentures, insured corporatedebentures, and corporate zero-coupon bonds.7 We excluded Rule 144a issuesand medium-term notes because the covenant information for these issues usu-ally is not present in the FISD. Following Billet, King, and Mauer (2007), weexcluded bonds for which both the “subsequent” and “covenant” data flags areset to “no,” which indicates that the FISD does not provide covenant informationfor this particular issue. In addition, we excluded issues for which the covenantflag is marked as “no covenants” but for which some covenants are reported.8

Convertible debt issues also are excluded because the equity option causes theseinstruments to be less comparable and because, as Kahan and Yermack (1998)report, convertible bonds rarely include debt covenants.

As a control in our regressions, we included Standard & Poor’s Compustatdata on firm characteristics from the year prior to issuance date (after adjust-ment for differences in fiscal year end). We collected the most recent state-of-incorporation data from Compustat files; then, by searching the FISD, we checkedeach firm to determine whether it had reincorporated during the time periodthat we considered. After merging the Compustat and FISD data and deletingobservations for which state of incorporation could not be identified or firmcharacteristics were missing, we obtained a sample of 5,514 debt issues by 1,444firms.

To collect data on state laws, we used Lexis/Nexis to review state statutes forpayout restrictions, as did Wald and Long (2007). A payout restriction is definedas the minimum asset-to-debt ratio necessary to make a distribution. This var-iable differs among states, from 0 for states such as Delaware, where payoutscan be taken from that year’s profits, to 1.25 for California and Alaska. We usedthe antitakeover index discussed by Bebchuk and Cohen (2003),9 although weadded a recapture (antigreenmail) variable for firms incorporated in Ohio orPennsylvania after 1990. Thus, the index that we used varies from 0 to 6.10 Inaddition, we checked the Investor Research Responsibility Center data to de-termine whether any of the firms in our sample had opted out of state anti-takeover laws. The ability to opt out is limited to only a few states, so this factorapplies to a small fraction of the total sample.

We controlled for a number of issue and firm characteristics in our analysis.The issue characteristics include the maturity of the security: we expect that debt

7 We also included corporate line-of-credit-backed bonds; however, none of these bonds appearin our final sample after filtering.

8 Only a few such issues exist, and they include unusual features such as covenants that disappearif the firm becomes investment grade.

9 Data on state antitakeover laws were collected from Lucian Arye Bebchuk, Data: Data on StateAntitakeover Index 1986–2001 (http://www.law.harvard.edu/faculty/bebchuk/data.shtml).

10 Separate consideration of antigreenmail laws has little impact on our results.




with longer maturity is more likely to include covenants because of the increasedopportunity for moral hazard problems. We also include a dummy variable forwhether the debt issue includes put or call features. Bodie and Taggart (1978)discuss how call features may reduce managers’ agency problems and how a putmay substitute for bond covenants by allowing creditors to force a repurchasein the event of contrary actions by management. Similarly, secured bonds maynot need additional bond covenants. Since these bond features may be seen asoutcomes of the same bargaining process that produces the choice of covenants,we tested whether the inclusion of these features has a significant impact on ourother results and found that it does not.

The firm characteristics we consider include the debt-to-market-value ratioas a measure of the firm’s riskiness. We also include a dummy variable forwhether the current debt is rated as high yield. In alternative regressions, weconsider the interest coverage ratio and the Altman Z-score as additional mea-sures of the debt’s risk, but these control variables did not have an impact onour primary results. As did Malitz (1986), we hypothesize that riskier firms aremore likely to use debt covenants. Also following Malitz, we use the size of thecurrent issue relative to the size of the firm’s total debt and a measure of thefirm’s size proxied by the log of book value. Malitz hypothesizes that if the issueis large relative to the firm’s outstanding debt, it is more likely to be a new entryin the public bond markets, and, thus, covenants may be required in order tocompensate for lower issuer reputation. Similarly, small firms may have a lowerreputation and, therefore, may require the use of covenants. Since the totalbenefits of negotiated covenants may increase with the size of the issue, whereasthe costs may be fixed, we include the log of the issue amount as an additionalcontrol variable. Nash, Netter, and Poulsen (2003) discuss how firms with greatergrowth opportunities want to preserve their financial flexibility and avoid re-strictive covenants. As in their analysis, we include variables for the firm’s market-to-book ratio and the ratio of research and development (R&D) to total assets.

In an alternative specification, we also include dummy variables for one- ortwo-digit standard industrial classification (SIC) codes. The inclusion of thesedummy variables decreases the number of available observations in the probitregressions, since certain dummy variables explain perfectly the use of certaincovenants (firms in certain industries either never or always use particular cov-enants). However, since the coefficients for state laws change little with theaddition of these dummy variables, we exclude them from our final specification.Alternative specifications that exclude financial and regulated firms also providesimilar results.

We also control for general market condition. Lehn and Poulsen (1991) findthat the incidence of event-risk covenants increased after the wave of takeoversin the 1980s. As a control variable for the amount of takeover activity, wetherefore include the log of the dollar value of mergers, from Thomson Financial’sSecurities Data Corportation database, in the firm’s industry (as assigned by theone-digit SIC code) in the prior year. We include all mergers in which a U.S.



Debt Covenants 187

firm was the target and the acquisition value was at least $50 million. Similarly,we control for the macroeconomic default risk by using the default rate for debtin the prior year, as reported by Standard & Poor’s (1986–2003).

Wald and Long (2007) find that a firm’s decision about whether to incorporatein the same state in which its headquarters is located is endogenously determinedalong with its capital structure. However, since our analysis of the use of cov-enants is explicitly conditioned on a firm’s leverage, we find little evidence thatstate self-selection has an impact on covenant choice.

4. Empirical Results

We begin by providing the frequencies of various covenants and summarystatistics for our control variables. We perform t-tests to determine whethercertain covenants are more frequently used by firms incorporated in states withmore restrictive payout restrictions. We use a probit regression to study whetherthe debt issue includes any covenants, and we use a Poisson regression to studythe determinant of the total number of covenants. Since the determinants ofcovenants may differ between covenants, these simple probit and Poisson re-gressions may be misspecified. We therefore consider separate probit regressionsfor each of the more commonly used debt covenants. The dependent variablein these probit regressions is a binary variable equal to one if a particular debtcovenant is used and zero otherwise. The independent variables are the statutoryrestrictions in state laws and a set of control variables that include firm andissue characteristics. We briefly contrast our results for the control variables withthe existing literature after our discussion of the interaction between state lawsand covenant choice. Since different bond issues from the same firm may bemore likely to have similar covenants, we adjust for heteroskedasticity by usinga White correction with clustering by firm in all regressions.

