Discussion of “The Role of Managerial Overconfidence in the

Design of Debt Covenants”Sudipta Basu

Is the paper interesting? No accounting contentBehavioral finance – but old theory…

Managerial hubris... Roll (1986)

Still interesting to understand whether bondholders “pierce the corporate veil”

(i.e. look through firm characteristics to managers actually making decisions)

What’s the paper about? Are overconfident managers more

restricted in their business activities?Do managers who do not rush stock

option exercises have their judgment questioned by bondholders?

Merger restrictions correlated with overconfidence, “abnormal” accruals, M/B, ROA, financing restrictions…

Libby Boxes

5

Control Agency costs, Transparency, Profitability Vs (prior), Zs (current causes)

4

2 3

Option delay X

Debt covenants Y

Operational

Overconfidence X (X )

Distrust Y (Y)

Conceptual1

Independent Dependent

Validity threats related to Libby Boxes

From easiest to hardest to think about:• Statistical Conclusion Validity (5)• Internal Validity (4)• Construct Validity (2 and 3)• External Validity (1 generalizes to ??)

Are the results persuasive? Basic question is how well are potential

validity threats addressed?

Is a definitive/sharp test presented?Are multiple test results consistent?What is the totality of the evidence?Thin (regression) versus thick (case

study, institutional detail) association

Theory/External Validity

Do we usually distrust overconfident people?How much is “optimal” confidence?How do we identify overconfidence?Can you be both depending on domain?Is overconfidence the same as optimism?

Review PSYCHOLOGY research

Overconfidence X (X )

Distrust Y (Y)

Conceptual1

Independent Dependent

Construct Validity (1)

2 3

Option delay X

Debt covenants Y

Operational

Overconfidence X (X )

Distrust Y (Y)

Conceptual1

Independent DependentNegative ProxyFounder CEO?Family CEO?Very wealthy CEO?Power-hungry CEO

Try Positive Proxies like N successive optimistic forecasts, MD&A or conference call tone, press or analyst descriptions…

Construct Validity (2)

2 3

Option delay X

Debt covenants Y

Operational

Overconfidence X (X )

Distrust Y (Y)

Conceptual1

Independent Dependent

What are distrustful actions?AvoidanceRecommend othersLimited trial (credit line?)Boundaries (covenants)Compensation (interest)

Model other distrustful actions—selection bias issues

Internal Validity

Control Agency costs, Transparency, Profitability Vs (prior), Zs (current causes)

4

2 3

Option delay X

Debt covenants Y

Operational

Easier to observe proxy for overconfidence? repeated optimistic management forecasts conference call behavior or MD& A tone

WHO observes and decides?

5

Other minor issues

Why don’t shareholders fire these CEOs?Abnormal accruals = accounting ignoranceConservatism reduces control denominatorsTime-series clustering? (mid-1980s?)Benchmark model with only control variablesMedians not means (very skewed variables)Include predicted signs in tables