CEO performance-vesting equity incentives and the role of accounting-based covenants in debt contracting

Abstract

This paper investigates how CEO performance-vesting equity awards affect the role of accounting-based covenants in debt contracting. When CEOs have equity awards contingent on accounting performance, accounting-based debt covenants can be more effective because covenant violations become more costly to CEOs. Anticipating the enhanced effectiveness of covenants, creditors lower the interest rate for tighter covenants when initiating the loan. I find consistent empirical evidence that the interest rate and covenant tightness are more negatively associated for CEOs with greater performance-vesting incentives before the loan maturity. This negative relationship only applies to performance covenants rather than capital covenants. Finally, I document that the impact of CEOs’ performance-vesting incentives on the debt contracting design is more prominent in loans unsecured by collateral and participated by more lenders, for CEOs with low severance pay, and for borrowers with higher earnings volatility.