Debt and Incentives

Professor Florencio Lopez de Silanes

Introduction

 MM  capital structure does not affect the value of the firm.

 Key assumption: investment policy is unaffected by capital structure.

 Capital structure affects firm value if it alters investment (and hence, CFs).

 Today’s Key Idea: Leverage may change the value of the firm by altering the incentives of
those making investment decisions (i.e, the size of the pie may depend on how it is shared).
1. Debt may increase firm value by deterring “bad” investment; or
2. Debt may decrease firm value by curtailing “good” investment.

 Thinking about incentives leads to a useful checklist of issues that need to be

addressed through financial contracting.

2
Debt’s Bright Side
Introduction

 Firms seem to find debt

attractive.
 Some of the reasons
may be linked to tax
breaks from interest
payment.
 But there may be other
considerations to take
into account.

4
What Can Go Wrong?

STOCKHOLDERS

Managers put their

Have little control
interests above
over managers
stockholders.
Lend Money Significant Social Costs
BONDHOLDERS MANAGERS SOCIETY
Bondholders can Managers may ignore social costs
get ripped off while pursuing stock price max
Delay bad news or Markets make
provide misleading mistakes and can
information over- or under-react

5
FINANCIAL MARKETS
The Agency Problem (1)
FCF problem Risk Shifting Debt Overhang Cash-in Play for time Bait and Switch Solutions

 The interests of shareholders and those of managers are not always perfectly aligned.
Potential problems include:
 Reduced effort;
 Perks; and
 Empire building.

 These conflicts between shareholders (“principals”) and managers (i.e., their “agents”) are
called “agency problems”.
 Equity investors know that managers may pursue value-destroying strategies.
 ↓stock value.
Entrepreneurs have an incentive to mitigate agency conflicts.
 Example. “Stage financing” in VC (money raised in multiple rounds).

6
The Agency Problem (2)
FCF problem Risk Shifting Debt Overhang Cash-in Play for time Bait and Switch Solutions

 Some firms have CFs in excess of what is required to fund all NPVs>0. Such firms are
said to have “Free Cash Flow” and referred to as “Cash Cows”.
 Example: Tobacco. High earnings but declining demand. Do they give back the
money to shareholder or do they buy food companies?

 Michael Jensen’s basic idea:

1. Managers of “cash cows” may become lazy; and/or
2. Managers of “cash cows” may pursue bad investments rather than give shareholders
their cash back.
 Debt can be used to limit the availability of Free CF to managers and commit them to
a repayment schedule.

7
The Agency Problem (3)
FCF problem Risk Shifting Debt Overhang Cash-in Play for time Bait and Switch Solutions

 The idea is that is the firm's free cash flow is dedicated for a payout, such as interest
payments, managers will not be able to use this free cash flow to pursue negative NPV
projects they like for fear of bankruptcy.

 If managers want more cash, they have to come to the capital market. The idea is to tie
the manager's hands.

 The best example of this strategy in action is leveraged recapitalizations (buying back
stock with debt), which result in large increases in the value of the companies that did it.

 Creditors face smaller free-rider problems, but D is not for all firms!

 Obviously, the cost is lost flexibility but this might be OK for mature companies

 But, who chooses debt levels?

 Free CF (1) -- Example
FCF problem Risk Shifting Debt Overhang Cash-in Play for time Bait and Switch Solutions

 ALLEQUITY expects CFs of $50M in each of the next two years.

 In addition, next year an investment opportunity will be available to invest $50 M in Year 1 in
exchange for CFs in Year 2 of:
 $60 M with prob 1/2; or
 $40 M with prob 1/2.

 Everyone knows whether the firm has a good or bad project BEFORE making the $50 M
investment.

 Managers come in two flavors: (1) “Good” managers (only pursue NPV>0); and (2) “Empire
builders” (pursue NPV>0 and NPV<0).

 Investors are risk-neutral. The interest rate is zero.

9
Free CF (2) : Example
FCF problem Risk Shifting Debt Overhang Cash-in Play for time Bait and Switch Solutions

 How much is ALLEQUITY worth with a “good” manager?

 How much is ALLEQUITY worth with an “empire builder”?

☛So, Agency costs reduce the value of the firm by ……

☛Can investors increase the value of the firm by clever contracting?

☛Can we use debt to avoid NPV<0 (without destroying NPV>0)?

