Bond Covenants and Forgone Opportunities: The Case of Burlington Northern Railroad Company

In 1896, J.P. Morgan and the Deutsche Bank developed a reorganization plan for Northern Pacific Railroad that included the issuance of $181.6 million of bonds with very restrictive covenants. Years later, Burlington Northern Railroad Company, which had assumed the Northern Pacific bonds, attempted to get around those restrictions. However, the indentures of the two series of bonds withstood the attacks of presumably clever bond lawyers. In 1987, Burlington Northern Railroad agreed to pay bondholders $35.5 million plus court costs to relax the covenants. This case provides an interesting illustration of one of the agency costs of bond covenants - forgone opportunities. While the payment to the bondholders amounted to 30% of the face value of the bonds, the gain to shareholders amounted to about $475 million in the form of abnormal returns.