4.1. Summary Statistics

For our final sample, we consider 5,514 debt issues from 1987 to 2004 thatwere from 1,444 firms. Table 1 presents summary statistics for the relevantcovenants considered in the FISD data. Overall, 96.2 percent of the issues in thesample include some covenants. The most frequently included covenants are ageneral (and relatively weak) consolidation/merger restriction and a restrictionon the sale of assets. Other frequently used covenants are the negative-pledgecovenant, defeasance with tax consequences covenant, defeasance without taxconsequences covenant, cross-acceleration covenant, sales leaseback restriction,indebtedness restriction, and the restricted-payments covenant. A variety of cov-enants for subsidiary actions also appear with some frequency, including a cov-enant for subsidiary dividend-related payments and subsidiary indebtedness.Restrictions on dividend payments and a net earnings test for additional issuanceappear less frequently, whereas other financing covenants are almost never used.To limit the scope of the study to the most relevant covenants, we focus our



Table 1

Frequency of Covenant Use

Covenant %

Any .962Payout:

Restricted payments .210Subsidiary dividend-related payments .192Dividend-related payments .039

Financing:Negative pledge .697Cross acceleration .527Subsidiary indebtedness .264Indebtedness .253Subsidiary stock issuance .099Subsidiary preferred-stock issuance .096Stock transfer, sale, or disposal .094Subordinated debt issuance .064Liens .058Subsidiary liens .050Cross default .042Subsidiary-funded debt .026Net earnings test for issuance .025Stock issuance restriction .020Senior debt issuance .012Funded debt .011Subsidiary fixed-charge coverage .003Subsidiary borrowing restriction .003Leverage test .002Subsidiary leverage test .002

Event risk:Consolidation/merger .878Poison put .232RDTP .021

Asset substitution:Asset sales restriction .875Sales leaseback restriction .448Subsidiary sales leaseback restriction .417Asset sales require redemption .145Investments .019Subsidiary investments .018Subsidiary asset sales reduce debt .008

Other:Defeasance with tax consequences .673Defeasance without tax consequences .619Transaction affiliates .211Legal defeasance .108Subsidiary guarantee .082Subsidiary redesignation .067Economic covenant defeasance .048After acquired property clause .023Maintenance net worth .019Declining net worth .015Fixed-charge coverage .004

Note. Data are percentages of corporate debt issues that use a particular covenantin a sample of nonconvertible bond issues from Mergent’s Fixed Investment Se-curities Database, 1987 to 2004. Of the sample of 5,514 debt issues, a total of 5,305issues use some sort of covenant. RTDP p rating decline triggers put.



Debt Covenants 189

Table 2

Summary Statistics for Control Variables

Mean Median SD25th

Percentile75th

Percentile

Total covenants 7.722 7.000 4.630 5.000 9.000Total asset constraint .407 .000 .493 .000 1.000Antitakeover index 2.146 1.000 1.667 1.000 4.000Market .407 .124 1.158 .043 .323Log(issue amount) 5.260 5.298 1.334 4.828 5.784Firm size 8.750 8.687 1.919 7.430 9.928Leverage .400 .366 .238 .211 .559Market-to-book ratio 1.197 .966 .942 .728 1.388R&D-to-assets ratio .009 .000 .023 .000 .002Log(maturity) 2.260 2.301 .695 1.935 2.483High yield .718 1.000 .450 .000 1.000Putable .030 .000 .170 .000 .000Callable .568 1.000 .495 .000 1.000Secured .049 .000 .217 .000 .000Default ratet�1 (%) 1.818 1.410 1.120 .600 2.590Log(mergerst�1) 10.705 10.777 1.365 9.914 11.715

Note. For all variables listed, data are based on 5,514 debt issues by 1,444 firms. Total asset constraint isthe minimum asset-to-debt ratio required for a distribution to shareholders, given the firm’s state ofincorporation. The antitakeover index gives the number of antitakeover statutes, given the firm’s state ofincorporation (as in Bebchuk and Cohen 2003), plus 1.0 if antigreenmail laws are in effect (that is, if thefirm is incorporated in Pennsylvania or Ohio, which have a recapture or disgorgement statute in effectafter 1990). Market is the size of the issue relative to the firm’s total debt. Log(issue amount) measuresthe size of the issue in millions of dollars. Firm size equals the log of the firm’s total assets. Leverage isthe firm’s debt divided by total market value at the year of issuance. Market-to-book ratio is the sum ofthe market value of the firm’s equity plus the sum of the book value of the firm’s debt and preferred stock,all divided by total assets. The R&D-to-assets ratio equals the firm’s research and development expensesdivided by total assets or zero if R&D is missing. Maturity is the number of years to maturity of the issue.High yield equals one if the issue is rated less than BAA by Moody’s. Putable equals one if the issue includesa put, and callable equals one if the issue includes a call. Secured equals one if the debt is senior securedand zero otherwise. The default rate is for all bonds rated by Standard & Poor’s in the prior year, andlog(mergerst�1) is the log of the market value of mergers in the corresponding one-digit standard industrialclassification code in the prior year.

analysis on those covenants closely related to payouts, financing, mergers, orasset substitution and with a frequency of at least 10 percent in the data (althoughwe also consider the infrequently used RDTP covenant).

As shown in Table 2, the mean number of covenants used is 7.72 (median of7.0 and maximum of 28). As Figure 1 demonstrates, the mean number of cov-enants varies widely across years.11 Firms in the sample issue public debt and,therefore, have a higher leverage ratio, at 40.0 percent for debt/value, than mostU.S. firms. Approximately one-half of larger U.S. public firms are incorporatedin Delaware, but, because our sample focuses on firms that issue public debtand because firms with a high debt use are more likely to incorporate in Delaware,58.8 percent of the debt issues are for firms incorporated in Delaware.

Table 3 presents the correlations between our explanatory variables and two

11 In contrast, the mean number of covenants in private loan agreements decreased to five in 2005,from six in the preceding 3 years (Ng 2006).




Figure 1. Total number of covenants, by year

dependent variables, an indicator of whether any covenants are included andthe total number of covenants. Consistent with our prediction of substitutionbetween state laws and covenants, we find significant negative coefficients be-tween the total asset constraint and the total number of covenants, as well asbetween the antitakeover index and the total number of covenants. We considerbelow the degree to which these negative correlations are robust when otherfactors are controlled.

