Loans and the Law

ZHANG, Jieying | HUNG, Mingyi | HONG, Hyun A.

Debt covenants are an important monitoring mechanism that govern cash-flow rights and control rights between borrowers and lenders. Although it is believed that enforcement and property rights are primary determinants of a firm’s ability to write comprehensive contracts, there is currently little evidence supporting if or how these legal institutions affect the use of covenants. To fill this gap, a recent study by Hong, Hung, and Zhang examined how the use of covenants worldwide responds to legal institutions.

Expecting that the effectiveness of covenants depends on the strength of law enforcement to resolve property and contract disputes, the authors predicted that covenants are more prevalent in countries with robust law enforcement. Moreover, assuming that weaker rights granted to creditors increases the risk of expropriation and thus the demand for covenants, they also assumed that covenants are more common in countries with weaker creditor rights. To investigate this, as well as construct the measure of the use of debt covenants worldwide, they used the DealScan database and looked at global bank loan contracts between 1990–2009 (this period was chosen because data coverage outside of the US in the database is relatively sparse before 1990). In order to minimise any measurement errors of coding missing covenant data, the study restricted its sample to loans with non-missing covenant information and control for lender-country fixed effects to better represent the variation in reporting practices across countries.

Based on syndicated loans in 36 countries and by regressing the covenant measure on law enforcement and creditor rights, Hong, Hung, and Zhang confirmed that loan covenants are indeed more common in countries with stronger law enforcement and weaker creditor rights. Additional findings also supported the authors’ hypotheses. First, the study found that covenants are negatively associated with creditor rights only in countries with robust law enforcement. In other words, the use of debt covenants increases with law enforcement and decreases with creditor rights. Second, it was determined that “the substitute effect between covenant use and creditor rights exists mainly in countries with strong law enforcement, and the effect of legal institutions on covenants is primarily driven by covenants that preserve seniority and capital”. Third, it was revealed that the results remained qualitatively the same after controlling for an extensive list of other country-level and loan-level variables, the selection bias in the samples, and various other design choices. Finally, examining the link between the use of covenants and accounting conservatism, the study also found that country-level accounting conservatism is positively related to the use of covenants, while strong creditor rights weaken this association.

Contributing to the literature on financial reporting practices, this is the first study to provide comprehensive evidence on the use of debt covenants worldwide. The findings offer valuable “insights into why covenants are used and how they are selected across countries, and therefore address a fundamental question about the role of accounting numbers in debt contracting”. Hong, Hung, and Zhang are also the first to document how the use of loan covenants responds to legal institutions that protect creditors’ rights, thereby extending the literature on these rights in a private debt setting. However, the authors are quick to point out that it is hard to completely resolve the endogeneity problem in their setting, and that while they attempted to control for as many firm and country characteristics as possible, the relationships should be seen more as associations than causal links.

HUNG, Mingyi

Head, Fung Term Professor of Accounting, Chair Professor