10
 Free CF (3) -- Example
FCF problem Risk Shifting Debt Overhang Cash-in Play for time Bait and Switch Solutions

 Assume that LEVERED is identical to ALLEQUITY except that LEVERED has $50 M in debt
maturing in Year 1 and $50 M in senior debt due in Year 2.
 How much is LEVERED worth with an “empire builder”?

 In Year 1, LEVERED receives CFs of $50 and pays it to its creditors.

 It then decides whether to invest in the new project. There are 2 scenarios:
1. The empire builder has a bad project; or
2. The empire builder has a good project.

 The empire builder with a bad project cannot raise financing to invest. So, how much is a
firm with bad projects worth?

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Free CF (3) -- Example
FCF problem Risk Shifting Debt Overhang Cash-in Play for time Bait and Switch Solutions

The empire builder with a good project can raise $50 in financing to invest. So, how much
is a firm with a good project worth?

12
Free CF (3) -- Example
FCF problem Risk Shifting Debt Overhang Cash-in Play for time Bait and Switch Solutions

The empire builder with a good project can raise $50 in financing to invest. So, how much
is a firm with a good project worth?
 The firm would have CFs of $110 in Year 2. It would pay:
 $50 to senior creditors;
 $50 to junior creditors (i.e. enough to recoup their $50 capital); and
 $10 to shareholders.
 The firm with a good project is worth $110 (=$50+$60).

 The firm is on average worth $105 (=0.5*110+0.5*100).

 Key Insight:: Debt eliminated the discretion of bad managers to pursue NPV<0.

13
Debt’s Dark Side
The Conflict of Interest between
Debtholders and Stockholders
FCF problem Risk Shifting Debt Overhang Cash-in Play for time Bait and Switch Solutions

Given the firm’s investment policy, the way in which the firm’s cash flows are
bundled into different securities does not matter (M&M).

But the firm's capital structure may in fact matter because the capital structure
actually has effects on the operations of the firm (investment policy).

One way this can happen is for equity-holders (who have the votes) to make
investment decisions that increase their share of the firm’s cash flows at the
expense of bondholders (while possibly decreasing the total value of cash
flows available).

That is, games between stockholders and bondholders lead to inefficient

investment decisions. This means that capital structure can have real effects
by distorting real investment decisions.
Debt May be Bad for Incentives
FCF problem Risk Shifting Debt Overhang Cash-in Play for time Bait and Switch Solutions

 Financial distress may induce managers to destroy value.

 Examples:
1. Excessive risk taking (“gambling for resurrection”);
2. Shareholders may refuse to contribute fresh funds to finance NPV>0 when their
equity has low value (let the roof leak);
3. Delay of efficient liquidation; and
4. Cash-in-and-run – Leave creditors with an empty shell.

 Creditors know that financially-distressed firms may pursue value-destroying strategies.

 Credit will be more expensive than in the absence of shareholders’ opportunistic
behavior.
 Shareholders will have an incentive to find ways to mitigate conflicts with creditors.
 These costs are part of the “indirect” costs of financial distress.
16
Risk Shifting (1)
FCF problem Risk Shifting Debt Overhang Cash-in Play for time Bait and Switch Solutions

 The interests of shareholders and creditors may diverge when debt is large (relative to the
value of equity).
 In an unlevered firm, the payoff to equity increases $1 for $1 with increases in firm
value.
Payoff to the shareholders of an all-equity Firm
Payoff

Value of the Firm

 Incentives are aligned – max firm value = max shareholder value.
17
Risk Shifting (2)
FCF problem Risk Shifting Debt Overhang Cash-in Play for time Bait and Switch Solutions

 Now, add debt with face value of F.

Payoff Payoff to equity

Payoff to debt

Value of the Firm

F
 When the value of the firm is close to F, shareholders capture most of the upside but little of
the downside  may induce them to gamble by taking risky negative NPV projects.
Example. S&L in the US.
18
Risk Shifting: Risky Projects Example (1)
FCF problem Risk Shifting Debt Overhang Cash-in Play for time Bait and Switch Solutions

 Imagine a firm facing two mutually exclusive projects:

 A low risk and a high risk investment projects
 There are two equally likely outcomes: recession and boom.
 The cash-flows for the firm can be described as follows:

Low Risk Project High Risk Project

Boom 200 240
Recession 100 50

 Suppose investors are risk-neutral and seek to maximize the expected value of the
firm:

 Low Risk Project  Expected Value =

 High Risk Project Expected Value =


Risk Shifting: Risky Projects Example (2)
FCF problem Risk Shifting Debt Overhang Cash-in Play for time Bait and Switch Solutions

 But, imagine the firm had debt outstanding for $100. Then shareholders would choose the
risky project. To see this, compute the expected cash-flows to shareholders:

Low Risk Project High Risk Project

Boom 100 140
Recession 0 0
Expected Value ……….. ……..

