We exploit an influential 1991 Delaware court ruling to examine simultaneously two types of conservatism that play important roles in resolving creditor–owner agency conflicts: contracting conservatism and reporting conservatism. The ruling expanded managerial fiduciary duties in favor of creditors for Delaware‐incorporated firms in the vicinity of insolvency. In those firms, following the ruling, debt contracts are less likely to include conservative adjustments to accounting numbers used for covenant compliance (i.e., contracting conservatism decreases), while public financial reporting becomes more conservative (i.e., reporting conservatism increases). The decrease in contracting conservatism is concentrated in firms that exhibit a greater increase in reporting conservatism, suggesting that reporting conservatism is more cost‐effective in resolving agency conflicts. In addition, the substitution effect is more pronounced in firms facing greater business uncertainty and firms with greater board independence.

We present new evidence on debt covenant violation ( DCV ) consequences that have not previously been examined in the literature. In particular, we show that a DCV triggers significant information asymmetry and uncertainty on the part of shareholders and auditors as reflected in higher bid–ask spreads, return volatility, and audit fees. Further, these consequences occur even when lender‐imposed costs are relatively lower, consistent with the act of default itself triggering shareholder and auditor uncertainty. The results highlight costs to the firm of having bright‐line rules in contracts, and add to an understanding of the consequences of DCV s.