In addition, we consider the variation of these covenants across time. Figure2 presents the frequency of payout and financing covenants for different yearsin our sample. Because the use of these covenants may be a response to thethreat of default, we also include the default rate in this figure. Figure 2 dem-onstrates the enormous increase in the use of the negative-pledge and cross-acceleration covenants after 1990. Other payout and financing covenants alsobecame more frequently used after 1992.12 Similarly, Figure 3 presents the fre-quency of the use of event-risk covenants. The use of the consolidation/mergercovenant increased significantly after 1989, whereas the RDTP covenant was usedprimarily in only 1989 and 1990. Figure 4 presents the frequency of use of theasset substitution covenants. A covenant requiring the redemption of bonds atthe sale of certain assets was not used until 1993 but appears in 26.5 percent of

12 The increase in the use of more general payout-restriction covenants substitutes for a sharpdecrease in the use of dividend-restriction covenants after 1990. Dividend-restriction covenantsappeared in approximately 17 percent of 1987 issues, but their use drops to less than 1 percent after2000. This change in type of covenant corresponds to the increase in repurchases relative to dividendsin the late 1980s (see Grullon and Michaely 2002).



Debt Covenants 191

Figure 2. Frequency of payment and financing covenants

issues in 2004. A subsidiary sales leaseback covenant was not used by any firmsin our sample in 1987 but appears in 53.6 percent of issues in 1999. Althoughstate laws, firm characteristics, and other security characteristics are able toexplain much of the variation in covenant use, they do not explain fully thetremendous variation over time in some of these covenants. Instead, changes incovenant use over time are consistent with legal innovations or fashions creatingnew trends in covenant use. Consistent with payout-restriction covenants re-placing dividend-restriction covenants after an increase in repurchases and withthe increase in restrictions on mergers after the merger wave in the late 1980s,covenant use responds to what creditors perceive as the most likely threats ofexpropriation.

4.2. Impact of State Law on Covenant Use: Univariate Tests

Table 4 presents the results of two-sided t-tests for whether the frequenciesof the more common financing, merger, or asset-substitution covenants aredifferent in states with a total asset constraint equal to zero or one. Consistentwith substitution between state laws and debt covenants, most financing cove-nants appear less frequently in states with stricter payout-restriction laws. Forinstance, in states with a total asset constraint equal to one, restricted-paymentsclauses appear 9 percentage points less frequently than in those states with atotal asset constraint equal to zero. This reduction (by approximately one-third)in the use of this covenant is both statistically and economically meaningful.Other common covenants also are less frequently used in states with strictertotal asset constraints, and these differences are often statistically significant.



192

Tab

le3

Cor

rela

tion

Coe

ffici

ents

and

Sign

ifica

nce

Leve

ls

An

yC

oven

ant

Tota

lC

oven

ants

Tota

lA

sset

Con

stra

int

An

tita

keov

erIn

dex

Mar

ket

Log(

Issu

eA

mou

nt)

Firm

Size

Leve

rage

Rat

io

Log

(Mat

uri

ty)

Pu

tabl

eC

alla

ble

Mar

ket

toB

ook

R&

Dto

Ass

ets

Tota

lco

ven

ants

.331

(.00

)To

tal

asse

tco

nst

rain

t�

.011

(.42

)�

.098

(.00

)A

nti

take

over

inde

x.0

25(.

07)

�.0

32(.

02)

.826

(.00

)M

arke

t�

.023

(.10

).2

31(.

00)

�.0

60(.

00)

�.0

48(.

00)

Log

(iss

ue

amou

nt)

.100

(.00

).0

36(.

01)

�.1

43(.

00)

�.0

90(.

00)

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(.27

)Fi

rmsi

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(.00

)�

.543

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00)

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00)

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00)

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00)

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00)

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00)

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00)

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)



193

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82)

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00)

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97(.

00)

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(.03

)�

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00)

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(mat

uri

ty)

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esby

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4fi

rms.

Tota

las

set

con

stra

int

isth

em

inim

um

asse

t-to

-deb

tra

tio

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ired

for

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stri

buti

onto

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ehol

ders

,gi

ven

the

firm

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ate

ofin

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orat

ion

.T

he

anti

take

over

inde

xgi

ves

the

nu

mbe

rof

anti

take

over

stat

ute

s,gi

ven

the

firm

’sst

ate

ofin

corp

orat

ion

(as

inB

ebch

uk

and

Coh

en20

03),

plu

s1.

0if

anti

gree

nm

ail

law

sar

ein

effe

ct(t

hat

is,

ifth

efi

rmis

inco

rpor

ated

inP

enn

sylv

ania

orO

hio

,w

hic

hh

ave

are

capt

ure

ordi

sgor

gem

ent

stat

ute

inef

fect

afte

r19

90).

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ket

isth

esi

zeof

the

issu

ere

lati

veto

the

firm

’sto

tal

debt

.Lo

g(is

sue

amou

nt)

mea

sure

sth

esi

zeof

the

issu

ein

mill

ion

sof

dolla

rs.

Firm

size

equ

als

the

log

ofth

efi

rm’s

tota

las

sets

.Le

vera

geis

the

firm

’sde

btdi

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dby

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ance

.M

arke

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kra

tio

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esu

mof

the

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ket

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eof

the

firm

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uit

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us

the

sum

ofth

ebo

okva

lue

ofth

efi

rm’s

debt

and

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erre

dst

ock,

all

divi

ded

byto

tal

asse

ts.

Th

eR

&D

-to-

asse

tsra

tio

equ

als

the

firm

’sre

sear

chan

dde

velo

pmen

tex

pen

ses

divi

ded

byto

tal

asse

tsor

zero

ifR

&D

ism

issi

ng.

Mat

uri

tyis

the

nu

mbe

rof

year

sto

mat

uri

tyof

the

issu

e.P

uta

ble

equ

als

one

ifth

eis

sue

incl

ude

sa

put,

and

calla

ble

equ

als

one

ifth

eis

sue

incl

ude

sa

call.

Secu

red

equ

als

one

ifth

ede

btis

sen

ior

secu

red

and

zero

oth

erw

ise.

Val

ues

inpa

ren

thes

esar

ep-

valu

es.




Figure 3. Frequency of event-risk covenants

Similarly, we examine univariate tests for the frequency of covenant use forbonds issued by firms incorporated in states with a 1.25 asset-to-debt payoutrestriction; however, because there are only 36 bond issues from firms incor-porated in such states, these results are not presented. However, in every case,firms incorporated in states with a 1.25 payout restriction use covenants lessfrequently, and, even with only 36 observations, the differences for negative-pledge covenants, sales leaseback covenants, and subsidiary sales leaseback cov-enants are statistically significant.13

4.3. Impact of State Law on Covenant Use: Regressions

Table 5 presents the results of a probit regression on whether the issue includesany covenants and a Poisson regression on the total number of covenants in thedebt issue. The independent variables include the total asset constraint and theantitakeover index (for the state in which the issuing firm is incorporated),controls for firm characteristics, controls for characteristics of the debt issue,and macroeconomic controls. For both the probit and Poisson regressions, thevariable for the total asset constraint is significant and negative. However, unlikein the raw correlations, the antitakeover index is positive and significant in bothcases. These results suggest substitution in the case of payout constraints butcomplementarity in the case of antitakeover statutes. Since the determining fac-tors for different types of covenants may not be similar, a Poisson regression

13 For instance, subsidiary sales leaseback covenants appear in only 11 percent of bond issues byfirms incorporated in a state with a 1.25 asset-to-debt payout restriction, compared with 44.1 percentof bond issues by firms incorporated in a state with a 0 asset-to-debt payout restriction.