 Key Intuition:
Risk Shifting: Risky Projects Example (2)
FCF problem Risk Shifting Debt Overhang Cash-in Play for time Bait and Switch Solutions

 But, imagine the firm had debt outstanding for $100. Then shareholders would choose the
risky project. To see this, compute the expected cash-flows to shareholders:

Low Risk Project High Risk Project

Boom 100 140
Recession 0 0
Expected Value 50 70

 Key Intuition:
 The high risk project yields higher cash-flows in booms and lower in recessions.
 The increase in value in a boom is captured fully by shareholders, because
bondholders are always paid in full, regardless of the project chosen.
 The drop in value in a recession is lost by bondholders, because they only receive
$50 with the high risk project. The shareholders will receive nothing in a recession
anyway.

 Stockholders expropriate value from bondholders by selecting high-risk projects.

Risk Shifting: Insolvency Example (1)
FCF problem Risk Shifting Debt Overhang Cash-in Play for time Bait and Switch Solutions

 ALLEQUITY has 100M in cash. In addition, it runs a business that has fallen on hard
times. It faces two options:
1. Immediate liquidation: Get $140M for sure; or
2. Reorganization: Get $200M with 50% probability and $0 otherwise.

 Both strategies require spending $100M.

 The risk-free rate is zero.

 Which strategy do shareholders in ALLEQUITY choose? How much is the firm worth
under each of the two strategies?
 NPV1=
 NPV2=
 Shareholders choose project …..
 The firm is worth $.....
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Risk Shifting: Insolvency Example (2)
FCF problem Risk Shifting Debt Overhang Cash-in Play for time Bait and Switch Solutions

 LEVERED is a twin firm identical to ALLEQUITY in every respect except that it has
borrowed $100M (i.e., it owes $100M).
 Creditors assumed that the firm would liquidate (i.e., follow optimal investment policy).
Will the firm liquidate?
Liquidation: payoff to shareholders =
Reorganization: payoff to shareholders =


 How are creditors doing?

 Value of debt =
 Summary:

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Risk Shifting: Insolvency Example (3)
FCF problem Risk Shifting Debt Overhang Cash-in Play for time Bait and Switch Solutions

 However, creditors will (sooner or later) figure out that the firm will not voluntarily liquidate.
 What is the face value of debt (FV) if the firm raises $100M and creditors anticipate
reorganization?

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Risk Shifting: Insolvency Example (4)
FCF problem Risk Shifting Debt Overhang Cash-in Play for time Bait and Switch Solutions

 One way out of this problem is to lower the level of debt.

 To induce the right incentives, shareholders have to be better off pursuing liquidation
rather than reorganization:
 140M - FV > 0.5*(200M-FV) + 0.5*0
 140M-100M > 0.5*FV
 40M/0.5 > FV
 80M > FV.

 Shareholders can be trusted to liquidate as long as the FV is below $80M.

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Debt Overhang (1)
FCF problem Risk Shifting Debt Overhang Cash-in Play for time Bait and Switch Solutions

 Underinvestment Problem: Shareholders may be reluctant to contribute fresh funds to

finance NPV>0 when their equity has low value because they may be throwing good money
after bad one.
 Example:
 Next year, the assets of XYZ are worth:
 $10 with probability ½; or
 $100 with probability ½.
 XYZ has debt with face value $35 due next year.
 XYZ also has an investment project that requires an initial outlay of $15 and pays, for sure,
$20 next year.

 Two questions:
 (1) Is this a good project if Investors are risk-neutral and the interest rate is zero?; and
 (2) If XYZ has no cash on hand, should shareholders raise new funds to pay for the
project? 26
Debt Overhang (2)
FCF problem Risk Shifting Debt Overhang Cash-in Play for time Bait and Switch Solutions

Economy Pursue Project Do Nothing Gain if invest

Gross Net

Does Well

Does Poorly

27
Debt Overhang (3)
FCF problem Risk Shifting Debt Overhang Cash-in Play for time Bait and Switch Solutions

 The problem goes away if creditors forgive some of the debt.

 Example: Suppose creditors propose to write down the FV of debt to $24 IF shareholders
undertake the project. Would shareholders accept the proposal?
 If they refuse the offer, the expected value of their equity next period is:

 If they accept the offer, the expected value of their equity next period is:

 Gain in equity value =



 Does it make sense for the creditors to make the proposal?

