Do Creditor Rights Increase Employment Risk? Evidence from Loan Covenants

Antonio Falato is an economist and Nellie Liang is a director at the Federal Reserve Board. This post is based on a recent article by Mr. Falato and Ms. Liang.

In our article, Do Creditor Rights Increase Employment Risk? Evidence from Loan Covenants, which was recently accepted for publication in the Journal of Finance, we provide evidence that binding financial contracts have a large impact on employees and are an amplification mechanism of economic downturns.

A fundamental question in both finance and macroeconomics is whether financing frictions and, more broadly, firm financial conditions, have real effects. Existing empirical research on this question focuses primarily on corporate investment (e.g., Whited (1992), Rauh (2006), and Chava and Roberts (2008); Benmelech, Bergman, and Seru (2011) is a recent exception that instead focuses on employment). However, a long tradition of theoretical research in both macro (e.g., Bernanke and Gertler (1989)) and corporate finance (e.g., Berk, Stanton, and Zechner (2010)) as well as the exceptional job losses in the aftermath of the financial crisis and in the Great Recession of 2008 and 2009 highlight the potential importance of financing effects on employment, which raises two important empirical questions: Are corporate financing and labor policies related, and how? The goal of our paper is to make progress on these questions by examining the response of corporate labor policies to loan covenant violations.

There are several reasons why loan covenant violations provide a unique opportunity for studying the employment impact of financing. First, violations give creditors the right to demand immediate repayment and withhold further credit. Thus, they provide a specific channel through which financing can impact employment, whereby firms may lay off employees in order to improve net cash flows and appease creditors who are concerned about the value of their claims. Second, violations are frequent and rarely lead to outright default, suggesting that they are well suited to study employment effects outside of bankruptcy. Third, because of their discrete nature, violations enable us to employ a regression discontinuity design analogous to that in Chava and Roberts (2008), which helps to overcome the identification challenge of distinguishing financing effects from changes in firm fundamentals and outlook. Finally, violations allow us to examine time-series variation in the effect of financing on employment, which has important implications for the academic and policy debate on the influence of financing on macroeconomic stability.

Using a regression discontinuity design, we document robust evidence that there are sharp and substantial employment cuts following loan covenant violations, when creditors gain rights to accelerate, restructure, or terminate a loan. Our baseline estimates indicate that covenant violations lead to a sharp drop of about 13 log points or about 10% of the workforce in a given year, an economically significant effect that corresponds to a quartile of the within-firm distribution of log employment. Violations also lead to an increase in the likelihood of a layoff of about three percentage points, which is economically significant relative to the 9% unconditional probability of a layoff and suggests that employment reductions are not due to just voluntary departures. These results are robust to restricting the sample to those observations that are “close” to the covenant threshold, where violations can plausibly be considered a “quasi-random” treatment, following an approach similar to Chava and Roberts (2008). They also hold up to a variety of falsification and sensitivity tests, which include using alternative measures of employment and covenants. Taken together, our evidence suggests that financial distress entails large costs for employees.

The employment impact of violations varies predictably with various proxies for a firm’s financial condition and for the relative bargaining strength of creditors versus the firm and its employees. Employment cuts subsequent to violations are as deep as 17 log points for highly levered firms and for firms with no credit rating, which have fewer alternative sources of external financing, as well as for firms in which labor has less bargaining power, based on industry-level measures of union membership and coverage. Thus, the acceleration and termination rights granted upon violation have more bite on employment when creditors are relatively stronger and labor is weaker. Employment cuts also are deeper for firms in industries with relatively high domestic concentration and low import penetration, suggesting that violations may help mitigate “quiet-life” type agency distortions that make managers reluctant to fire employees (see Bertrand and Mullainathan (2003) and Atanassov and Kim (2009)). Investment cuts also vary predictably with labor bargaining power and are bigger when labor is stronger, which highlights an interesting implication of our findings, namely, the substitutability between labor and capital.

The impact of violations on employment also varies predictably in the time series, with employment cuts following violations being outsized in bad times and in industry downturns, when employees have fewer alternative job opportunities. For example, violations lead to employee cuts that are more than twice as large in NBER recession periods as in non-recession periods. The combination of a higher likelihood of violations and bigger job cuts when violations occur leads to an estimated expected impact on employment that is about three times larger in recession than in non-recession times. Since employment cuts are concentrated exactly in those times when creditors have the most bargaining power and labor has the least, the time-series evidence corroborates our interpretation that the impact of violations reflects the relative strength of creditor and labor rights. The time-series results suggest that financial covenants are an important amplification mechanism of economic downturns since violations are both more likely to occur and, if they occur, have an even larger adverse impact on employment in bad times.

In our final set of tests, we examine whether loan prices impound labor rights, that is, whether firms face a higher cost of capital when labor is stronger. Our identification is a regression discontinuity design that exploits the requirement of U.S. labor laws that, in order to create a new labor bargaining unit, an election must be held in which workers vote by majority rule for or against union representation. In a sample of elections that took place in the U.S. between 1985 and 2010 with pricing information from Dealscan and accounting data from Compustat, we find that union wins are reliably associated with higher spreads on loans originated within two years of the election. The effect of unionization is particularly large for low-rated and unrated borrowers, for which the allocation of bargaining rights should be expected to matter the most because these borrowers have higher risk of financial distress. This result is robust to a matched sample methodology and continues to hold when we consider “close” elections to address potential concerns about the anticipation of election outcomes and omitted variables. The evidence together suggests that there is a tradeoff between credit pricing and the allocation of control rights, as creditors demand ex-ante compensation when the ex-post bargaining power of employees is higher.

Overall, our findings have several important implications. First, we contribute to the literature on loan covenants that grant rights to creditors upon violation (Chava and Roberts (2008), Roberts and Sufi (2009), and Nini, Smith, and Sufi (2009, 2012)) and, more broadly, to the literature on the real effects of financing frictions (e.g., Whited (1992) and Rauh (2006)), by examining firm labor policies. Second, while prior evidence shows that bankruptcies entail costs for workers, we show that there are real effects of finance on employment also outside bankruptcy. At about 10%, the magnitude of our estimate of the average employment decrease following a loan covenant violation is sizable but on the low end of the range of existing estimates for other financial distress events, which include estimates that average employment decreases by 27% around a bond default (Agrawal and Matsa (2013)) and by 50% or more around a bankruptcy filing (Hotchkiss (1995) and Graham et al. (2013)). Third, an important by-product of our approach is that we offer direct evidence that binding financial covenants are a mechanism for the credit supply channel of theories such as Bernanke and Gertler (1989) and, more recently, Khan and Thomas (2013), as job losses due to binding financial covenants are larger in economic downturns. As such, loan covenant violations operate as an amplification mechanism of an initial negative shock to the real economy, since a deterioration in firms’ financial conditions has an even larger effect on employment in bad times. The finding that there are sizable costs of financial distress even outside bankruptcy can help explain why economic downturns lead to large job losses even when they do not trigger a similarly large wave of corporate bankruptcies, as in the case of the Great Recession of 2008 and 2009.

The full article is available for download here.

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