Shareholder-management conflict and event-risk covenants

Event-risk covenants (ERCs) constitute a class of bond covenants that extend event-risk protection to bondholders. Event risk is the risk of a decline in the credit quality of an issuer resulting from its takeover, leveraged recapitalization, or similar restructuring. Two competing hypotheses of ERCs are tested in this study, the Shareholder Interest Hypothesis and the Management Entrenchment Hypothesis. The Shareholder Interest Hypothesis states that managers use ERCs primarily to benefit shareholders by reducing the true costs of borrowing. The Management Entrenchment Hypothesis states that managers use ERCs primarily to raise costly barriers to takeover, that is, to entrench.; The results of this study indicate that at least one type of ERC (the nonwaivable poison put) decreases shareholder wealth, on average. The evidence suggests that shareholders of firms that use ERCs would not be harmed by issuances of unprotected debt. However, shareholders of these firms are harmed by issuances of ERC-protected debt. Also, the results indicate that debt issuers which suffer greater shareholder-management conflict are more likely to use nonwaivable poison puts. After controlling for the effects of industry and firm size, a positive relationship is found between estimated free cash flow and the probability of nonwaivable poison put use. Overall, the evidence presented in this study is consistent with the Management Entrenchment Hypothesis.