 If they don’t make the proposal, the expected value of debt next period is:

 If shareholders accept, the expected value of debt next period is:

 Gain in debt value = 28


Debt Overhang (4)
FCF problem Risk Shifting Debt Overhang Cash-in Play for time Bait and Switch Solutions

 The problem also goes away if creditors contribute new capital to pay for project.
 Coordination problems may prevent creditors from contributing fresh funds. Hence,
firms with valuable future growth opportunities should prefer:
 Bank debt rather than public bonds;
 Few rather than many banks;
 Relationship banking rather than arms-length lending;
 Simple rather than complex debt structures (e.g., creditors with similar seniority,
maturity, or security).

 One way to avoid the coordination problem, is to issue senior debt to pay for the new
investment.
 Senior debt would get fully paid in our example.
 However, covenants may preclude the issuance of senior debt.

☛Obvious Practical Implication: Firms that29 expect to have valuable future growth
opportunities should avoid too much debt.
Cash-in and run
FCF problem Risk Shifting Debt Overhang Cash-in Play for time Bait and Switch Solutions

 Leave creditors with an empty shell by paying a large dividend or repurchasing a large
number of shares. Examples:
 Turkey’s Banking Crisis.
 “Turkish banks taken over by the government are owed about $12 billion by
customers that have defaulted on loans.... Some 80 percent of the bad loans were
given to companies that belong to the banks' former owners...” (Bloomberg 3-28).
 Kaiser Steel Corporation / Asset Stripping.
 Messrs. Frates and Rial acquired Kaiser in an LBO.
 Following the LBO, Kaiser formed a wholly-owned subsidiary, Kaiser Coal
Corporation, to hold its coal reserves.
 This entity then borrowed against the coal reserves (see next page).
 The loan proceeds were dividended up to Kaiser Steel and part of them were
used to repay Citibank and bondholders (because they both were protected by
bond covenants).
30
Cashing in at Kaiser

 Post LBO Transactions:

 The rest of the loan proceeds, together

with some California real estate and
cash proceeds from asset sales, were
dividended up to the joint venture and
subsequently paid out to its owners.

 In sum, Kaiser Steel’s most valuable

assets were sold or placed in the coal
company where they were collateralizing
secured loans.

 The retirees were the steel company’s

only significant creditor and they were
left holding an empty bag. 31
 Play for Time
FCF problem Risk Shifting Debt Overhang Cash-in Play for time Bait and Switch Solutions

 Shareholders may try to maximize the

value of their option.
 Their hope is that, given more time, the
firm’s cash flows will have greater
change of bouncing back and leaving
them with a positive net worth.
 If things get even worse, bondholders
will bear the cost anyway

 It takes multiple forms. Examples:

 Misleading accounting;
 Reluctance to invest in the
business when default is possible
 Swaps of equity for debt in default;
 Delay the resolution of insolvency; 32
Bait and Switch
FCF problem Risk Shifting Debt Overhang Cash-in Play for time Bait and Switch Solutions

 An unexpected increase in D/E.

 Example: Marriott Corp.

 The market for hotel properties was depressed. The firm wanted to strengthen its
credit rating to be able to buy hotel properties at distressed prices.

 Marriott’s Strategy:
 Split company into two separate entities: (1) Lodging and service management; and
(2) Real estate holdings
 Put most of the debt on the balance sheet of the real estate firm & spin off the lodging
assets to shareholders → expropriate growth opportunities → bondholders forgot to
include covenants against such transactions.
 → The stock price rose 12% on the announcement; but
 → Bond prices fell 10%. 33
Solutions
Raise the Cost of Debt

 These distortions occur when the probability of financial distress is high.

 Bondholders know that when financial distress is imminent, they cannot expect
help from shareholders.

 Bondholders will react by raising the required rate of return on bonds.

 Because shareholders have to pay these higher interest costs, they ultimately
bear the costs of the investment distortions imposed by debt.
Bond Covenants (1)
FCF problem Risk Shifting Debt Overhang Cash-in Play for time Bait and Switch Solutions

 Companies with growth opportunities may choose to have an increasing financing leverage.
By choosing a higher leverage, many companies choose to finance projects by issuing long-
term debt.

 Long-term financiers may require additional support from shareholders to enter into a long-
term financing agreement, such as restrictions on dividend payments, additional leverage,
collateral structures and so forth.

