Chapter 11 Bankruptcy and Loan Covenant Strictness

By Garence Staraci (Yale University, School of Management) and Meradj Pouraghdam (Institut d’Etudes Politiques de Paris (Sciences Po))

In syndicated loan contracts, a borrower’s failure to comply with a covenant restriction triggers a default, and as such the lender’s right to terminate the loan (or foreclose on assets which are serving as collateral). The likelihood that such a covenant violation would occur depends on the loan covenant strictness, which measures how stringent covenant restrictions are on the borrower. Rationales for creditors to demand strict covenants include the pricing of default risk and the allocation of bargaining power in more frequently triggered renegotiations.

In this paper, we propose a new determinant of covenant strictness: the degree of creditor friendliness in Chapter 11 bankruptcy practices. This new determinant dictates that the more debtor(creditor)-friendly the bankruptcy practice is, the more creditors will seek to increase(decrease) their level of loan monitoring outside of bankruptcy through an adjustment in covenant strictness. Borrowers would agree on stricter covenants in exchange for a lower loan spread, and vice-versa. We demonstrate that covenants are not only included in order to shift the governance from debtors to creditors once they are breached, but to also potentially address the concern creditors might have about how the bankruptcy law is practiced if the borrowing firm goes bankrupt.

This paper finally relates to the recent recommendations of the American Bankruptcy Institute Commission to Study the Reform of Chapter 11, which has investigated the creditor friendliness of the corporate bankruptcy practice. Our results imply that any amendment to the Code that would limit the creditors’ rights during bankruptcy would have an impact on the pricing of syndicated debt through a modification of the covenant structure of loan contracts.

The full paper is available here.