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Managerial Stock Ownership and Debt Covenants

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 Managerial Stock Ownership and Debt Covenants

Abstract

This study examines the role of managerial ownership in determining the number and

types of debt covenants imposed on corporate bonds and the effect of debt covenants on the

relation between managerial ownership and cost of debt. We find that managerial stock

ownership is positively associated with the number of debt covenants imposed on corporate

bonds, particularly dividend payout and accounting-based restrictive covenants. We also find

that the above positive relation is more pronounced for firms with low growth opportunities,

where agency costs between shareholders and managers are high. Finally, we show that

restrictive debt covenants attenuate the positive relation between managerial stock ownership

and the yields on newly issued bonds, indicating that restrictive debt covenants mitigate debt

holders’ concerns over a closer alignment of interests between managers and shareholders.

Overall, our findings indicate that managers increase the use of debt covenants when their

interest is more aligned with the interest of shareholders; the use of debt covenants in turn

reduces the cost of debt.

Keywords: managerial stock ownership, debt covenants, growth opportunities, cost of debt

JEL Classification: D82, G32, G34.

1
 Managerial Stock Ownership and Debt Covenants

1. Introduction

This study examines how managerial ownership affects the number and types of debt

covenants imposed on corporate bonds, and in turn whether debt covenants affect the relation

between managerial ownership and cost of debt. It is well documented in the finance literature

that the use of debt can alleviate the agency problems between shareholders and managers (e.g.

Jensen and Meckling 1976; Jensen 1986; Stulz 1990; Hart and Moore 1995), although the use of

debt gives rise to conflicts of interest between shareholders and debt holders. Prior studies (e.g.,

Myers 1977; Smith and Warner 1979; Barnea et al. 1980; Beneish and Press 1993; Chen and

Wei 1993; Billett et al. 2007) examine how debt features, such as maturity and restrictive

covenants, are used to address the conflicts of interest between shareholders and debt holders.

These studies implicitly assume that managers make optimal choices on behalf of shareholders

and debt holders impose certain debt features to protect their own interests.

Recent studies examine the role of managerial ownership in determining debt contracting

features. Datta et al. (2005) examine the role of managerial incentives in determining debt

maturity. They find that managerial stock ownership is negatively associated with debt maturity

and that managers with low stock ownership use longer maturity debt even when the liquidity

risk of their firms is low. Their finding indicates that managers have incentives to choose optimal

financing choices only when their interest is aligned with that of shareholders. Begley and

Feltham (1999) find that both dividend and additional borrowing covenants are positively

associated with the ratio of CEO equity holdings to cash compensation and the fraction of equity

2
held by the CEO. This finding suggests that managerial compensation incentives play an

important role in determining specific types of restrictive debt covenants. This positive

association, however, is also consistent with an alternative explanation, that is, debt holders have

concerns over a closer alignment of manager and shareholder interest and therefore impose more

restrictive covenants to protect their interests. Chava et al. (2010) provide evidence that

managerial entrenchment1 is positively associated with investment restrictions that constrain

management’s propensity for “empire building” but is negatively associated with dividend

payout and takeover related restrictions that limit cash payout. Their finding suggests that

entrenched managers may not always pursue shareholders’ best interest and can aggravate or

mitigate debt holders’ risks.

Prior research thus provides two different views on the relative roles of debt holders and

managers in determining the number and types of debt covenants imposed on corporate bonds.

The traditional view suggests that debt holders impose debt covenants to prevent shareholders

from opportunistic actions under the assumption that manager and shareholder interest is

perfectly aligned. However, imposing restrictive debt covenants to firms may not always be in

the interest of debt holders (Smith and Warner 1979) because these covenants could constrain

managers’ ability to implement policies that could improve firms’ operational position and

reduce default risk. Hence, debt holders may not impose restrictive debt covenants unless there is

serious agency risk from opportunistic investors and managerial moral hazard (Chava et al.

2010). The other view, however, suggests that debt holders have no ex ante preferences with

respect to debt covenants and firms’ managers play an important role in determining the number

1
Chava et al. (2010) use several proxies for management entrenchment, including long CEO tenure, high cash
compensation ratio, CEO duality, large external shareholders, high institutional shareholding, and high Governance
index.
3
and types of restrictive debt covenants (Begley and Feltham, 1999)2. Both views predict a

positive association between managerial stock ownership and restrictive debt covenants, but this

positive association can arise from the agency costs between managers and shareholders or the

conflicts of interest between shareholders and debt holders.

This study attempts to shed light on these two competing views by investigating how the

relation between managerial stock ownership and the number and types of restrictive debt

covenants imposed on corporate bonds varies with a firm's growth opportunities, a proxy for the

underlying agency costs between managers and shareholders and conflicts of interest between

shareholders and debt holders. Prior studies (e.g., Myers 1977; McConnell and Servaes 1995;

Billett et al. 2007) have documented that when firms’ growth opportunities are low, the agency

costs between managers and shareholders are high while the conflicts of interest between

shareholders and debt holders are low. If the traditional view that debt holders impose debt

covenants to protect their own interests prevails, then we should observe that the positive

association between managerial shareholding and debt covenants is stronger when firm growth

opportunities are high. On the other hand, if managerial shareholding aligns managers’ interest

with that of shareholders and managers voluntarily impose debt covenants to constrain

managerial opportunism, then we should observe that the positive association between

managerial shareholding and debt covenants is stronger when firm growth opportunities is low.

2
Begley and Feltham (1999, p.232) argue that covenants are ex ante restrictions on management’s post-contract
actions and are likely to influence the bondholders’ belief about the payments they will receive. The bondholders do
not impose the covenants and in a competitive market, in which the price of the debt provides bondholders with the
expected market return, they have no ex ante preferences with respect to those covenants. Instead, covenants are
voluntarily chosen by the equity-holders or management presumably because the value of the covenants exceeds
their cost.

4
 Ortiz-Molina (2006) documents a positive relation between the yields of newly issued

bonds and managerial stock ownership, suggesting that debt holders raise their expected return to

respond to potential increased risk-taking incentives of managers due to a closer alignment of

interests between shareholders and managers. We further examine whether the use of more debt

covenants is indeed value enhancing by examining whether more debt covenants attenuate the

positive association between the yields of newly issued bonds and managerial stock ownership.

Using large institutional block-holders as a proxy for shareholder control (or opportunism),

Cremers, Nair, and Wei (2007) find that protective covenants reduce debt holders’ concerns over

shareholder control.3 To the extent that restrictive debt covenants alleviate debt holders’ concerns

over a closer alignment of interests between shareholders and managers, we should expect these

restrictive covenants to attenuate the positive association between cost of debt and managerial

stock ownership.

Using a large sample of 4,305 debt issues during the period of 1992 through 2007, we

document a positive and significant association between managerial stock ownership and the

amount of debt covenants. We also find that firms with higher managerial ownership are more

likely to use dividend payout and accounting-based restriction covenants, indicating that

managers intend to constrain their cash payout and allow debt holders to monitor their

accounting policies when the interests of shareholders and managers are more aligned. Further,

we find this positive relation is more pronounced for firms with low-growth opportunities, where

the agency costs between shareholders and managers are high. This finding indicates that

managers voluntarily impose dividend payout and accounting based restrictive debt covenants to

constrain managers’ opportunism. Finally, our results show that restrictive covenants attenuate

3
Cremers, Nair, and Wei (2007) show that shareholder control is associated with higher (lower) bond yields for
firms with higher (lower) takeover vulnerability.
5
the positive association between the yields of newly issued bonds and managerial stock

ownership, indicating that debt covenants effectively ease debt holders’ concerns over a closer

alignment of interest between shareholders and managers. Use of restrictive debt covenants

increases firm value by reducing the cost of debt. The above findings are robust using alternative

measures of managerial stock ownership, considering managerial stock options, controlling for

the endogeneity of managerial stock ownerships, and controlling for both level of debt and debt

maturity.