 Main Types of Bond Covenants (see Appendix for detailed examples)

1. Restrictions on subsequent financing

 Issuance of new debt prohibited unless certain ratios are met.
 Some of the key ratios are: tangible assets to long term debt, earnings coverage
ratio, leverage ratio.
 Restrictions on the issuance of secured debt
36
Bond Covenants (2)
FCF problem Risk Shifting Debt Overhang Cash-in Play for time Bait and Switch Solutions

2. Restriction on dividends
 Allow payments of dividends only if sufficient payable funds exist. Payable funds are a
function of earnings, assets, leverage and past dividends.
3. Restriction on merger activity (Poison Puts)
 Bondholder has the right to sell the bond back to company at some given price if some
specific event (such as a takeover) occurs.
4. Restriction on disposition of assets
 restrictions on asset sales unless used to retire debt
 restrictions mandating maintenance of assets
 restrictions on investment in financial securities, which prevent stockholders from
increasing risk
5. Restriction on net worth
 Mandatory debt retirement at par if net worth falls below specified minimum

 Caveat: Having too many covenants may 37 also be costly since it can severely restrict the
flexibility of firms to make investment, financing, or dividend decisions.
Bond Covenants in the U.S.
FCF problem Risk Shifting Debt Overhang Cash-in Play for time Bait and Switch Solutions

 Smith and Warner report some numbers on different classes of restrictions imposed in bond
indentures in the U.S.:
 90.8% restrict issuance of additional debt (Bait and switch).
 23% restrict dividend payments (Cash-in and run).
 39% restrict merger activity (Risk shifting).
 35.6% restrict disposition of assets (Risk shifting, cash-in and run).

38
 Bond Covenants in the U.S. across time

 Sample of 10,513 public bonds issued in the U.S.

 Average (median) 4.7 (4) covenants per bond.
Source: Zhang & Zhao (2013)
 Bond Covenants in the U.S.

 Source: Chava et al (2009)

 Bond Covenants in the U.S.

 Source: Du (2015)
Determinants of Bond Covenants in the U.S.

 Source: Bradley & Roberts

Determinants of Bond Covenants in the U.S.

 Source: Bradley & Roberts

 Determinants of Bond Covenants in the U.S.
 Source: Bradley & Roberts
Bond Covenants in Brazil (2000-2010)
Other Solutions
FCF problem Risk Shifting Debt Overhang Cash-in Play for time Bait and Switch Solutions

1. Delegated monitoring. Rather than have detailed covenants, we could have a “close”
lender offering short-term debt and monitoring the firm on behalf of itself and other
creditors. Such lender would have more “control” over the borrower's activities because it
could always threaten not to renew its loan to the firm. This may be the primary purpose of
bank debt.
2. Security design. Basic intuition is to give bondholders a piece of the pie if things go well.
Contracts like convertibles may mitigate the risk-shifting problem. Shareholders know that
debt holders will convert if risky projects pay off. This softens shareholders’ incentive to
take risky NPV<0 projects.
3. Management compensation contracts can be structured so that management takes the
interests of all claim-holders into account.
4. Reputation. If you plan to be an entrepreneur or an executive for a long time, you don’t
want to go around reneging on your contracts and disappointing creditors. This will make
it hard to borrow money in the future.
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A Comprehensive Example:
The Case of Goodyear (1)
The Diversification:
 Manufacturer of rubber products. The firm has tried to diversify into oil and gas and to
build an oil pipeline from Texas to California without much success.
 It decided to initiate a diversification strategy based on acquiring several oil producers.
 Shareholders did not react favorably to the diversification plans and the stock price fell
65% (relative to the S&P) over the 3 1/2 years that followed the diversification strategy.

The Leverage Recapitalization:

 Under pressure, Goodyear started a cash tender offer for 40 million of its shares at $50
a share. This offer represented a 50% premium over its recent share price.
 Its long-term debt-to-equity ratio rose from 28% to 150% in 3 years.

 Goodyear recapitalization forced management to discontinue its diversification strategy

since Goodyear was forced to sell most of its non-tire assets to pay its debt.
A Comprehensive Example:
The Case of Goodyear (2)
 Benefits
 Tax Benefits: Interest expense increased from $101 million to $282 million in two years
 taxable income lower.

 Lowering Agency Costs: The new debt from the levered recapitalization can be
thought of as a type of control device for the shareholders of Goodyear to limit the
choices faced by management.