Debt Covenants 195

Figure 4. Frequency of asset sales covenants

may be misspecified. We therefore consider the most commonly used payout,financing, event-risk, and asset-substitution covenants separately.

Table 6 presents the results of probit regressions on the payout and financingrestrictions used more than 10 percent of the time. These covenants include therestricted-payments covenant (which restricts repurchases as well as other po-tential payments to shareholders), subsidiary dividend-related payments cove-nant, the firm’s overall indebtedness, the subsidiary’s indebtedness, the negative-pledge covenant, and a cross-acceleration covenant. Consistent with a sub-stitution effect, incorporation in a state with a larger total asset constraint isnegatively associated with the usage of either the restricted-payments or thesubsidiary dividend-related payments covenant. In terms of economic impact,a marginal increase in the total asset constraint (roughly corresponding to achange from zero to one in the total asset constraint) corresponds to a 6.6percent decrease in the fitted frequency of the restricted-payments covenant anda 4.2 percent decrease in the use of the subsidiary dividend-related paymentscovenant, when all other variables are evaluated at their mean values. Becausethese covenants appear in 21.0 percent and 19.2 percent of issues, respectively,the fitted decreases correspond to relatively large changes.

For covenants that restrict the firm’s or the subsidiary’s total debt, there isless of a direct substitution with the total asset constraint. The coefficients forthe total asset constraint are negative for both the indebtedness and subsidiaryindebtedness regressions in Table 6; however, only the coefficient for subsidiaryindebtedness is significantly different from zero. Another financing-related cov-enant is the negative-pledge covenant, which requires that secured debt can be




Table 4

Covenant Use by State Law Restrictions

Covenant

State Law Restriction

Difference inMeans: No TotalAsset Constraint

versus TotalAsset ConstraintEquals One (t-

Statistic)No Total Asset

Constraint (SD)

Total AssetConstraint Equals

One (SD)

Payout:Restricted payments .247 (.431) .157 (.364) .090** (8.311)Subsidiary restricted payments .223 (.417) .147 (.354) .077** (7.310)

Financing:Indebtedness .262 (.440) .242 (.428) .020� (1.686)Subsidiary indebtedness .281 (.449) .241 (.428) .040** (3.320)Negative pledge .749 (.433) .622 (.485) .127** (9.915)Cross acceleration .553 (.497) .486 (.500) .067** (4.859)

Event risk:Poison put .264 (.441) .185 (.388) .079** (7.018)Consolidation/merger .890 (.313) .859 (.348) .031** (3.330)RDTP .018 (.133) .026 (.159) �.008� (�1.922)

Asset substitution:Asset sales restriction .888 (.315) .854 (.353) .034** (3.618)Asset sales clause .177 (.382) .099 (.298) .078** (8.511)Sales leaseback restriction .468 (.499) .422 (.494) .047** (3.423)Subsidiary sales leaseback

restriction .441 (.497) .385 (.487) .056** (4.117)

Note. Data are results of two-sided t-tests for correlation between covenant use and state law and arebased on 3,277 debt issues when payout restriction equals zero and 2,201 debt issues when payout restrictionequals one. Total asset constraint equals the minimum ratio of assets to liabilities for a payout. Unequalvariances are assumed for all tests. RDTP p rating decline triggers put.

� Significant at the 10% level.** Significant at the 1% level.

issued only if the current issue also is secured. If the firm’s total assets arerestricted, this covenant may be less necessary. We find a significant negativecoefficient for the total asset constraint in regressions for the use of the negative-pledge covenant. The marginal impact implies that an average firm incorporatedin a state with a total asset constraint equal to one is approximately 20 percentless likely to use this covenant than is a similar firm in a state with a total assetconstraint equal to zero. An additional covenant that considers the rights ofbondholders relative to other creditors is the cross-acceleration covenant. Thiscovenant allows bondholders to accelerate payments on their debt if any otherdebt has received accelerated payments owing to default. As with most otherfinancing covenants, a state’s total asset constraint is negatively and significantlyassociated with the use of cross-acceleration covenants.

We find that the antitakeover index is positively and significantly associatedwith most of these covenants. For instance, the coefficient for the antitakeoverindex is positive and significant at the 1 percent level for the restricted-paymentscovenant. At the margin, a 1-point increase in the antitakeover index corresponds



Debt Covenants 197

Table 5

Probit Regression on If Covenants Are Used and PoissonRegression on Number of Covenants Used

Covenants Used? Total Number of Covenants

Constant 2.216** (6.407) 2.785** (26.839)Total asset constraint �.377** (�2.986) �.220** (�6.655)Antitakeover index .127** (3.136) .051** (5.423)Market �.119* (�2.356) �.030* (�2.424)Log(issue amount) .111** (3.813) .112** (6.364)Firm size �.117** (�3.513) �.150** (�12.800)Leverage �.162 (�.702) .191** (3.052)Market-to-book ratio .014 (.187) .012 (1.075)R&D-to-assets ratio �.454 (�.244) .695* (2.269)Log(maturity) �.112* (�2.249) �.053** (�4.433)High yield �.120 (�1.026) �.345** (�10.909)Putable �.371* (�2.184) �.190** (�3.173)Callable .236** (2.716) .202** (10.001)Secured .012 (.056) �.142** (�2.783)Default ratet�1 (%) .051 (1.325) .003 (.303)Log(mergerst�1) .021 (.758) .004 (.562)

Note. Regressions are based on data for 5,514 debt issues by 1,444 firms. White heteroskedastically con-sistent t-statistics, adjusted for clustering by firm, are in parentheses. Total asset constraint is the minimumasset-to-debt ratio required for a distribution to shareholders, given the firm’s state of incorporation. Theantitakeover index gives the number of antitakeover statutes, given the firm’s state of incorporation (as inBebchuk and Cohen 2003), plus 1.0 if antigreenmail laws are in effect (that is, if the firm is incorporatedin Pennsylvania or Ohio, which have a recapture or disgorgement statute in effect after 1990). Market isthe size of the issue relative to the firm’s total debt. Log(issue amount) measures the size of the issue inmillions of dollars. Firm size equals the log of the firm’s total assets. Leverage is the firm’s debt dividedby total market value, at the year of issuance. Market-to-book ratio is the sum of the market value of thefirm’s equity plus the sum of the book value of the firm’s debt and preferred stock, all divided by totalassets. The R&D-to-assets ratio equals the firm’s research and development expenses divided by total assetsor zero if R&D is missing. Maturity is the number of years to maturity of the issue. High yield equals oneif the issue is rated less than BAA by Moody’s. Putable equals one if the issue includes a put, and callableequals one if the issue includes a call. Secured equals one if the debt is senior secured and zero otherwise.The default rate is for all bonds rated by Standard & Poor’s in the prior year, and log(mergerst�1) is thelog of the market value of mergers in the corresponding one-digit standard industrial classification codein the prior year.

