Contingency and Renegotiation of Financial Contracts: Evidence from Private Credit Agreements

Using a large random sample of private credit agreements between US publicly traded firms and financial institutions, we show that over 90% of long-term debt contracts are renegotiated prior to their stated maturity, despite being designed with a number of contingencies that tie the contract terms to future verifiable events. Renegotiations result in material changes to the terms of the contract, and lead to an average effective maturity that is half of the average stated maturity. Our empirical model of the bargaining game occurring in renegotiation reveals that new information concerning creditor quality and investment opportunities are the primary determinants of renegotiation outcomes, though fluctuations in the macroeconomic environment and ex ante contingencies in the original contract also play a significant role. Overall, our results have important implications for several aspects of financial contracting research including security design, debt maturity structure, and corporate capital structure. A large body of theoretical research in financial contracting focuses on the contingency and renegotiation of optimal contracts. Contingency corresponds to ex ante contractual terms that are an explicit function of future verifiable states of the world. For example, the rights of creditors to seize debtors' assets are typically contingent upon timely payment of interest and principal (e.g., Bolton and Scharfstein (1990) and Hart and Moore (1994)). Renegotiation corresponds to the ex post revision of contract terms that arises when a Pareto-inefficient state is reached under the initial terms of the contract. For example, long-term debt contracts are often renegotiated when ex post changes in the credit quality of the borrower lead to gains from trade contingency and renegotiation of financial contracts affect a large number of important corporate decisions, including the choice of capital structure and the design of financial securities. 1 While theoretical research suggests that contingency and renegotiation are first order concerns in corporate finance, there are relatively few empirical studies that focus on the relationship between these two components. Even fewer studies provide evidence of renegotiation outside of default. Consequently, a number of important, and even basic, questions remain unanswered, such as: How often are financial contracts renegotiated? What are the primary outcomes of renegotiation? What factors trigger renegotiation? And, how is ex post renegotiation affected by the presence of ex ante contingencies? In this study, we attempt to answer these questions by exploring the contingencies and renegotiations observed in a random sample of 1,000 private credit agreements between financial institutions …