Strategic Disclosure and Debt Covenant Violation

Abstract

This study examines how managers change their forecasting behavior as a debt covenant violation (DCV) approaches. We find that management forecasts are more optimistic in the quarter before a DCV, and this result is stronger when firms face a higher risk of shifting control rights to lenders in the event of a DCV. Furthermore, we find that managers combine their forecast optimism with actions that are favorable to shareholders but would likely be curtailed by lenders after the DCV. Lastly, we find managers who are more optimistic in their forecasts are less likely to be replaced after a DCV. Overall, our results are consistent with managers changing their disclosure behavior in an attempt reduce lenders’ awareness of an impending DCV, and thus, buy themselves time to take actions favorable to equity investors.