This study contributes to both managerial and debt contracting literature in three ways.

First, while most of previous studies assume that debt holders impose debt covenants for their

own interests, this study shows that managers play a proactive role in determining the number

and types of restrictive debt covenants imposed on corporate bonds. This study extends Begley

and Feltham (1999) by examining whether the positive association between managerial

ownership and the number of debt covenants varies with the underlying agency costs among

managers, shareholders, and debt holders. We find this relation is more pronounced for firms

with low growth opportunities, where the agency costs between shareholders and managers are

high while the conflicts of interest between shareholders and debt holders are low. This study

also complements Berger et al. (1997) and Datta et al. (2005), which document that managers

play an important role in choosing debt level and debt maturity.

Second, we find that use of more debt covenants reduces the cost of debt arising from the

concerns of debt holders over a closer alignment of interest between shareholders and managers.

This finding suggests that imposing debt covenants might be a curable mechanism to address the

agency costs of debt arising from managerial compensation structure documented by Ortiz-

Molina (2006). This study also complements the finding of Brockman et al. (2010) that short-

6
maturity debt can be used to mitigate agency costs of debt arising from managerial compensation

structure. Finally, the results suggest that managers (instead of debt holders) voluntarily impose

payout and accounting-based debt covenants to constrain shareholder opportunism, which in turn

increases firm value through reduction in cost of debt.

The remainder of the paper is organized as follows. Section 2 discusses the related

literature on managerial ownership and debt covenants. Section 3 describes the data. Section 4

presents results, and Section 5 concludes the paper.

2. Related Literature

Prior literature has largely emphasized the role of debt in reducing agency problems of

equity, i.e., the agency problems between managers and shareholders arising from the separation

of ownership and control (Jensen and Meckling 1976; Jensen 1986; Stulz 1990; Hart and Moore

1995). The use of debt increases firm value especially for firms with higher agency problems

between managers and shareholders (McConnell and Servaes 1995; Harvey et al. 2004).

The use of debt financing, however, also gives rise to conflicts of interest between

shareholders and debt holders. For instance, in a levered firm, shareholders may have incentive

to shift to high-risk projects from low-risk projects after debts are issued, a phenomenon known

as asset substitution (Jensen and Meckling 1976). Shareholders can also dilute the claims of

existing debt holders through subsequent issuance of debt with higher seniority (Smith and

Warner 1979). Finally, there is also a potential under-investment problem as shareholders may

forego positive net present value projects if the payoff from new investments largely goes to the

existing debt holders (Myers 1977).

7
 Debt contracting mechanisms such as using short-maturity debt (or imposing callable

option, another way to shorten the maturity of debt), requiring collaterals, and imposing debt

covenants can mitigate agency costs of debt associated with asset substitution, foregone growth

opportunities, and claim dilution (Myers 1977; Smith and Warner 1979; Barnea et al. 1980).

Debt covenants can reduce overinvestment by limiting management's opportunities to undertake

negative present value projects through mechanisms such as: (1) preventing borrowers from

raising additional cash; (2) curtailing investment; and (3) transferring the control right or

triggering renegotiation upon technical default. Debt covenants can also reduce underinvestment

by restricting distributions to shareholders in the forms of dividend payments or share

repurchases, therefore allowing firms to undertake net positive present value projects.

Prior studies largely assume that debt holders may have imposed debt covenants to

protect their own interests (Smith and Warner 1979; Beneish and Press 1993; Chen and Wei

1993). Begley and Feltham (1999), however, state that debt holders do not necessarily impose

debt covenants. Instead, debt covenants can be imposed by management presumably because the

value of using debt covenants exceeds their cost. Hence, managers may have played an important

role in determining debt contracting features, including maturity, covenants, seniority, etc., and

the corresponding cost of debt.

Another implicit assumption in the prior studies is that managers will choose optimal

debt level and debt contracting mechanisms to maximize firm value. However, due to the

separation of ownership and control, managers might not voluntarily choose the optimal debt

contracting mechanism (Novaes and Zingales 1995; Datta et al. 2005). Bertand and Mullainathan

(2003) argue that managers prefer less monitoring and enjoy a “quiet” life.

8
 Taken together, previous studies find that managers may not act in the best interest of

shareholders due to agency problems between them. Managerial ownership serves as an

important mechanism to align the interests of managers and shareholders (Murphy 1999) and

may affect a firm’s choice over debt contracting features. Consistent with this argument, Berger

et al. (1997) find that firms with weak managerial incentives, measured by lower managerial

shareholding, avoid high levels of leverage. Datta et al. (2005) find that firms with weak

managerial incentives choose longer maturity debt that subjects managers to less scrutiny. We

focus on debt covenants and predict that when the alignment of the interests of managers and

shareholders is high, managers are more likely to subject themselves to debt covenant

restrictions. Our first hypothesis is stated as follows.

H1: There is a positive relation between managerial stock ownership and the extent of

use of debt covenants.

There are also significant costs of using debt covenants. First, violations of debt

covenants could lead to costly renegotiation (Beneish and Press 1993). Second, as Billett et al.

(2007) point out, covenants designed to restrict one activity may also restrict other activities.

Therefore, covenants might restrain managers’ ability to make value-enhancing decisions such as

investing in positive net present value (NPV) projects. Covenants might also increase firms’

suboptimal liquidation risk when covenants make it harder for the firm to raise funds to meet

additional liquidity needs. Thus, managers and shareholders would trade off the costs and

benefits of using debt covenants (Begley 1994). We thus examine the cross-sectional variation of

the relation between managerial stock ownership and the number of debt covenants imposed on

corporate bonds, which allows us to shed light on whether managers play an important role in

determining the use of debt covenants.

9
 The agency costs between management and shareholders are especially high for firms

with greater assets in place and less growth opportunities (Jensen 1986). Consistent with this

argument, in the U.S. setting, McConnell and Servaes (1995) find that the relation between firm

value and leverage is positive (negative) when growth opportunities are low (high). In an

emerging market setting, Harvey et al. (2004) find that the value of firms with overinvestment

problems increase with more debt issuances. In contrast, the conflicts of interest between

shareholders and debt holders are high when growth opportunities are high (Myers 1977). As

such, debt holders demand higher returns for firms with high growth opportunities, and rational

shareholders, in turn, tend to borrow less (Billett et al. 2007). Consistent with this notion, Rajan

and Zingales (1995) find that firms with high growth opportunities have lower leverage.

As we mentioned earlier, debt covenants can reduce overinvestment by limiting

management's opportunities to undertake negative present value projects. Financial, investment,

and operating flexibility are particularly important for firms with high growth opportunities

relative to firms with low growth opportunities. For firms with high growth opportunities,

managers are unlikely to impose more restrictive debt covenants to constrain the ability of

managers to operate their firms. In contrast, for firms with low growth opportunities where

management has incentives to overinvest, managerial ownership may provide more incentives

for managers to voluntarily impose restrictive debt covenants to mitigate the agency costs

between shareholders and managers. Therefore, we expect the positive relation between

managerial stock ownership and debt covenants to be more pronounced for firms with less

growth opportunities where the agency problems between managers and shareholders are strong

and financial, investment, and operating flexibility are less important. Hence, our second

hypothesis is stated as follows.

10
 H2: The positive association between debt covenants and managerial ownership is more

pronounced for firms with low growth opportunities.

