Abstract: We study the interplay between the design of financial covenants and the operational decisions
of a retailer that obtains financing through secured (asset-based) lending contracts. While it is widely held
that covenants serve to protect lenders, the ways in which a retailer adapts his operations in response
have not been studied. We characterize the market conditions (involving demand distribution, growth
potential, profit margin, inventory depreciation rate or competition in the lending market) under which
covenants are (not) superfluous, and discuss how retailers and lenders can ``operationalize'' financial
covenants, i.e., think about their effectiveness, design, and implementation, in light of these
considerations. Under a monopolistic lender, we show that a retailing firm responds in surprising ways to
stricter covenants, making use of all operational levers -- such as inventory investment or partial
liquidation -- to circumvent or diminish their impact. By endogenizing this effect, we show that covenants
can be complementary to other contractual terms (such as interest rates or loan limits), that stricter
covenants may result in non-monotonic profits for the lender, and that covenant effectiveness critically
depends on the retailer's operational flexibility, in a surprising (non-monotonic) way.