Special purpose entities and bank loan contracting

This study examines the relation between a firm’s use of special purpose entities (SPEs) and its bank loan contracting. An SPE is defined as a legally distinct entity created specially to carry out pre-specified activities for a sponsor company. Although SPEs can serve many legitimate business purposes, they have been used improperly by sponsor firms to manipulate earnings and hide losses, resulting in higher information risk for lenders. As a result, we find that (1) the use of SPEs tends to be associated with unfavorable loan contracting terms, including higher loan rates, collateral requirements, and restrictive covenants, and (2) the above associations between SPE use and loan contracting terms are more pronounced when the borrower firm has greater CEO pay–performance sensitivity (delta) and no prior loan relationship with the lender.