* Significant at the 5% level.** Significant at the 1% level.

to an increase of 1.3 percent in the frequency with which this covenant is used,when all other variables are evaluated at their mean values.

Table 7 considers the correlation between state laws and antitakeover cove-nants. These include the poison put provision, the consolidation/merger restric-tion, and the put in the event of a rating decline. Although the RDTP covenantis used infrequently (only 2.1 percent of corporate bond issues include thiscovenant) and is not usually considered a pure takeover restriction, Kahan andKlausner (1993) discuss how this covenant more effectively protects bondholdersin the event of a takeover. They suggest that other antitakeover covenants, suchas the poison put, are more effective at entrenching management than they areat protecting bondholders. Instead of a substitution effect, we find that stateantitakeover laws are positively correlated with these antitakeover covenants.Our estimated coefficients are significant at the 1 percent level in the case of



Tab

le6

Use

ofP

ayou

tor

Fin

anci

ng

Cov

enan

ts

Res

tric

ted

Pay

men

ts

Subs

idia

ryD

ivid

end-

Rel

ated

Pay

men

tsIn

debt

edn

ess

Subs

idia

ryIn

debt

edn

ess

Neg

ativ

eP

ledg

eC

ross

Acc

eler

atio

n

Con

stan

t1.

838*

*(3

.829

)2.

376*

*(4

.999

)2.

434*

*(5

.380

)2.

155*

*(4

.784

).7

53*

(1.9

61)

2.75

9**

(6.7

77)

Tota

las

set

con

stra

int

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11**

(�4.

153)

�.5

01**

(�2.

877)

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66(�

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5)�

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*(�

2.22

2)�

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**(�

4.31

7)�

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*(�

2.04

3)A

nti

take

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inde

x.1

20**

(2.8

37)

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*(1

.997

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rm,a

rein

pare

nth

eses

.Tot

alas

set

con

stra

int

isth

em

inim

um

asse

t-to

-deb

trat

iore

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ra

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ribu

tion

tosh

areh

olde

rs,g

iven

the

firm

’sst

ate

ofin

corp

orat

ion

.The

anti

take

over

inde

xgi

ves

the

nu

mbe

rof

anti

take

over

stat

ute

s,gi

ven

the

firm

’sst

ate

ofin

corp

orat

ion

(as

inB

ebch

uk

and

Coh

en20

03),

plu

s1.

0if

anti

gree

nm

ail

law

sar

ein

effe

ct(t

hat

is,

ifth

efi

rmis

inco

rpor

ated

inP

enn

sylv

ania

orO

hio

,w

hic

hh

ave

are

capt

ure

ordi

sgor

gem

ent

stat

ute

inef

fect

afte

r19

90).

Mar

ket

isth

esi

zeof

the

issu

ere

lati

veto

the

firm

’sto

tal

debt

.Lo

g(is

sue

amou

nt)

mea

sure

sth

esi

zeof

the

issu

ein

mill

ion

sof

dolla

rs.

Firm

size

equ

als

the

log

ofth

efi

rm’s

tota

las

sets

.Le

vera

geis

the

firm

’sde

btdi

vide

dby

tota

lm

arke

tva

lue,

atth

eye

arof

issu

ance

.M

arke

t-to

-boo

kra

tio

isth

esu

mof

the

mar

ket

valu

eof

the

firm

’seq

uit

ypl

us

the

sum

ofth

ebo

okva

lue

ofth

efi

rm’s

debt

and

pref

erre

dst

ock,

all

divi

ded

byto

tal

asse

ts.

Th

eR

&D

-to-

asse

tsra

tio

equ

als

the

firm

’sre

sear

chan

dde

velo

pmen

tex

pen

ses

divi

ded

byto

tal

asse

tsor

zero

ifR

&D

ism

issi

ng.

Mat

uri

tyis

the

nu

mbe

rof

year

sto

mat

uri

tyof

the

issu

e.H

igh

yiel

deq

ual

son

eif

the

issu

eis

rate

dle

ssth

anB

AA

byM

oody

’s.

Pu

tabl

eeq

ual

son

eif

the

issu

ein

clu

des

apu

t,an

dca

llabl

eeq

ual

son

eif

the

issu

ein

clu

des

aca

ll.Se

cure

deq

ual

son

eif

the

debt

isse

nio

rse

cure

dan

dze

root

her

wis

e.T

he

defa

ult

rate

isfo

ral

lbo

nds

rate

dby

Stan

dard

&P

oor’

sin

the

prio

rye

ar,

and

log(

mer

gers

t�1)

isth

elo

gof

the

mar

ket

valu

eof

mer

gers

inth

eco

rres

pon

din

gon

e-di

git

stan

dard

indu

stri

alcl

assi

fica

tion

code

inth

epr

ior

year

.�

Sign

ifica

nt

atth

e10

%le

vel.

*Si

gnifi

can

tat

the

5%le

vel.

**Si

gnifi

can

tat

the

1%le

vel.



Debt Covenants 199

Table 7

Use of Event-Risk Covenants

Poison Put Consolidation/Merger RDTP

Constant 2.268** (5.378) 1.104* (2.106) �.310 (�.646)Total asset constraint �.420** (�2.732) �.257* (�2.024) �.227 (�.912)Antitakeover index .084* (2.262) .105** (3.114) .133* (2.068)Market �.062 (�1.272) �.056 (�1.229) �.081 (�1.450)Log(issue amount) .398** (4.150) .129** (3.633) .130 (1.463)Firm size �.513** (�8.625) �.176** (�4.369) �.238** (�3.869)Leverage 1.796** (7.464) .386 (1.562) .656� (1.909)Market-to-book ratio .027 (.555) �.048 (�.943) .113� (1.883)R&D-to-assets ratio .451 (.280) 1.943 (.855) �6.536 (�1.512)Log(maturity) �.186** (�2.905) �.124** (�2.833) .105 (1.455)High yield �1.128** (�11.106) �.161 (�1.175) �.168 (�1.100)Putable �.848* (�2.342) �.037 (�.262) �.159 (�.500)Callable .560** (5.474) .213** (2.783) �.463** (�3.137)Secured �.063 (�.411) �1.583** (�8.391) �.864* (�2.245)Default ratet�1 (%) �.052 (�1.549) .093* (2.386) �.056 (�1.170)Log(mergerst�1) �.079** (�2.965) .097** (2.928) �.073* (�2.355)