Prior studies document a positive relation between the yield of newly issued bonds and

managerial stock ownership (Ortiz-Molina 2006; Shuto and Kitagawa 2011), indicating that debt

holders intend to protect their interests through a higher expected return for shareholders-

oriented managers. When managers are motivated to choose optimal debt contracting features in

the form of imposing more debt covenants, we expect that debt covenants attenuate this positive

relation. Our third hypothesis is therefore stated as follows.

H3: The use of more restrictive debt covenants mitigates the positive association between

the yield of newly issued bonds and managerial shareholding.

3. Data and Empirical Model

We obtain data on managerial stock ownership from the Standard & Poor’s (S&P)

ExecuComp database over the period 1992–2007. We obtain subsequent debt covenant choices

on newly issued bonds from the Mergent Fixed Income Securities Database (FISD), which

contains detailed covenant information about public debt issues. These covenants either protect

debt holders or restrict the issuer’s actions. We require firms to have sufficient annual financial

data on Compustat to conduct our empirical analyses. We exclude firms in the financial

industries (e.g., firms with two-digit SIC codes between 60 and 69). Since we use the prior year’s

managerial stock ownership to measure the alignment of interests between managers and

shareholders and examine its impact on the debt covenant choices in the current year, our sample

consists of 4,305 firm-year observations over the period 1993–2008.

11
 Table 1 presents the number of yearly observations that have sufficient data to be

included in our tests. As ExecuComp covers firms in the S&P500, S&P Midcap 400, S&P

SmallCap 600, and other firms that have been previously in the S&P indexes, the annual number

of observations generally increases in time, from 88 in 1993 to 403 in 2008.

[Insert Table 1]

Measurement of debt covenants

Following Nikolaev (2010), we classify debt covenants into five categories: (1) payout-

related covenant restrictions that restrict dividend payments to shareholders and share

repurchases (COV_DIV); (2) investment-related covenant restrictions that restrict investments,

merger and acquisition activities, sales or transfers of assets, and sales-and-leaseback

transactions(COV_INV); (3) financing-related covenant restrictions that restrict the issuance of

additional subordinate, senior, secured debt or the issuance of additional common and preferred

stock(COV_FIN); (4) accounting-related covenant benchmarks that are based on minimum net

worth, minimum ratio of earnings to fixed charge, net earnings, and limitation on total

indebtedness of the issuer and the subsidiary(COV_ACC); (5) other covenants such as cross-

default provision, poison put provision, bondholders put option, and restrictions on transactions

with affiliates (COV_OTHER). We then construct an index of covenant intensity (COV_TOTAL)

as the total number of covenants within a public debt issue. We assign these individual and total

covenants measures of each public debt issue to its issuer's fiscal years whose fiscal year end

falls between the issuance date and maturity date of the debt issue.

Measurement of managerial stock ownership

Following LaFond and Roychowdhury (2008), we use two proxies for managerial stock

ownership. The first measure, CEO's stock ownership (CEO_OWN), is defined as the number of

12
shares held by the firm’s CEO divided by the total number of shares outstanding. The second

measure, the ownership of the firm’s top five highest compensated managers (MGT_OWN), is

defined as the number of shares held by these managers divided by the total number of shares

outstanding. In the empirical tests, we focus on MGT_OWN, and the results are qualitatively

similar when we use CEO_OWN. In section 4.6, we also include managerial stock options in

calculating managerial ownership.

Empirical models:

We follow Billett et al. (2007) and use the following model to empirically examine the

relation between managerial stock ownership and debt covenants.

COVt = β0 + β1MGT_OWNt−1 + β2SIZEt−1 + β3LEVt−1 + β4ST_DEBT3t−1 + β5MBt−1 +

β6VOLATILITYt−1 +β7ZSCORE_Dt−1 + β8CONVERTt + β9LOG_MATt + β10ISSUE_AMTt
+ Year_dum + Ind_dum + ε, (1)

Where COV indicates COV_DIV, COV_INV, COV_FIN, COV_ACC, COV_OTHER or

COV_TOTAL. SIZE is the natural logarithm of market value of equity. LEV is the total liability

divided by the market value of assets, where the market value of assets is the book value of

assets plus the market value of equity minus the book value of equity. ST_DEBT3 is the

proportion of debt that matures in three years or less. MB is the ratio of market value to the book

value of equity. VOLATILITY is the standard deviation of the first difference in earnings before

interest, taxes, depreciation, and amortization (EBITDA) over the preceding 5 years, scaled by

the average book value of assets. ZSCORE_D is equal to one if Altman’s Z-score is less than

1.81, where Altman’s Z-score is calculated as Z = 3.3 × EBIT/total assets + 1.0 × sales/total

assets + 1.4 × retained earnings/total assets + 1.2 × working capital/total assets + 0.6 × market

value equity/total debt. CONVERT is equal to 1 if the underlying debt issue is convertible bond,

0 otherwise. LOG_MAT is the natural logarithm of debt maturity of the debt issue. ISSUE_AMT
13
is the natural logarithm of the debt issue amount. To the extent that more managerial stock

ownership aligns managerial interest with that of shareholders and provides managers with

incentives to impose more external monitoring, we expect β1 to be positive.

To examine whether growth opportunities attenuates the positive relation between

managerial stock ownership and debt covenants, we modify model (1) by including the

interaction term MB_Dt-1*MGT_OWNt−1 as follows:

COVt = β0 + β1MB_Dt-1 + β2MGT_OWNt−1 + β3MB_Dt-1*MGT_OWNt−1 + β4SIZEt−1 + β5LEVt−1

+ β6STt−1 +β7MBt−1 + β8Volatilityt−1 +β9ZSCORE_Dt−1 + β10CONVERTt + β11LOG_MATt
+β12ISSUE_AMTt + Year_dum + Ind_dum + ε, (2)

where MB_D is equal to one if the firm is in the top tercile of the annual MB distribution, zero if

it is in the low tercile of the annual MB distribution. To the extent that a firm’s growth

opportunities attenuate the positive relation between managerial stock ownership and debt

covenants, we expect β3 to be negative.

We estimate models (1) and (2) using pooled regression. For these pooled sample

estimations, the t-statistics are based on White’s (1980) heteroskedasticity-adjusted robust

variance estimates.

4. Results

4.1. Descriptive statistics

Table 2 reports the summary statistics for all variables used in the empirical model (1).

The mean of total covenants (COV_TOTAL) per debt contract is 5.719, with the range from 0 to

21. Regarding the individual type of covenants, the mean (median) of COV_DIV, COV_INV,

COV_FIN, COV_ACC, and COV_OTHER is 0.269 (0), 2.913 (4), 0.946 (1), 0.368 (0), 1.223 (1)

respectively. The mean value of the CEO stock ownership (CEO_OWN) is 1.240 percent, while
14
the median of CEO_OWN is 0.158 percent, indicating a considerable positive skewness. The

mean (median) value of the managerial stock ownership of the firm’s top five highest

compensated managers (MGT_OWN) is 1.863 (0.352) percent. The values of managerial

ownership in our sample are lower than those in prior studies (Datta et al. 2005; LaFond and

Roychudhury 2008). The possible explanation is that our sample is restricted to firms with new

bond issues. Firms that have corporate bond issues tend to be big firms (Shuto and Kitagava

2011). As prior studies have documented, managerial ownership is negatively associated with

firm size. This negative association is also evident in our sample (the coefficient of Pearson

correlation between firm size and MGT_OWN and CEO_OWN are -0.224 and -0.197

respectively),

The mean (median) value of SIZE is 8.649 (8.656), corresponding to market value of

equity of $5,701.8 ($5,745.1) million, indicating that the sample firms are relatively large. The

mean and median values of leverage (LEV) are 21.6% and 19.1%, respectively. On average, only

32.0% of debt matures in three years or less; this percentage is lower than those reported in

Johnson (2003) and is comparable to the amount reported in Datta et al. (2005).4 Our sample

firms tend to be large firms who have less short-term debt ratio than smaller firms. The mean

(median) value of MB, the ratio of market value to the book value of equity, is 1.782 (1.476). Of

sample firms, 23.1% have the Altman Z-score below 1.81, a cut-off used to classify whether

firms are subject to financial distress. Among all debt issues, 15.5% of them are convertible

bonds.

