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agency costs of debt

European Business Organization Law Review (EBOR) (1)

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The Economics of Covenants as a Means of Efficient Creditor Protection
Klaus M. Schmidt
Journal:

European Business Organization Law Review (EBOR) / Volume 7 / Issue 1 / March 2006

Published online by Cambridge University Press:

21 June 2006, pp. 89-94

Print publication:

March 2006
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Covenants are a means to mitigate the agency problems between borrower and lender that are induced by the allocation of cash flow rights in a debt contract. This comment shows that if covenants could be renegotiated without any transaction costs they could be used to induce efficient behaviour on the part of the borrower and to fully protect lenders. Due to problems of asymmetric information, collective action and hold-up, however, covenants are imperfect. The analysis suggests several ways to improve the functioning of covenants.