Note. Results are from probit regressions are based on 5,514 debt issues by 1,444 firms. White heteros-kedastically consistent t-statistics, adjusted for clustering by firm, are in parentheses. Total asset constraintis the minimum asset-to-debt ratio required for a distribution to shareholders, given the firm’s state ofincorporation. The antitakeover index gives the number of antitakeover statutes, given the firm’s state ofincorporation (as in Bebchuk and Cohen 2003), plus 1.0 if antigreenmail laws are in effect (that is, if thefirm is incorporated in Pennsylvania or Ohio, which have a recapture or disgorgement statute in effectafter 1990). Market is the size of the issue relative to the firm’s total debt. Log(issue amount) measuresthe size of the issue in millions of dollars. Firm size equals the log of the firm’s total assets. Leverage isthe firm’s debt divided by total market value, at the year of issuance. Market-to-book ratio is the sum ofthe market value of the firm’s equity plus the sum of the book value of the firm’s debt and preferred stock,all divided by total assets. The R&D-to-assets ratio equals the firm’s research and development expensesdivided by total assets or zero if R&D is missing. Maturity is the number of years to maturity of the issue.High yield equals one if the issue is rated less than BAA by Moody’s. Putable equals one if the issue includesa put, and callable equals one if the issue includes a call. Secured equals one if the debt is senior securedand zero otherwise. The default rate is for all bonds rated by Standard & Poor’s in the prior year, andlog(mergerst�1) is the log of the market value of mergers in the corresponding one-digit standard industrialclassification code in the prior year. RDTP p rating decline triggers put.

� Significant at the 10% level* Significant at the 5% level** Significant at the 1% level.

the general consolidation/merger covenant and at the 5 percent level for poisonputs and the RDTP covenant. In this case, instead of state laws substituting fordebt covenants, we find that firms with state antitakeover protection are morelikely to add further debt protection. This result is consistent with those firmsmost at risk of a takeover adding whatever additional protections that they can;that is, bondholders of firms more at risk of takeover may place a higher valueon protection from antitakeover covenants, and these firms also may be the onesmost likely to incorporate in a state with more protection. Alternatively, thisresult also may reflect how management that is more entrenched (as measuredby antitakeover statutes) adds additional takeover defenses at the expense ofshareholders to further entrench their position. Since Mansi, Maxwell, and Wald(2006) find little evidence that bondholders place value on these state antitakeoverlaws, the latter explanation seems more likely.




In an alternative specification, we add year dummy variables to all the re-gressions. Because the antitakeover index is correlated with time effects, theaddition of time dummy variables reduces the significance of the antitakeoverindex in the regressions for event-risk covenants. These results suggest that theantitakeover index is one possible cause in the increased use of antitakeovercovenants, but other time-varying effects may be responsible. Time dummyvariables do not significantly change our other results with respect to either thetotal asset constraint or the overall increased use of covenants by firms subjectto a higher antitakeover index.

In terms of cross effects, we find some evidence that issues subject to a morerestrictive total asset constraint are less likely to include event-risk protection,whereas issues subject to stronger state antitakeover laws are somewhat morelikely to include payout or financing restrictions. These results are consistentwith the findings of Lehn and Poulsen (1991), who suggested that firms thatuse a payout covenant are more likely to include event-risk covenants. Thus,stricter total asset constraints have some spillover effects with regard to other,less directly related protections. In alternative regressions, we also included thenumber of other covenants in the probit regressions. In all cases, the use of moreother covenants implied a higher probability of the addition of a covenant, whichsuggests a declining marginal cost for additional covenants.

We also consider the impact of these laws on asset sales restrictions in Table8. Restrictions on assets are related to additional financing restrictions becausethey often require the redemption of debt in the event of certain sales. Theserestrictions are split into several types based on a direct restriction on the saleof certain assets, a requirement that proceeds be used to redeem debt, or arestriction on sales leaseback transactions, in which an asset is sold and thenleased back by the company. In each case, the use of these covenants is negativelyassociated with the total asset constraint, which suggests that state payout re-strictions that limit the disposition of assets can substitute for some of thesemore specific limitations. In three of four cases, we also find that firms with ahigher antitakeover index use these covenants significantly more frequently. Con-sistent with the results of Chava, Kumar, and Warga (2005), this finding suggeststhat firms with managers who are more entrenched may be subject to additionalagency costs and that covenants may be needed to reduce these agency problems.

To further examine whether other agency controls could better explain cov-enant use, we include the index of Gompers, Ishii, and Metrick (2003) and dataon institutional blockholder ownership used by Cremers and Nair (2005) inthese regressions.14 However, since these variables are not significant in anyregressions, we do not include them in our final specification.

Overall, we find strong evidence for rejecting our first null hypothesis: statepayout restrictions are negatively correlated with the use of a number of similar

14 We thank Cremers and Nair (2005) for providing access to their data on institutional blockholderownership.



Tab

le8

Use

ofA

sset

-Res

tric

tion

Cov

enan

ts

Ass

etSa

les

Req

uir

eR

edem

ptio

nA

sset

Sale

sR

estr

icti

onSa

les

Leas

ebac

kR

estr

icti

ons

Subs

idia

rySa

les

Lea

seba

ckR

estr

icti

ons

Con

stan

t�

2.33

1**

(�4.

049)

1.00

2�(1

.922

).6

62(1

.549

).0

55(.

129)

Tota

las

set

con

stra

int

�.4

88**

(�3.

293)

�.2

49*

(�1.

981)

�.5

03**

(�2.

866)

�.5

98**

(�3.

711)

An

tita

keov

erin

dex

.044

(1.0

47)

.100

**(2

.982

).1

10*

(2.2

46)

.134

**(3

.052

)M

arke

t�

.071

*(�

1.98

0)�

.053

(�1.

157)

�.1

75**

(�5.

814)

�.1

76**

(�5.

764)

Log(

issu

eam

oun

t).4

87**

(7.5

68)

.129

**(3

.608

).2

58**

(3.6

86)

.373

**(5

.609

)Fi

rmsi

ze�

.466

**(�

8.57

8)�

.167

**(�

4.17

4)�

.206

**(�

5.51

2)�

.233

**(�

6.14

9)Le

vera

ge.8

41**

(3.4

98)

.417

�(1

.699

)�

1.30

8**

(�5.

220)

�1.

307*

*(�

5.13

4)M

arke

t-to

-boo

kra

tio

.009

(.18

5)�

.024

(�.4

51)

.101

(1.5

41)

.083

1.41

7)R

&D

-to-

asse

tsra

tio

�2.