[Insert Table 2]

4
Datta et al. (2005) defines the short-term debt as the proportion of total debt that matures in more than three years.
15
4.2. Correlations

Table 3 reports the Pearson correlations for the variables used in our empirical models.

As expected, COV_TOTAL is positively correlated with its components: COV_DIV, COV_INV,

COV_FIN, COV_ACC, and COV_OTHER with the correlation coefficients of 0.830, 0.407,

0.743, 0.803, and 0.762 respectively. Compared with other individual covenant components,

COV_INV is relatively less correlated with COV_TOTAL. COV_INV is also negatively correlated

with COV_DIV, COV_ACC, and COV_OTHER.

The variables of interest, managerial stock ownership (CEO_OWN and MGT_OWN) are

positively correlated with COV_TOTAL, COV_DIV and COV_ACC, and COV_OTHER.

Consistent with the notion that firms with high leverage tend to have more agency costs of debts,

and correspondingly more demand of debt covenants, the correlation between COV_TOTAL and

LEV is positive (0.217). Consistent with the finding of Billett et al. (2007) that firms substitute

short-maturity debt and debt covenants to mitigate agency costs of debts, COV_TOTAL and

ST_DEBT3 are negatively correlated (-0.073). The correlation between COV_TOTAL and MB is

negative (-0.129), consistent with prior research which documents that firms with more growth

opportunities have fewer covenants (Kahan and Yermack 1998; Nash et al. 2003). Consistent

with prior research (e.g., Barclay and Smith 1995; Johnson 2003), MB exhibits positive

correlation with ST_DEBT3 (0.175) and negative correlation with LEV (-0.602).

[Insert Table 3]

4.3. Results for the association between debt covenants and managerial stock ownership

Table 4 reports pooled cross-sectional regression results from estimating model (2) using

alternative proxies for the extent of using debt covenants.

[Insert Table 4]

16
 We mainly focus on COV_TOTAL to describe the results. Consistent with prior research,

the coefficient on SIZE is negative (-0.803), indicating that large firms tend to have fewer debt

covenants, presumably because larger firms have higher credit quality. The coefficient on LEV is

positive (6.791), indicating that firms with high leverage tend to be subject to more agency costs

of debt, therefore having more covenants. The coefficient on ST_DEBT3 is negative (-0.262),

consistent with the finding of Billett et al. (2007) that firms substitute short-maturity debt and

debt covenants to reduce agency costs of debt. The coefficient on MB is negative (-0.078) but

statistically insignificant at the 0.10 level. The coefficient on VOLATILITY is positive (3.610)

and statistically significant at the 0.05 level, indicating that firms with more volatile operating

performance have more debt covenants. The coefficient on ZSCORE_D is negative (-0.323) and

statistically significant at the 0.05 level. The coefficient on CONVERT is negative (-4.199) and

statistically significant at the 0.01 level, indicating that creditors with convertible options

demand less protections from debt covenants.

Turning to our test variable, MGT_OWN, the coefficient is positive (0.040) and

statistically significant at the 0.01 level. This result is consistent with our first hypothesis that

firms with stronger managerial ownership tend to impose more external monitoring in the form

of debt covenants. In terms of economic magnitude, the result suggests that when managerial

stock ownership increases by one standard deviation (4.581%), total debt covenants increase by

3.20% relative to its mean of 5.719.

When we use the individual debt covenants, we find similar results for COV_DIV,

COV_ACC, and COV_OTHER, but not for COV_INV and COV_FIN. These results suggest that

managers do not simply increase the covenants across the board when their interests are aligned

with shareholders. They are more likely to impose the monitoring covenants such as dividends

17
restriction, accounting related covenants, and covenants that restrict transactions with affiliates.

However, they reserve the flexibility in investment and financing.

Overall, the findings in Table 4 provide supportive evidence to our first hypothesis.

These findings also suggest that managers trade off the benefits and costs of debt covenants

when their interest is aligned with shareholders. Next, we examine this relation in the context of

a firm's growth opportunities.

4.4. Results for the role of growth opportunities on the association between debt covenants and

managerial stock ownership

Table 5 presents mean debt covenants per managerial stock ownership for market-to-

book terciles. Specifically, the three rows correspond to market-to-book ratio from lowest tercile

to highest tercile. The three columns correspond to terciles based on management stock

ownership. For each tercile of market-to-book ratio, the far-right column, which is the difference

of debt covenants between column (3) and column (1), represents the difference in the use of

debt covenants for firms with highest management stock ownership and firms with the lowest

management stock ownership. It appears that market-to-book ratio significantly attenuates the

positive relation between managerial stock ownership and debt covenants. Regarding the total

debt covenants (COV_TOTAL), as the market-to-book ratio increases from lowest to higher

tercile, the difference between mean debt covenants in the lowest and highest managerial stock

ownership terciles (as seen in the Low – High column) decreases from 2.101 to 1.175, then to

0.449. We observe a similar pattern for COV_DIV, COV_ACC, and COV_OTHER. Interestingly,

we even observe this similar pattern for COV_INV and COV_FIN, in which we do not observe

the positive relation for the overall sample.

[Insert Table 5]

18
 Next, we formally test this relation using multivariate tests. We create a dummy variable

MB_D, which is equal to one if the firm is in the top tercile of the annual MB distribution, and

zero if it is in the low tercile of the annual MB distribution. Panel A of Table 6 reports the

descriptive statistics for firms in the bottom market to book ratio tercile (Low Growth) and firms

in the top market to book ratio tercile (High Growth). Compared with Low Growth firms, High

Growth firms have fewer covenants in all of categories except for investment. High Growth

firms also use less leverage and more short-maturity debt relative to Low Growth firms. Table 6,

Panel B reports the pooled OLS regression results from estimating model (2). Consistent with the

results in Table 4, the coefficients on MGT_OWN are positive and statistically significant for

COV_TOTAL, COV_DIV, COV_ACC, and COV_OTHER. More important, we find that the

coefficients on MB_D*MGT_OWN are negative and significant at the 0.05 level or lower for

COV_TOTAL, COV_FIN, COV_ACC, and COV_OTHER. Overall, the results provide supportive

evidence to our second hypothesis that the positive relation between managerial stock ownership

and the use of debt covenants is more pronounced for firms with low growth opportunities,

where the agency costs between management and shareholders are higher. This also indicates

that managers play a proactive role in determining the amount and type of restrictive debt

covenants.

[Insert Table 6]

4.5. The impact of debt covenants on the positive relation between at-issue yield spread of

corporate bonds and managerial stock ownerships

Prior studies (e.g., Ortiz-Molina 2006; Shuto and Kitagava 2011) document a positive

relation between managerial stock ownership and at-issue yield spread of corporate bonds,

indicating that debt holders price protect for potential shareholder-oriented managers. To the

19
extent that debt covenants mitigate the agency costs of debt, we expect that debt covenants can

mitigate the positive relation between at-issue yield spread of corporate bonds and managerial

stock ownerships. As debt covenants and at-issue yield spread of corporate bonds could be

simultaneously determined, we use the following two-stage least squares to simultaneously

model the use of debt covenant and the yield spread of newly issued corporate bonds. Given that

the covenants and cost of debt are closely related, it is difficult to find the instrument variables

that are related to COV_TOTAL (SPREAD) but not related to SPREAD (COV_TOTAL). We

follow Billett et al. (2007) and use CONVERT as the instrumental variable for COV_TOTAL and

use PROFIT as the instrumental variable for SPREAD.

