Review of Quantitative Finance and Accounting, 21: 157–177, 2003
2003 Kluwer Academic Publishers. Manufactured in The Netherlands.
Bondholder-Stockholder Conﬂict: Contractual
Covenants vs. Court-Mediated Ex-Post Settling-Up
P. V. VISWANATH
Lubin School of Business, Pace University, 1 Pace Plaza, New York, NY 10038, USA
Tel.: (212) 346-1817, Fax: (212) 346-1573.
E-mail: firstname.lastname@example.org; Web: http://webpage.pace.edu/pviswanath
Graduate School of Management, Rutgers University, 92 New Street, Newark, NJ 07102, USA
Abstract. Bondholders have failed to respond to corporate restructurings by demanding more protective pro-
visions; in fact, the trend has been toward fewer rather than more restrictive covenants. In this article, we model
the use of contractual covenants as a trade-off between contract implementation costs and deadweight efﬁciency
losses. We ﬁnd that the current lack of restrictive covenants is arguably consistent with rational investor behavior.
The key to this conclusion is the recognition that there is an implicit ex-post settlement component to debt con-
tracts, which is enforced by the courts. A look at the behavior of the courts and of bondholders supports our point
Key words: bondholder-stockholder conﬂict, bond covenants, agency problems, judicial intervention, implicit
JEL Classiﬁcation: G32, G34, K12, K22
In the aftermath of the 1980s wave of corporate capital restructurings through leveraged
buyouts and other means, bondholders did not respond by demanding more protective
provisions in their contracts with corporations. In fact, if anything, the trend was in the
other direction, toward fewer rather than more restrictive covenants.
that restrict additional debt and limit dividend payments, which had declined to negligible
levels by the mid-1980s, did not rebound.
Sinking funds designed to ensure debt repay-
ment, which had appeared in the overwhelming majority of new issues through 1987, have
appeared in only around 5% of new issues since then. Overall, bondholders are not demand-
ing more protection now than they were during the mid-1980s; and compared to the period
they are demanding less.
The current low level of bond covenants presents an intriguing puzzle. Why did the wave
of corporate restructurings, some of them with negative consequences for bondholders,
not produce a rush to protective provisions? In this article, we suggest that corporate and
bondholder actions can be explained on the basis of an implicit component in debt contracts