557

(�1.

532)

1.29

4(.

592)

13.7

46**

(4.1

95)

11.6

16**

(4.3

27)

Log(

mat

uri

ty)

�.2

88**

(�4.

857)

�.1

29**

(�2.

980)

.126

**(2

.732

).1

21**

(2.6

37)

Hig

hyi

eld

�1.

401*

*(�

9.49

2)�

.179

(�1.

323)

.194

*(1

.977

).1

94*

(1.9

65)

Pu

tabl

e�

.743

(�1.

543)

�.0

12(�

.086

)�

.085

(�.5

93)

�.0

27(�

.180

)C

alla

ble

1.01

2**

(7.1

04)

.223

**(2

.936

)�

.067

(�.8

89)

�.0

07(�

.101

)Se

cure

d.0

28(.

190)

�1.

585*

*(�

8.49

6)�

.471

*(�

2.55

5)�

.411

*(�

2.30

3)D

efau

ltra

tet�

1(%

).1

29**

(3.3

21)

.094

*(2

.398

).0

50�

(1.8

56)

.029

(1.1

04)

Log(

mer

gers

t�1)

.224

**(5

.420

).0

98**

(2.9

45)

�.0

48*

(�2.

037)

�.0

33(�

1.40

0)

No

te.

Res

ult

sar

efr

ompr

obit

regr

essi

ons

base

don

5,51

4de

btis

sues

by1,

444

firm

s.W

hit

eh

eter

oske

dast

ical

lyco

nsi

sten

tt-

stat

isti

cs,

adju

sted

for

clu

ster

ing

byfi

rm,

are

inpa

ren

thes

es.

Tota

las

set

con

stra

int

isth

em

inim

um

asse

t-to

-deb

tra

tio

requ

ired

for

adi

stri

buti

onto

shar

ehol

ders

,gi

ven

the

firm

’sst

ate

ofin

corp

orat

ion

.T

hean

tita

keov

erin

dex

give

sth

en

um

ber

ofan

tita

keov

erst

atu

tes,

give

nth

efi

rm’s

stat

eof

inco

rpor

atio

n(a

sin

Beb

chu

kan

dC

ohen

2003

),pl

us

1.0

ifan

tigr

een

mai

lla

ws

are

inef

fect

(th

atis

,if

the

firm

isin

corp

orat

edin

Pen

nsy

lvan

iaor

Oh

io,

wh

ich

hav

ea

reca

ptu

reor

disg

orge

men

tst

atu

tein

effe

ctaf

ter

1990

).M

arke

tis

the

size

ofth

eis

sue

rela

tive

toth

efi

rm’s

tota

lde

bt.

Log(

issu

eam

oun

t)m

easu

res

the

size

ofth

eis

sue

inm

illio

ns

ofdo

llars

.Fi

rmsi

zeeq

ual

sth

elo

gof

the

firm

’sto

tala

sset

s.Le

vera

geis

the

firm

’sde

btdi

vide

dby

tota

lm

arke

tva

lue,

atth

eye

arof

issu

ance

.M

arke

t-to

-boo

kra

tio

isth

esu

mof

the

mar

ket

valu

eof

the

firm

’seq

uit

ypl

us

the

sum

ofth

ebo

okva

lue

ofth

efi

rm’s

debt

and

pref

erre

dst

ock,

all

divi

ded

byto

tal

asse

ts.

Th

eR

&D

-to-

asse

tsra

tio

equ

als

the

firm

’sre

sear

chan

dde

velo

pmen

tex

pen

ses

divi

ded

byto

tal

asse

tsor

zero

ifR

&D

ism

issi

ng.

Mat

uri

tyis

the

nu

mbe

rof

year

sto

mat

uri

tyof

the

issu

e.H

igh

yiel

deq

ual

son

eif

the

issu

eis

rate

dle

ssth

anB

AA

byM

oody

’s.

Pu

tabl

eeq

ual

son

eif

the

issu

ein

clu

des

apu

t,an

dca

llabl

eeq

ual

son

eif

the

issu

ein

clu

des

aca

ll.Se

cure

deq

ual

son

eif

the

debt

isse

nio

rse

cure

dan

dze

root

her

wis

e.T

he

defa

ult

rate

isfo

ral

lbo

nds

rate

dby

Stan

dard

&P

oor’

sin

the

prio

rye

ar,

and

log(

mer

gers

t�1)

isth

elo

gof

the

mar

ket

valu

eof

mer

gers

inth

eco

rres

pon

din

gon

e-di

git

stan

dard

indu

stri

alcl

assi

fica

tion

code

inth

epr

ior

year

.�

Sign

ifica

nt

atth

e10

%le

vel.

*Si

gnifi

can

tat

the

5%le

vel.

**Si

gnifi

can

tat

the

1%le

vel.




and less similar covenants. We also find some evidence for rejecting our secondnull hypothesis: antitakeover laws appear to be positively correlated with somecovenants, although this positive correlation is weakened when year dummyvariables are included in the regressions for event-risk covenants.

4.4. Control Variables and Covenants

A number of our control variables have an impact on the use of covenants,and we briefly review the theory and prior empirical findings related to thesevariables. Malitz (1986) hypothesizes and finds that smaller firms are more likelyto use covenants, higher-leverage firms are more likely to use covenants, andissues that are a larger proportion of the firm’s total debt are more likely tohave covenants attached. Consistent with her findings, we find that larger firmsare significantly less likely to include any of the covenants that we examine. Ourfindings on leverage are somewhat mixed because we use two control variablesfor leverage, a debt-to-market ratio and a dummy variable equal to one if thedebt is rated high yield (less than BAA by Moody’s). We find significant positivecoefficients for leverage in nine regressions and significant negative coefficientsin three regressions. We also find significant coefficients for the high-yield variablein most cases, which suggests a nonlinear relation between leverage and covenantuse. In contrast to Malitz (1986), we find negative coefficients in four regressionsfor the market variable, equal to the size of the issue relative to the firm’s totaldebt. We also control for the log of issue amount, hypothesizing that larger issuesize may have an impact on covenant choice. The fixed costs of negotiatingcovenants may be less significant if the total size of the deal is larger; thus, weexpect to find a positive coefficient for this variable. We find that the coefficientfor deal size is positive and significant in all our regressions, with the exceptionof that for the RDTP covenant (used in only a small fraction [2.1 percent] ofthe issues that we examine).

