Labor unions and debt covenant violations*

ABSTRACT

This study examines the relationship between labor unions and firms’ decisions to violate debt covenants. We find that firms with high unionization rates are more likely to violate debt covenants than firms with low unionization rates. This relationship is stronger for firms with larger cash reserves. Our analysis also reveals that debt covenant violations lead to a lower probability of a strike. Additionally, we find that high-unionization firms are in better financial condition prior to covenant violations than low-unionization firms. Our study confirms the existing literature by showing that long-term abnormal stock returns after covenant violations are significantly positive. However, our results also show that high-unionization firms experience smaller stock returns compared to low-unionization firms. Furthermore, we provide evidence that high-unionization firms tend to manipulate earnings downward before covenant violations. These findings suggest that firms may strategically violate debt covenants to gain bargaining flexibility and force labor unions to make concessions in subsequent negotiations.

KEYWORDS:

• Labor union
• union election
• debt covenant
• covenant violation
• earnings management

JEL CLASSIFICATIONS:

• G31
• G32
• J51

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 http://finance.wharton.upenn.edu/~mrrobert/styled-9/styled-11/index.html.

2 Covenant violation is disclosed in quarterly reports, thus the date of covenant violation disclosed in quarterly report may differ from the date when the violation actually took place. We follow Nini, Smith, and Sufi (2012) and calculate the long-term stock return after covenant violations based on the disclosure date of covenant violation in quarterly reports.

Additional information

Notes on contributors

Guangzi Li

Guagzi Li is a professor at Institute of Finance and Banking at Chinese Academy of Social Sciences.

Yili Lian

Yili Lian is an associate professor of finance at California State University at Stanislaus.

Yi Zhang

Yi Zhang is an associate professor of finance at Southwestern University of Finance and Economics.