 Costs
 Financial Distress: Its debt was downgraded. Its level of investment fell from 1/5 billion
to 750 million (perhaps not a bad thing).

 Financial Slack: Loss of financial slack can preclude strategic options if competitors cut
prices or increase capital spending.
 Many people think that this is what happened when Bridgestone announced intentions
to raise capital spending in USA. Goodyear could not counter by raising investment. To
do so would have required raising equity  costly option (pecking order).
Things to Remember (1)

 M&M assumes that investment policy is unaffected by the firm’s capital structure. This
ignores that the way the CF is divided between shareholders and creditors may affect the
firm’s investment policy (and thus change its CFs and value).

 However, it is quite plausible that investment may directly be affected by capital structure.
 Leverage may reduce wasteful investments. It may also induce managers and
employees to work harder.
 If the value of the firm is close to the face value of debt, shareholders may invest in
NPV<0 projects with high upside profits.
 If the value of the firm is lower than the face value of debt, shareholders will not want to
invest fresh funds in NPV>0 projects as they will eventually loose their equity in the
firm (even if the new projects succeed).

49
Things to Remember (2)

 In addition, investment may indirectly be affected by capital structure.

 Shareholders may cash-in and run by awarding themselves large dividends.

 Shareholders can resort to many other methods to separate creditors from their
money, such as play for time, bait and switch, etc.

 Creditors will anticipate this behavior and demand higher interest rates. As a result,
fewer NPV>0 will be pursued.

 To prevent the expropriation of creditors, various forms of creditor protection have arisen,
including bond covenants, delegated monitoring, and security design.
 These solutions are imperfect. For example, rules against issuing new debt may
avoid bait-and-switch. At the same time, they may worsen the debt- overhang
problems.
50
Things to Remember (3)

 Advantages of debt:
 Interest is tax deductible.
 Bonds management promise to pay out cash in a way that dividends can’t.

 Costs of debt:
 Agency conflicts between bondholders and shareholders.
 Financial distress.
 Bankruptcy
 Appendix:
Examples of Bond Covenants
Examples of Covenants (1)

Covenant 1: Accounting Based Restrictions. Ratio covenants.

a) (DEBT/EBITDA): Variable Debt means the sum of all consolidated debts from a
company. Some companies used net debt instead of total debt. EBITDA is the earnings
before interest, depreciation and amortization.
b) (Interest Coverage Index): This index is the proportion of EBITDA divided by net debt.
c) (Short-term debt / EBITDA): Another financial covenant to maintain the firm under certain
conditions. Short-term debt means all debts that mature within one year or less.
d) (Debt/Equity): This covenant specifies a limit of indebtedness measured by the
proportion of Debt (all debts) to Equity.
e) (Other Financial Covenants): Here we group financial covenants that do not appear often
in the prospects. For example, a minimum level of net worth, limits for bank debts and
bank debts divided by net worth.
f) (EBITDA/CAPEX): A covenant that specifies a measure of how a company can cover its
capital needs using internal funding.
Examples of Covenants (2)
Covenant 2: Dividend Restrictions.
• (Dividend Restrictions): This covenant stipulates a limit of dividends that must be paid or a
prohibition of dividend payments.
Covenant 3: Reduction of Capital.
• The issuer of the corporate bond must not reduce their capital/net worth in the company.
Covenant 4: Liquidation, Dissolution or Bankruptcy.
• The company must not allow its own Liquidation, Dissolution or Bankruptcy.
Covenant 5: Change in Core Business.
• It is not allowed to change the main purpose of a company. It has to do what it is widely
known to do for clients.
Covenant 6: Change in Company’s Structure;
a) Merger, Split or Privatization: Companies are not allowed to be part of other companies
or to let others be part of the company who issued the corporate bond.
b) Change in legal structures: Companies must also maintain their legal structures to list in
the stock market while corporate bonds exist.
Examples of Covenants (3)

Covenant 7: Transfer or Change in Issuer’s Control.

• The company that issues a corporate bond cannot change its controlling stockholders
and/or its main directors.
Covenant 8: Sale, Disposal or Transfer of Assets.
• Companies are not allowed to sell, negotiate or use the companies’assets for other
purposes.
Covenant 9: Default.
a) The company must pay all its debts in time.
b) Lowering the credit rating: In accordance with a rating agency, companies cannot have
a reduction in their risk classification.
Covenant 10: Problems with legal obligations and environmental permissions.
• All licenses and work contracts that a company has must be in perfect condition. The
company cannot be part of environmental problems and must face all their legal
obligations.