Finance and Economics Discussion Series

Do Creditor Rights Increase Employment Risk? Evidence from Debt Covenants

Antonio Falato and Nellie Liang
2012-42

Abstract: This paper studies whether financial contracts exacerbate or mitigate agency conflicts among stakeholders. We consider a specific contractual provision, debt covenants, and examine how, by allocating control rights between shareholders and debtholders, debt covenants affect the employment relationship. We analyze the role of covenants in both public (bonds) and private (loans) debt contracts. For public debt covenants, we estimate dynamic employment equations and find a significant negative effect of leverage on employment only for firms with relatively high covenant protection. For private debt covenants, we use a regression discontinuity design and document sizable job cuts following a covenant violation. Overall, these findings suggest that creditor rights increase employment risk. As such, they complement the recent literature on financial covenants by showing that covenants affect a broader set of operating decisions than previously recognized. Moreover, the results contribute to our understanding of the consequences of the allocation of control rights within the firm by identifying a specific risk-shifting channel from debtholders to employees.

Keywords: Covenant violations, employment