When a debt covenant is violated the lender has the right to demand immediate repayment of the loan. Using this right, the lender can extract certain concessions from the borrower (manager), which may be inefficient. I propose a theory that explains why, despite this inefficiency, tight and often violated debt covenants may be optimal. In a repeated moral hazard problem combined with an incomplete contract set-up, the debt overhang prevents the manager from exercising optimal effort. I deviate from the standard incomplete contract set-up by allowing outside market participants to observe the uncontractable outcome. I model the manager's outside option as the opportunity to refinance his debt on a competitive loan market. In this situation, the market independently evaluates the manager's performance based on observable parameters. The value of the outside option has an important impact on the covenant design. A strict covenant will severely punish the manager if his outside option is low. If the covenant is violated the lender will have control over the manager's assets and the manager will face a renegotiation game in which the lender has all the bargaining power. In this case a high outside option allows the manager to retain some rents. The manager will exercise effort to increase his chances to have a high outside option.

Financial innovations are a common explanation for the rise in credit card debt and bankruptcies. To evaluate this story, the authors develop a simple model that incorporates two key frictions: asymmetric information about borrowers’ risk of default and a fixed cost of developing each contract lenders offer.