Nash, Netter, and Poulsen (2003) hypothesize and find that firms with greatergrowth options may prefer the financial flexibility implied by fewer covenants.As in their regressions, we include market-to-book and R&D-to-assets ratios asadditional control variables. We find that the R&D-to-assets ratio variable hasa negative coefficient for all the financing covenants, with the exception of thenegative-pledge covenant. (Nash, Netter, and Poulsen [2003] find similar results.)Use of R&D is not significantly related to the use of event-risk protection, butfirms with a higher R&D-to-assets ratio are more likely to include sales leasebackcovenants. The market-to-book ratio variable is not significantly correlated withuse of most of the covenants that we consider, although it is positively correlatedwith indebtedness (at the 10 percent level) and with the RDTP covenant.

Agency problems are more likely to occur when the debt’s maturity is longer,and we therefore anticipate that covenants will be more frequent in these cases.Similarly, we anticipate that a bond issue with a put feature may reduce agencyconflicts and make protective covenants less likely. However, we find significant



Debt Covenants 203

negative coefficients for maturity in nine of our probit regressions and significantpositive coefficients in the regressions for negative-pledge covenants and salesleaseback covenants. Consistent with our expectations, the variable for putablebond flag has negative coefficients in all our regressions, and five of these co-efficients are significant.

Bodie and Taggart (1978) suggest that callable bonds would need covenantsless frequently, since the call can act to reduce agency conflict. However, we findthat callable bonds are more likely to include most of the covenants that weconsider. We find significant positive coefficients in nine of our regressions anda significant negative coefficient for the RDTP covenant.

Debt features, such as maturity and whether the debt includes a call or put,may be considered part of the same bargaining process that produces covenants;thus, these features may be endogenous to the covenant decision. We thereforeran all our regressions after excluding these three variables and found little impacton the state law coefficients in these alternative specifications.

Last, we consider macroeconomic effects, such as the default rate in the prioryear and the dollar value of merger activity in the firm’s industry in the prioryear. Lehn and Poulsen (1991) show that event-risk protection increased afterthe increase in merger activity in the 1980s. We therefore expect a positivecoefficient for both default rate and merger variables. Instead, the coefficientsfor default rate are rather mixed, with significant positive coefficients for theconsolidation/merger covenant and three of the asset sales restrictions but asignificant negative coefficient for the cross-acceleration covenant. Similarly, thelagged variable for merger activity provides mixed results, with significant neg-ative coefficients for the poison put and RDTP covenants but a significant positivecoefficient for the consolidation/merger covenant.

5. Conclusion

We analyzed the use of debt covenants in relation to state laws to determinewhether state laws are substitutes for or complements to (or neither) specificdebt restrictions. We find that state laws that restrict payouts appear to substitutefor a variety of debt covenants, including restrictions on payments, negative-pledge covenants, and asset-substitution covenants. Stronger payout restrictionsalso diminish the likelihood of the use of antitakeover covenants such as poisonputs, possibly because these restrictions reduce the benefits gained from theaddition of any covenants to the debt contract.

These findings are consistent with a costly contracting explanation of covenantchoice, and they demonstrate how laws can substitute for individual contracts.Although state payout laws also may reduce the financial flexibility of certainfirms, a variety of legal environments exist in the United States, and firms canreincorporate in states with fewer restrictions if these prohibitions become overlybinding.

We also find some evidence that the number of antitakeover statutes in the




firm’s state of incorporation is positively correlated with the use of antitakeovercovenant defenses. This finding is consistent with managers of firms who aremore entrenched being able to add covenants that reduce the probability oftakeover. In addition, as discussed by Gompers, Ishii, and Metrick (2003), anti-takeover laws may reduce the effectiveness of a firm’s governance. Firms withgreater governance problems may be more subject to agency issues, and theirdebt may include more covenants in order to reduce these agency problems.

Although state laws, firm characteristics, and issue characteristics help to ex-plain the use of debt covenants, their use also varies between years in a way thatcannot be fully explained by the macroeconomic variables, overall default rates,and takeover activity that we considered. While the interaction between statelaws and covenants presented here extends our understanding of covenant choice,some portion of covenant usage may be explained best by legal innovation andtrends among corporate lawyers.

Appendix

Table A1

Definitions of Frequently Used Covenants

Covenant Category Description

Dividend-relatedpayments

Payout Indicates that payments made to shareholders or otherentities may be limited to a certain percentage of netincome or some other ratio

Restricted payments Payout Restricts the issuer’s freedom to make payments toshareholders and others; may restrict the purchasing orredemption of any capital stock of the company or ofany warrants, rights, or options to purchase or acquireshares of any class or the making of any principalpayment prior to any schedules maturity

Subsidiary dividend-related payments

Payout Limits subsidiaries’ payment of dividends to a certainpercentage of net income or some other ratio; forcaptive finance subsidiaries, this provision limits theamount of dividends that can be paid to the parentfirm; this provision protects the bondholder from aparent firm draining assets from its subsidiaries

Indebtedness Financing Restricts the user from incurring additional debt bylimiting the absolute dollar amount of debt outstandingor the percentage of total capital

Subsidiary indebtedness Financing Restricts the total indebtedness of subsidiariesNegative pledge Financing Prevents the issuance of secured debt unless the issuer

secures the current issue on a pari passu basisCross acceleration Financing Protects bondholders by allowing them to accelerate their

debt if any other debt of the organization has beenaccelerated owing to a default event

Asset sales restriction Asset Restricts the ability of an issuer to sell assets orrestrictions on the issuer’s use of the proceeds from thesale of assets; such restrictions may require the issuerto apply some or all of the sales proceeds to therepurchase of debt through a tender offer or call



Debt Covenants 205

Table A1 (Continued)

Covenant Category Description

Sales leasebackrestriction

Asset Restricts the issuer to the type or amount of propertyused in a sales leaseback transaction and may restrictits use of the proceeds of the sale

Subsidiary salesleaseback restriction

Asset Restricts subsidiaries from selling and then leasing backassets that provide security for the bondholder; thisprovision usually requires that assets or cash equal tothe property sold and leased back be applied to theretirement of the debt in question or used to acquireanother property to increase the debtholders’ security

Asset sales requireredemption

Asset Requires the issuer to use net proceeds from the sale ofcertain assets to redeem the bonds at par or at apremium; this covenant does not limit the issuer’s rightto sell assets

Consolidation/merger Takeover Indicates that a consolidation or merger of the issuer withanother entity is restricted and often requires that thesurviving corporation assumes all debts; thus, thiscovenant is not binding for most acquisitions

Poison put Takeover Upon a change of control in the issuer, bondholders havethe option of selling the issue back to the issuer; otherconditions may limit the bondholder’s ability toexercise the put option; poison puts often are usedwhen a company fears an unwanted takeover, thusensuring that a successful hostile-takeover bid willtrigger an event that substantially reduces the value ofthe company

RDTP Takeover Rating decline triggers put; a decline in the credit ratingof the issuer (or issue) triggers a bondholder putprovision

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