COV_TOTAL t = β0 + β1SPREAD + β2MGT_OWNt−1 + β3SIZEt−1 + β4LEVt−1 + β5ST_DEBT3t−1

+ β6MBt−1 + β7VOLATILITYt−1 +β8ZSCORE_Dt−1 + β9LOG_MATt + β10ISSUE_AMTt +
β11CONVERTt + ε (3)

SPREADt = α0 + α1 COV_TOTAL + α2MGT_OWNt−1 + α3MGT_OWNt−1*COV_TOTAL +

α4SIZEt−1 +α5LEVt−1 + α6ST_DEBT3t−1 + α7MBt−1 + α8VOLATILITYt−1 +
α9ZSCORE_Dt−1 + α10LOG_MATt + α11ISSUE_AMTt + α12PROFIT t−1 + u (4)

In equation (4), we follow prior studies to control for both firm level and debt issue level

characteristics. Specifically, we control for firm size (SIZE), leverage (LEV), short-maturity debt

ratio (ST_DEBT3), growth opportunities (MB), earnings volatilities (VOLATILITY), and financial

distress (ZSCORE_D). For the debt issue level characteristics, we control for the maturity of the

new debt issue (LOG_MAT) and the amount of debt issuance (ISSUE_AMT). Table 7 reports the

second stage results for equation (4). The coefficient on MGT_OWN is positive (21.303) and

statistically significant at the 0.05 level. This is consistent with the results of prior studies (Ortiz-

Molina 2006; Shuto and Kitagava 2011), indicating that firms with more share-holder oriented

managers tend to incur higher cost of debt financing. We find that the coefficient on our variable

of interest, the interaction term between COV_TOTAL and MGT_OWN, is negative (-3.634) and
20
statistically significant at the 0.05 level. This finding indicates an ex post benefit of reducing the

cost of debt on newly issued bonds by imposing more debt covenants. Therefore, this finding

provides the supportive evidence that imposing more debt covenants is value-enhancing though

managers are subject to more external monitoring from debt holders. Further analysis shows that

the imposing of more dividend payout, investment, financing, or accounting-based debt

covenants attenuates the positive association between cost of debt and managerial ownership.

[Insert Table 7]

4.6. Including managerial stock options

While the percentage of managerial/CEO stock ownership is widely used in prior studies,

it ignores stock options and might not fully capture managerial/CEO equity based incentives. As

a robustness test, we also use CEO_OWN_SO, which considers managers’ stock options.

Specifically, CEO_OWN_SO is the percentage of stock and option deltas held by a CEO as

calculated as (the number of stocks and the delta of all stock options held by a CEO)/(the number

of all outstanding stocks + the delta of all outstanding stock options).5 Option delta is the

sensitivity of the value of stock options (i.e., newly granted options, un-exercisable options, and

exercisable options) to change in a firm’s stock price. The sample size reduces to 3,611. The

results (untabulated) are qualitatively similar to the results reported earlier.

4.7. Robustness test: Endogeneity issue concerning managerial stock ownership

Although we have controlled for relevant variables identified in the prior literature when

examining the relation between managerial stock ownership and debt covenants, there is still a

potential endogeneity issue, i.e. managerial stock ownership is likely to be endogenous. To

5
We obtain the CEO_OWN_SO estimates and the sum of maximum marginal state and federal personal income tax
rates on the Journal of Financial Economics web page made available by Kim and Lu (2011).

21
address this issue, we employ the instrumental variables approach, in which we base on the tax

implication of granting stock based compensation (from firms’ perspective) and holding or

selling these stock based compensation (from managers’ perspective) to identify suitable

instruments for managerial stock ownership. Specifically, we use the presence of investment tax

credit (ITC_Dum) and the sum of the maximum state and federal marginal personal income tax

rates (PERSONAL_TAX) as instrumental variables for managerial stock ownership in two-stage

least squares regressions. For the first-stage models, the coefficient on ITC_Dum is negative and

statistically significant at the 0.01 level. The coefficient on PERSONAL_TAX is not significantly

different from 0. The partial F-statistic, which tests whether the coefficients on ITC_Dum and

PERSONAL_TAX are jointly not different from zero, is statistically significant at the 0.01 level,

suggesting that weak instruments are less likely to be an issue. We also perform the over-

identifying restrictions test using Hansen’s J test. The test does not reject the null hypothesis of

the exogeneity of the instruments. In the second-stage of pooled regression, we continue to find a

positive association between managerial stock ownership and the use of restrictive debt

covenants (untabulated).

5. Summary and Conclusions

The use of debt can serve as an external monitoring mechanism to alleviate manager–

shareholder agency conflicts arising from the separation of management control and ownership

(e.g., Jensen and Meckling 1976). Debt features such as debt covenants render this monitoring

more effective as they constrain ex post managers’ operations and subject managers to external

monitoring when covenants are in technical default. However, managers will not voluntarily

choose the optimal debt covenants unless managerial and shareholder interests are aligned.

22
Theory contends that managerial stock ownership is an important mechanism to align the

interests between managers and shareholders.

Motivated by both debt contracting and managerial compensation contracting literature,

this study examines three related research questions: (1) how a firm’s managerial stock

ownership affects its use of debt covenants; (2) how this effect varies with a firm's growth

opportunities, a widely used proxy for the extent of the agency costs between managers and

shareholders, and the conflicts of interest between shareholders and debt holders; and (3)

whether imposing more debt covenants indeed is value enhancing to the firm by examining its

impact on the positive relation between the yields of newly-issued bonds and managerial stock

ownership.

As predicted, we document a positive relation between managerial stock ownership and

the extent of debt covenants. Further, we find this positive relation between managerial stock

ownership and covenants is more pronounced for firms with low-growth opportunities, where the

agency costs between shareholders and managers are high. This finding therefore supports that

managerial incentives play an important role in determining the number and types of debt

covenants imposed on corporate bonds. Probing further, we also show that this positive

association is mainly driven by the dividend payout and accounting-based restrictive covenants.

Finally, we find that imposing more restrictive debt covenants does benefit firms as it attenuates

the positive relation between managerial stock ownership and the yields on newly issued bonds.

This study advances the understanding of the effect of managerial incentives on debt contracting.

23
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26
 Table 1. Sample distribution by fiscal year

Fiscal Year Frequency Percent Cum.Freq Cum.Percent

1993 88 2.04 173 4.02
1994 155 3.60 328 7.62
1995 194 4.51 522 12.13
1996 248 5.76 770 17.89
1997 304 7.06 1074 24.95
1998 251 5.83 1325 30.78
1999 222 5.16 1547 35.93
2000 329 7.64 1876 43.58
2001 281 6.53 2157 50.10
2002 325 7.55 2482 57.65
2003 288 6.69 2770 64.34
2004 241 5.60 3011 69.94
2005 269 6.25 3280 76.19
2006 348 8.08 3628 84.27
2007 274 6.36 3902 90.64
2008 403 9.36 4305 100.00

This table reports sample distribution for each fiscal year.

