Covenant Violation and Operational Efficiency

We examine the impact of covenant violation on corporate operational efficiency. Using aggregate measures of operational efficiency developed by Demerjian et al. (2012), we find that covenant violations are negatively associated with operational efficiency, suggesting lower operational efficiency in firms violating a debt covenant. This finding is robust to alternative definitions of operational efficiency and various model specifications to address potential endogeneity issues. Further analysis shows the negative effect of covenant violation on operational efficiency is alleviated in firms with weaker governance ex-ante, indicating that creditors’ monitoring can constrains managerial opportunistic actions. Moreover, covenant-violating firms invest less in capital and labor than the levels justified by the economic fundamentals, consequently leading to lower operational efficiency in these firms