Chapter 11 Bankruptcy and Loan Covenant Strictness

Abstract

We propose a new determinant of covenant strictness in syndicated loan contracts: the degree of creditor friendliness of Chapter 11 bankruptcy practices. This new channel dictates that the more debtor(creditor)-friendly the bankruptcy practice is, the more creditors will seek to increase(decrease) their level of loan monitoring outside of bankruptcy through an adjustment in covenant strictness. Borrowers would agree on stricter covenants in exchange for a lower loan spread, and vice-versa. We first theoretically illustrate our claim by providing a framework linking creditor control inside and outside of bankruptcy. We next empirically show that judicial discretion is the primary driver of bankruptcy outcomes. This finding allows us to use several debtor or creditor-friendly Chapter 11 bankruptcy practice proxies as instruments in order to test our channel, with a focus on the U.S. manufacturing sector. Using both covenant tightness and covenant intensity as proxies for covenant strictness, we show that our legal channel not only impacts covenant strictness but also ultimately accounts for a significant fraction of the total cost of credit.