27
 Table 2. Descriptive statistics.

Variable N Mean Std Dev Q1 Median Q3 Min Max

COV_TOTAL 4,305 5.719 3.282 4.000 5.000 6.000 0.000 21.000
COV_DIV 4,305 0.269 0.714 0.000 0.000 0.000 0.000 3.000
COV_INV 4,305 2.913 1.233 2.000 4.000 4.000 0.000 6.000
COV_FIN 4,305 0.946 0.783 0.000 1.000 1.000 0.000 6.000
COV_ACC 4,305 0.368 0.835 0.000 0.000 0.000 0.000 4.000
COV_OTHER 4,305 1.223 1.227 0.000 1.000 2.000 0.000 6.000
CEO_OWN 4,305 1.240 3.553 0.052 0.158 0.517 0.000 23.262
MGT_OWN 4,305 1.863 4.581 0.125 0.352 1.035 0.005 28.520
SIZE 4,305 8.649 1.565 7.565 8.656 9.723 5.181 12.247
LEV 4,305 0.216 0.134 0.113 0.191 0.298 0.005 0.591
ST_DEBT3 4,305 0.320 0.252 0.121 0.281 0.463 0.000 1.000
MB 4,305 1.782 0.931 1.195 1.476 2.016 0.854 6.175
VOLATILITY 4,305 0.032 0.032 0.012 0.022 0.039 0.003 0.187
ZSCORE_D 4,305 0.231 0.422 0.000 0.000 0.000 0.000 1.000
CONVERT 4,305 0.155 0.362 0.000 0.000 0.000 0.000 1.000
LOGMAT 4,305 2.274 0.750 1.792 2.303 2.714 -1.386 4.606
ISSUE_AMOUNT 4,305 12.634 0.949 12.206 12.612 13.122 0.000 18.421

This table reports descriptive statistics on a sample of 4,305 firm-years from 1993 to 2008. COV_TOTAL is the
overall count of covenant restrictions a contract includes, COV_DIV is a count of payout restrictions, COV_INV is a
count of covenants that limit M&A and investment activities and asset dispositions, COV_FIN is a count of
covenants that limit financing activities, and COV_ACC is a count of accounting-based covenants. COV_OTHER is
a count of other covenants such as cross-default provision, poison put provision, bondholders put option, and
restrictions on transactions with affiliates. CEO_OWN is the ownership of the CEO, defined as the number of shares
held by the CEO divided by the total number of shares outstanding. MGT_OWN is the ownership of the top five
highest compensated managers by the firm, defined as the number of shares held by these managers divided by the
total number of shares outstanding. SIZE is measured as the natural logarithm of market value of equity. LEV is
measured as the total liability divided by the market value of assets, where the market value of assets is the book
value of assets plus the market value of equity minus the book value of equity. ST_DEBT3 is the proportion of debt
that matures in three years or less. MB is the ratio of market value to the book value of equity. VOLATILITY is the
standard deviation of the first difference in EBITDA over the preceding 5 years, scaled by the average book value of
assets. ZSCORE_D is equal to one if the Altman’s Z-score is less than 1.81, where Altman’s Z-score is calculated as
Z = 3.3 × EBIT/total assets + 1.0 × sales/total assets + 1.4 × retained earnings/total assets + 1.2 × working
capital/total assets + 0.6 × market value equity/total debt. CONVERT is equal to one if the underlying debt issue is
convertible bond, zero otherwise. LOG_MAT is the natural logarithm of debt maturity of the debt issue. ISSUE_AMT
is the natural logarithm of the debt issue amount.

28
 Table 3. Pearson correlations

v1 v2 v3 v4 v5 v6 v7 v8 v9 v10 v11 v12 v13 v14 v15 v16

v1 COV_TOTAL 1.000
v2 COV_DIV 0.830 1.000
v3 COV_INV 0.407 -0.037 1.000
v4 COV_FIN 0.743 0.561 0.316 1.000
v5 COV_ACC 0.803 0.831 -0.007 0.495 1.000
v6 COV_OTHER 0.762 0.751 -0.092 0.368 0.675 1.000
v7 CEO_OWN 0.074 0.087 -0.042 0.001 0.096 0.123 1.000
v8 MGT_OWN 0.113 0.127 -0.040 0.024 0.129 0.165 0.863 1.000
v9 SIZE -0.198 -0.285 0.221 -0.030 -0.237 -0.405 -0.197 -0.224 1.000
v10 LEV 0.217 0.289 -0.091 0.177 0.255 0.218 0.033 0.069 -0.143 1.000
v11 ST_DEBT3 -0.073 -0.096 0.077 -0.083 -0.088 -0.105 -0.020 -0.043 0.119 -0.145 1.000
v12 MB -0.129 -0.169 0.050 -0.119 -0.140 -0.125 0.019 -0.009 0.020 -0.602 0.175 1.000
v13 VOLATILITY 0.069 0.138 -0.120 -0.051 0.095 0.191 0.033 0.032 -0.335 -0.015 -0.065 0.042 1.000
v14 ZSCORE_D 0.065 0.132 -0.108 0.043 0.145 0.080 0.013 0.036 -0.106 0.639 -0.073 -0.341 0.005 1.000
v15 CONVERT -0.287 -0.149 -0.378 -0.466 -0.168 0.111 0.076 0.074 -0.351 -0.061 0.004 0.088 0.294 -0.065 1.000
v16 LOGMAT -0.050 -0.068 0.012 -0.020 -0.070 -0.047 0.001 0.000 -0.033 -0.048 -0.096 -0.010 -0.022 -0.060 0.064 1.000
v17 ISSUE_AMOUNT -0.064 -0.104 0.063 -0.046 -0.076 -0.093 -0.085 -0.116 0.478 -0.150 0.075 0.137 -0.103 -0.058 -0.060 -0.043

This table reports Pearson correlations. COV_TOTAL is the overall count of covenant restrictions a contract
includes, COV_DIV is a count of payout restrictions, COV_INV is a count of covenants that limit M&A and
investment activities and asset dispositions, COV_FIN is a count of covenants that limit financing activities, and
COV_ACC is a count of accounting-based covenants. COV_OTHER is a count of other covenants such as cross-
default provision, poison put provision, bondholders put option, and restrictions on transactions with affiliates.
CEO_OWN is the ownership of the CEO, defined as the number of shares held by the CEO divided by the total
number of shares outstanding. MGT_OWN is the ownership of the top five highest compensated managers by the
firm, defined as the number of shares held by these managers divided by the total number of shares outstanding.
SIZE is measured as the natural logarithm of market value of equity. LEV is measured as the total liability divided by
the market value of assets, where the market value of assets is the book value of assets plus the market value of
equity minus the book value of equity. ST_DEBT3 is the proportion of debt that matures in three years or less. MB is
the ratio of market value to the book value of equity. VOLATILITY is the standard deviation of the first difference in
EBITDA over the preceding 5 years, scaled by the average book value of assets. ZSCORE_D is equal to one if the
Altman’s Z-score is less than 1.81, where Altman’s Z-score is calculated as Z = 3.3 × EBIT/total assets + 1.0 ×
sales/total assets + 1.4 × retained earnings/total assets + 1.2 × working capital/total assets + 0.6 × market value
equity/total debt. CONVERT is equal to one if the underlying debt issue is convertible bond, zero otherwise.
LOG_MAT is the natural logarithm of debt maturity of the debt issue. ISSUE_AMT is the natural logarithm of the
debt issue amount.

