CEO overconfidence and debt covenant violations

Abstract

We examine how the level of chief executive officer (CEO) overconfidence might affect a borrowing firm's ex ante covenant intensity and ex post covenant violations. We find that overconfident CEOs are less effective in steering the firm away from unfavorable opportunistic behavior, and hence creditors include more stringent covenant restrictions in the loan contracts of their firms. The interpretational bias and other positive illusions of overconfident CEOs coupled with the more stringent and/or greater number of stringent ex ante covenants lead to a greater likelihood of covenant violation. These results remain robust after accounting for potential endogeneity issues through various techniques. Ex post tests reveal that firms with more confident CEOs are more likely to violate loan covenants after controlling for covenant intensity. We also find that overconfident CEOs can mitigate the incidence of covenant violations, but only among loans to lower rated (non-investment-grade) borrowers and revolving lines of credit where benefits of effective monitoring are most pronounced.