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Abstract: Using a regression discontinuity design, we provide evidence that incentive conflicts between firms and their creditors have a large impact on employees. There are sharp and substantial employment cuts following loan covenant violations, when creditors exercise their ex post control rights. The negative impact of violations on employment is stronger for firms that face more severe agency and financing frictions and those whose employees have weaker bargaining power. Employment cuts following violations are much larger during industry and macroeconomic downturns, when employees have fewer alternative job opportunities and reduced bargaining power. Union elections that create new labor bargaining units lead to higher loan spreads, consistent with creditors requiring compensation for their reduced control rights when labor is stronger. Overall, these findings enrich our understanding of the consequences of the state contingent transfer of control rights by identifying a risk-shifting channel from creditors to employees. Our analysis establishes an endogeneity-free link between financing frictions and employment and offers direct evidence that binding financial covenants are an important amplification mechanism of economic downturns.

Keywords: Covenant violations, employment

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