29
 Table 4. OLS regression results: The association between managerial stock ownership and the
extent of debt covenants

COV_TOTAL COV_DIV COV_INV COV_FIN COV_ACC COV_OTHER

Parameter Estimate t Value Estimate t Value Estimate t Value Estimate t Value Estimate t Value Estimate t Value
Intercept 6.197 5.64 0.203 0.86 1.943 4.60 0.881 2.95 0.691 2.41 2.479 5.34
MGT_OWN 0.040 3.38 0.008 2.79 0.003 0.81 0.003 1.09 0.012 3.64 0.014 3.25
SIZE -0.803 -15.83 -0.179 -15.40 0.086 4.85 -0.111 -8.84 -0.191 -14.53 -0.408 -22.29
LEV 6.791 11.04 1.691 12.00 -0.182 -0.90 1.304 8.84 1.642 9.96 2.335 10.67
ST_DEBT3 -0.262 -1.43 -0.050 -1.21 0.066 0.98 -0.099 -2.26 -0.062 -1.21 -0.117 -1.73
MB -0.078 -1.29 -0.005 -0.40 -0.044 -1.84 -0.003 -0.17 0.003 0.22 -0.030 -1.41
VOLATILITY 3.610 2.13 1.785 4.41 -1.348 -2.33 0.480 1.20 1.355 2.73 1.337 2.11
ZSCORE_D -0.323 -2.05 -0.103 -2.96 -0.051 -0.92 -0.102 -2.73 0.000 0.01 -0.067 -1.18
CONVERT -4.199 -29.68 -0.663 -21.90 -1.197 -24.13 -1.182 -35.61 -0.776 -22.19 -0.382 -7.32
LOGMAT -0.062 -1.42 -0.030 -3.57 0.031 1.48 -0.004 -0.37 -0.032 -2.77 -0.027 -1.67
ISSUE_AMOUNT 0.251 3.60 0.060 3.46 -0.027 -0.98 0.041 2.72 0.063 3.51 0.114 3.55
Year_dum yes yes yes yes yes yes
Industry_dum yes yes yes yes yes yes
N 4,305 4,305 4,305 4,305 4,305 4,305
R-Square 0.370 0.329 0.321 0.367 0.290 0.390

COV_TOTAL is the overall count of covenant restrictions a contract includes, COV_DIV is a count of payout
restrictions, COV_INV is a count of covenants that limit M&A and investment activities and asset dispositions,
COV_FIN is a count of covenants that limit financing activities, and COV_ACC is a count of accounting-based
covenants. COV_OTHER is a count of other covenants such as cross-default provision, poison put provision,
bondholders put option, and restrictions on transactions with affiliates. MGT_OWN is the ownership of the top five
highest compensated managers by the firm, defined as the number of shares held by these managers divided by the
total number of shares outstanding. SIZE is measured as the natural logarithm of market value of equity. LEV is
measured as the total liability divided by the market value of assets, where the market value of assets is the book
value of assets plus the market value of equity minus the book value of equity. ST_DEBT3 is the proportion of debt
that matures in three years or less. MB is the ratio of market value to the book value of equity. VOLATILITY is the
standard deviation of the first difference in EBITDA over the preceding 5 years, scaled by the average book value of
assets. ZSCORE_D is equal to one if the Altman’s Z-score is less than 1.81, where Altman’s Z-score is calculated as
Z = 3.3 × EBIT/total assets + 1.0 × sales/total assets + 1.4 × retained earnings/total assets + 1.2 × working
capital/total assets + 0.6 × market value equity/total debt. CONVERT is equal to one if the underlying debt issue is
convertible bond, zero otherwise. LOG_MAT is the natural logarithm of debt maturity of the debt issue. ISSUE_AMT
is the natural logarithm of the debt issue amount. The industry fixed effects is based on two-digit SIC code. The t-
statistics are based on White (1980) heteroskedasticity-adjusted robust variance estimates.

30
Table 5. Mean of total and individual components of debt covenants, categorized by managerial
stock ownership and Market-to-Book terciles

The sample consists of 4,305 firm-year observations between 1993 and 2008, where managerial
ownership is defined as the sum of common stock owned by the top five executives divided by
shares outstanding at the fiscal year end.

COV_TOTAL Managerial stock ownership terciles

Market to book ratio terciles 1 = Low 2 = Medium 3 = High High-low
1 = Low 5.399 5.910 7.500 2.101
2 = Medium 5.134 5.139 6.308 1.175
3 = High 5.030 5.390 5.479 0.449

COV_DIV Managerial stock ownership terciles

Market to book ratio terciles 1 = Low 2 = Medium 3 = High High-low
1 = Low 0.284 0.366 0.718 0.434
2 = Medium 0.134 0.147 0.394 0.261
3 = High 0.072 0.064 0.196 0.124

COV_INV Managerial stock ownership terciles

Market to book ratio terciles 1 = Low 2 = Medium 3 = High High-low
1 = Low 2.883 2.708 2.739 -0.143
2 = Medium 2.973 2.855 2.845 -0.128
3 = High 3.087 3.270 2.887 -0.200

COV_FIN Managerial stock ownership terciles

Market to book ratio terciles 1 = Low 2 = Medium 3 = High High-low
1 = Low 0.968 1.012 1.182 0.214
2 = Medium 0.908 0.948 0.951 0.043
3 = High 0.875 0.870 0.755 -0.120

COV_ACC Managerial stock ownership terciles

Market to book ratio terciles 1 = Low 2 = Medium 3 = High High-low
1 = Low 0.291 0.464 0.878 0.587
2 = Medium 0.196 0.209 0.488 0.292
3 = High 0.217 0.175 0.322 0.105

COV_OTHER Managerial stock ownership terciles

Market to book ratio terciles 1 = Low 2 = Medium 3 = High High-low
1 = Low 0.973 1.360 1.982 1.009
2 = Medium 0.923 0.980 1.630 0.707
3 = High 0.780 1.012 1.320 0.539

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Table 6. The attenuating effect of growth opportunities on the relation between managerial stock
ownership and the extent of debt covenants

Panel A. The comparison of firm characteristics between low growth and high growth firms.

Low Growth (N = 1430) High Growth (N = 1434)

Variable Mean Median Std Dev Mean Median Std Dev t-test Wilcoxon's Z
COV_TOTAL 6.331 5.000 3.899 5.258 5.000 2.566 8.700 4.163
COV_DIV 0.468 0.000 0.885 0.103 0.000 0.472 13.760 14.145
COV_INV 2.769 2.000 1.243 3.086 4.000 1.198 -6.960 -7.249
COV_FIN 1.060 1.000 0.866 0.841 1.000 0.694 7.480 6.808
COV_ACC 0.562 0.000 0.986 0.233 0.000 0.676 10.430 10.160
COV_OTHER 1.471 1.000 1.408 0.994 1.000 0.995 10.470 8.045
CEO_OWN 0.952 0.182 2.752 1.315 0.105 3.953 -2.850 6.377
MGT_OWN 1.692 0.391 4.091 1.667 0.234 4.506 0.160 7.747
SIZE 7.969 7.993 1.471 9.423 9.493 1.511 -26.100 -23.509
LEV 0.327 0.314 0.127 0.108 0.100 0.066 57.730 41.057
ST_DEBT3 0.303 0.267 0.226 0.366 0.328 0.291 -6.460 -4.475
MB 1.117 1.110 0.134 2.732 2.413 1.056 -57.380 -46.339
VOLATILITY 0.032 0.023 0.030 0.031 0.020 0.034 0.580 3.812
ZSCORE_D 0.494 0.000 0.500 0.037 0.000 0.189 32.400 27.718
CONVERT 0.134 0.000 0.341 0.177 0.000 0.382 -3.170 -3.162
LOGMAT 2.252 2.286 0.738 2.266 2.303 0.778 -0.490 -0.954
ISSUE_AMOUNT 12.489 12.443 1.119 12.799 12.707 0.918 -8.090 -8.054

