Corporate Governance and Covenants in Debt Contracts

Abstract:     

We investigate the association between direct debtholder monitoring via bond covenants and delegated monitoring via borrowers’ corporate governance mechanisms. We find that bond contracts include fewer covenants when the borrower’s corporate governance is more effective in mitigating the agency risk of debt. Bond contracts have fewer covenants when the borrowing firm’s board size is larger, board members have more expertise, the firm has more activist shareholders and there are fewer powerful insiders on the board or blockholders. We document that these associations vary cross-sectionally with debtholders’ monitoring efficiency. Bondholders rely more on corporate governance monitoring mechanisms when borrowers are informationally opaque and closer to insolvency, two settings associated with higher bondholder monitoring costs. However, when bondholders have the opportunity to delegate monitoring to senior creditors or to insure against credit losses in the CDS market, they rely less on corporate governance mechanisms. Finally, we document that, consistent with banks being more efficient monitors than bondholders, bank syndicates rely less on corporate governance monitoring unless they have a dispersed ownership.

Number of Pages in PDF File: 72

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

JEL Classification: G34, M10, O16