The market response to implied debt covenant violations

Previous research documents a negative stock price reaction to the announcement of a debt covenant violation (DCV). However, managers of firms that violate a covenant often obtain waivers and renegotiate debt contracts with lenders before the SEC requires them to disclose a violation. Firms therefore may not report some covenant violations, and prior research has not documented their cost to shareholders. Exploiting the fact that over half of all private debt contracts contain a debt covenant reliant on some variation of accounting earnings, I construct a sample of firms with debt contracts that contain at least one earnings-based covenant. Combining earnings-based-covenant contract values from debt agreements with information publicly available at the earnings announcement date, I predict firms in violation of a debt covenant and provide evidence that equity investors react negatively to these implied violations, regardless of whether managers ever disclose that a violation occurred. In additional tests, I find no evidence of a negative stock price reaction to a firm disclosure of a DCV that market participants could infer from previously reported earnings, but I demonstrate that equity investors do react to the disclosure of a violation of a balance-sheet covenant that would not have been inferable. This study complements previous research on DCVs by documenting the costliness to shareholders of violations subsequently resolved with lenders but not disclosed.