Debt Covenants after Bankruptcy

We provide evidence that the resolution of financial distress through bankruptcy has implications for the subsequent covenant design of loan contracts. We document that lenders prefer performance covenants and put less weight on capital covenants in loans agreed in the year after the firm’s emergence from bankruptcy. To keep control over excessive leverage after bankruptcy, lenders compensate the decrease in capital covenants with a greater use of non-accounting and liquidity covenants that directly restrict the firm’s investment and financing activities. We also find that the changes in covenant preferences post-bankruptcy are more pronounced when creditors gained greater control rights through the bankruptcy process, by means of debtor-in-possession financing. Our results suggest that the significant transfer of rights to creditors arising in bankruptcy, vis-à-vis voluntary debt restructuring, has implications for loan contracting after the bankruptcy; and that creditors shift their preference towards mechanisms that elicit proactive monitoring over the firm’s performance rather than mechanisms that align interests with shareholders