COV_TOTAL is the overall count of covenant restrictions a contract includes, COV_DIV is a count of payout
restrictions, COV_INV is a count of covenants that limit M&A and investment activities and asset dispositions,
COV_FIN is a count of covenants that limit financing activities, and COV_ACC is a count of accounting-based
covenants. COV_OTHER is a count of other covenants such as cross-default provision, poison put provision,
bondholders put option, and restrictions on transactions with affiliates. CEO_OWN is the ownership of the CEO,
defined as the number of shares held by the CEO divided by the total number of shares outstanding. MGT_OWN is
the ownership of the top five highest compensated managers by the firm, defined as the number of shares held by
these managers divided by the total number of shares outstanding. MB_D is equal to one if the firm is in the top
tercile of the annual MB distribution, zero if it is in the low tercile of the annual MB distribution. SIZE is measured
as the natural logarithm of market value of equity. LEV is measured as the total liability divided by the market value
of assets, where the market value of assets is the book value of assets plus the market value of equity minus the book
value of equity. ST_DEBT3 is the proportion of debt that matures in three years or less. MB is the ratio of market
value to the book value of equity. VOLATILITY is the standard deviation of the first difference in EBITDA over the
preceding 5 years, scaled by the average book value of assets. ZSCORE_D is equal to one if the Altman’s Z-score is
less than 1.81, where Altman’s Z-score is calculated as Z = 3.3 × EBIT/total assets + 1.0 × sales/total assets + 1.4 ×
retained earnings/total assets + 1.2 × working capital/total assets + 0.6 × market value equity/total debt. CONVERT
is equal to one if the underlying debt issue is convertible bond, zero otherwise. LOG_MAT is the natural logarithm
of debt maturity of the debt issue. ISSUE_AMT is the natural logarithm of the debt issue amount.

32
Table 6. The attenuating effect of growth opportunities on the relation between managerial stock
ownership and the extent of debt covenants (Continued).

Panel B. OLS regression results.

COV_TOTAL COV_DIV COV_INV COV_FIN COV_ACC COV_OTHER

Parameter Estimate t Value Estimate t Value Estimate t Value Estimate t Value Estimate t Value Estimate t Value
Intercept 6.563 4.89 0.204 0.70 2.319 5.00 0.917 2.44 0.676 1.97 2.447 4.60
MGT_OWN 0.065 2.79 0.013 2.16 -0.006 -0.82 0.009 1.57 0.021 3.62 0.029 3.20
MGT_OWN*MB_D -0.056 -1.98 -0.009 -1.26 0.008 0.87 -0.013 -1.97 -0.015 -1.95 -0.027 -2.52
MB_D 0.018 0.09 -0.118 -2.80 0.273 3.52 0.021 0.46 0.002 0.05 -0.160 -2.27
SIZE -0.773 -12.99 -0.169 -12.31 0.069 3.41 -0.105 -6.97 -0.175 -11.40 -0.393 -18.80
LEV 6.886 8.41 1.596 8.48 0.102 0.38 1.330 6.62 1.725 8.01 2.133 7.49
ST_DEBT3 -0.101 -0.48 -0.055 -1.12 0.158 1.98 -0.085 -1.66 -0.013 -0.21 -0.107 -1.39
MB -0.127 -1.75 0.011 0.78 -0.125 -4.11 -0.016 -0.89 -0.001 -0.06 0.003 0.11
VOLATILITY 2.552 1.18 1.161 2.25 -0.791 -1.10 0.273 0.55 0.856 1.31 1.054 1.29
ZSCORE_D -0.371 -1.81 -0.125 -2.74 -0.091 -1.30 -0.070 -1.50 -0.029 -0.53 -0.056 -0.77
CONVERT -4.053 -23.16 -0.627 -17.25 -1.212 -19.64 -1.168 -28.55 -0.723 -17.36 -0.324 -5.07
LOGMAT -0.051 -0.93 -0.042 -4.01 0.052 2.01 0.006 0.48 -0.034 -2.38 -0.033 -1.65
ISSUE_AMOUNT 0.201 2.70 0.051 2.61 -0.030 -1.01 0.033 1.96 0.054 2.72 0.094 2.69
Year_dum yes yes yes yes yes yes
Industry_dum yes yes yes yes yes yes
N 2859 2859 2859 2859 2859 2859
R-square 0.383 0.3546 0.3265 0.377 0.3037 0.4162

COV_TOTAL is the overall count of covenant restrictions a contract includes, COV_DIV is a count of payout
restrictions, COV_INV is a count of covenants that limit M&A and investment activities and asset dispositions,
COV_FIN is a count of covenants that limit financing activities, and COV_ACC is a count of accounting-based
covenants. COV_OTHER is a count of other covenants such as cross-default provision, poison put provision,
bondholders put option, and restrictions on transactions with affiliates. MGT_OWN is the ownership of the top five
highest compensated managers by the firm, is defined number of shares held by these managers divided by the total
number of shares outstanding. MB_D is equal to one if the firm is in the top tercile of the annual MB distribution,
zero if it is in the low tercile of the annual MB distribution. SIZE is measured as the natural logarithm of market
value of equity. LEV is measured as the total liability divided by the market value of assets, where the market value
of assets is the book value of assets plus the market value of equity minus the book value of equity. ST_DEBT3 is
the proportion of debt that matures in three years or less. MB is the ratio of market value to the book value of equity.
VOLATILITY is the standard deviation of the first difference in EBITDA over the preceding 5 years, scaled by the
average book value of assets. ZSCORE_D is equal to one if the Altman’s Z-score is less than 1.81, where Altman’s
Z-score is calculated as Z = 3.3 × EBIT/total assets + 1.0 × sales/total assets + 1.4 × retained earnings/total assets +
1.2 × working capital/total assets + 0.6 × market value equity/total debt. CONVERT is equal to one if the underlying
debt issue is convertible bond, zero otherwise. LOG_MAT is the natural logarithm of debt maturity of the debt issue.
ISSUE_AMT is the natural logarithm of the debt issue amount. The industry fixed effects is based on two-digit SIC
code. The t-statistics are based on White (1980) heteroskedasticity-adjusted robust variance estimates.

33
Table 7. The impact of debt covenants on the relation between at-issue yield spread of corporate
bonds and managerial stock ownerships.

SPREAD
Parameter Estimate t Value
Intercept -564.265 -3.46
MGT_OWN 21.303 2.40
COV_TOTAL 75.547 3.10
MGT_OWN*COV_TOTAL -3.634 -2.42
SIZE 20.196 1.78
LEV -89.132 -1.03
ST_DEBT3 28.643 1.47
MB -3.097 -0.49
VOLATILITY -30.607 -0.11
ZSCORE_D 44.503 2.62
LOGMAT 5.834 0.98
ISSUE_AMOUNT 9.751 1.41
PROFIT -203.108 -2.17
N 2052
R-square 0.0586

SPREAD is the difference between the spread on the newly issued bonds and the spread on the U.S. treasury bond
with the same maturity. COV_TOTAL is the overall count of covenant restrictions a contract includes. MGT_OWN
is the ownership of the top five highest compensated managers by the firm, defined as the number of shares held by
these managers divided by the total number of shares outstanding. SIZE is measured as the natural logarithm of
market value of equity. LEV is measured as the total liability divided by the market value of assets, where the market
value of assets is the book value of assets plus the market value of equity minus the book value of equity.
ST_DEBT3 is the proportion of debt that matures in three years or less. MB is the ratio of market value to the book
value of equity. VOLATILITY is the standard deviation of the first difference in EBITDA over the preceding 5 years,
scaled by the average book value of assets. ZSCORE_D is equal to one if the Altman’s Z-score is less than 1.81,
where Altman’s Z-score is calculated as Z = 3.3 × EBIT/total assets + 1.0 × sales/total assets + 1.4 × retained
earnings/total assets + 1.2 × working capital/total assets + 0.6 × market value equity/total debt. CONVERT is equal
to one if the underlying debt issue is convertible bond, zero otherwise. LOG_MAT is the natural logarithm of debt
maturity of the debt issue. ISSUE_AMT is the natural logarithm of the debt issue amount. PROFIT is the ratio of
operating income before depreciation to total assets. The t-statistics are based on White (1980) heteroskedasticity-
adjusted robust variance estimates.

34