Change of contract – control of assets under construction

This covenant restricts the issuer from making material changes to their already-entered-into construction or rental contracts. The covenant was first used in Norway in 2004, and the use has increased from 4.7 percent in 2004 to 19.5 percent in 2007. We find evidence for this development being related to the increased use of pledged assets. The covenant is primarily used to secure the pledged asset in asset-backed issues where the asset is not already in place, by not allowing the issuer to agree to change important aspects of the construction contract. These changes can be, for example, with regard to the delivery data, quality, or quantity of assets. We find that 100 percent of the issues including this covenant also have pledged assets, providing an explanation for the development. This would support a hypothesis that the market has learned and evolved on this point. The covenant is also used by real estate companies in their rental contracts. 6.5.2 Maintenance, insurance and monitoring – uncertain level of protection

In contrast with most of the other covenants, this one requires the issuer to perform certain actions. Smith and Warner (1979) argue that maintenance requirements with regard to property, for example, will not have much impact if they are costly to enforce. Furthermore, they argue that this problem can be solved if third parties provide the maintenance, which often is the case in businesses such as shipping. Requiring sufficient insurance is easier and less costly to supervise. In most cases, the issuer would have incentives to take out insurance that will be viewed as satisfactory by the bondholders. However, by looking at the stockholders’ claims in the company

0.0 % 5.0 % 10.0 % 15.0 % 20.0 % 25.0 % 30.0 % 35.0 % 40.0 % 2007 2006 2005 2004 2003 2002 2001 2000

Change of contract Maintenance, insurance and monitoring Restriction on registratation Hedging/ Evvironment

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as a real option, one can see that this may not always be the case. If the firm in particular has a lot of risky debt outstanding relative to equity and/or the risky debt is secured by pledged assets, the stockholder/company may not have incentives to invest in insurance. In these situations, the real option is a long way from being in the money, and the management has incentives to increase the upside potential and the company’s volatility by not buying insurance. Thus, the bondholders bear most of the risk, and the covenant can be a valuable tool in minimizing the effect of the incentives created by leverage and the conflict between bond- and stockholders. This is the reason why we would expect to find this covenant in issues by firms that are young and/or highly leveraged, and when assets are used as collateral.

Most examples we find state that maintenance, insurance and monitoring should be at a satisfactory level. The contracts that include all three aspects of this covenant are almost exclusively found in asset-backed issues where the asset is not yet in place. Restrictions on maintenance and insurance are also found in issues by real estate companies and other firms with valuable assets already in place. The use of this covenant has increased from being included in no contracts at all in the year 2000, to inclusion in 36.5 percent of the total contracts in 2007. We almost never find a specific explanation of what a satisfactory level implies and means in practical terms. We never find stated in the contracts the frequency of maintenance, how much to spend on it, or which suppliers to use. The level of insurance is also not specified in the contracts. The monitoring as a part of the covenant is exclusively related to issues where the asset not is yet built. In these cases, the covenant is used to ensure that the company oversees the construction, and makes them to some extent liable for how the supplier carries out the agreed-upon building of the asset.

We find evidence indicating a strong relationship between pledged assets and the use of this covenant; 93 percent of the contracts with the covenant are secured by pledged assets. This supports the argument that protecting pledged assets is one of the important rationales behind this covenant. All the contracts with this covenant have also included the CC covenant, illustrating the fact that this covenant is almost exclusively used when the pledged asset is not yet delivered to the issuer (with a couple of real estate companies being the exception). In line with Smith and Warner’s argument, we do find that most of the issuers using this covenant are in shipping or oil, businesses that at least to some extent use external providers. More importantly, we find that this

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covenant can provide valuable protection when included in these types of contracts, or if the firm has a high degree of leverage. It is possible to specify both insurance and maintenance more extensively to provide better protection, increasing the company’s incentive to spend money on maintenance and insurance. From the company’s point of view, this covenant has some obvious and direct costs, but from the way it is formulated in the contracts in our data, it is not clear how high these costs are in reality. One reason why it has become so popular may be that the real cost, and therefore the real protection it gives the bondholders, is in fact quite low.