Corporate Governance and Restrictions in Debt Contracts

Abstract:     
We test the efficient contracting hypothesis by investigating the association between direct lender monitoring via restrictions in public bond contracts and delegated monitoring via borrowers’ corporate governance mechanisms. We expect public bond contracts to contain fewer restrictions when the borrower’s corporate governance is more effective in mitigating the agency risk of debt. Using a broad set of corporate governance indicators, we find that bond contracts have fewer restrictions when the borrowing firm’s board size is larger, when board members have more expertise, and when the firm has more activist shareholders. However, public bondholders demand more restrictions when the borrowing firm is characterized by more powerful insiders or blockholders. We document that the above associations vary cross-sectionally with debt monitoring mechanisms’ relative efficiency. Bondholders rely more on corporate governance monitoring mechanisms than bank lenders which are more efficient monitors, especially when borrowers are informationally opaque and credit risky. However, when borrowers issue bank debt, bondholders rely less on corporate governance mechanisms and instead prefer to delegate monitoring to senior bank lenders.

Number of Pages in PDF File: 70

Keywords: restrictions, monitoring cost, delegated monitoring, debt, corporate governance, lender governance

JEL Classification: G34, M10, O16

working papers series