Default Clauses in Debt Contracts

This paper examines the structure, determinants and implications of the set of default clauses required in lending agreements, a contracting feature that was previously overlooked in the debt literature. Default clauses are critical contractual provisions that facilitate the transfer of control rights to debtholders when certain pre-specified events ensue. We document significant cross-sectional variation in the presence of various default clauses and the restrictiveness of their two main characteristics, the grace period and the threshold value allowed before a clause can trigger default. We find that an index of the restrictiveness of the set of default clauses decreases with the credit quality of the borrowing firm in both bond and syndicated loan contracts. However, only the default clause restrictiveness of bonds decreases with expected bankruptcy costs, consistent with bondholders’ interest to avoid bankruptcy events due to their limited ability to renegotiate contracts when defaults occur and lower priority claims. Finally, we show that the restrictiveness of default clauses is positively associated with the probability of a subsequent bankruptcy filing and with events that avoid bankruptcy filings such as bond repurchases in the case of bonds and loan amendments in the case of syndicated loans.