Corporate Boards and Bond Contract Terms

Abstract

I use the NYSE and NASD board independence reforms to examine the relation between board structure and the contract terms of new bond issues. Using a difference-in-differences design, I find that noncompliant firms that transition to independent boards experience reductions in payout, financing, investment, and event risk covenants and attract higher credit ratings on their new bond issues. These contracting benefits are not offset by higher at-issue credit spreads. I further show that the effects of the reforms are concentrated in Delaware, where state law governing directors’ fiduciary duties limits their incentives to favor equity over debt. I also find that these incentives dominate co-opted directors’ allegiance to the CEO, to the extent that following the reforms, covenants of bonds issued by Delaware firms with co-opted boards decrease, whereas those of non-Delaware firms increase. These contracting outcomes are not influenced by shareholder control, and are stronger when firms are more vulnerable to takeovers and have fewer distracted directors. Collectively, my findings are consistent with the disciplining effect of independent boards on entrenched managers and suggest that when directors have legal incentives to consider the interests of creditors, increased oversight of managers through board independence reforms can reduce bondholders’ agency costs.

Keywords: Bond Covenants, Corporate Boards, Corporate Governance, Cost of Debt, Debt Contracting, Entrenchment, Fiduciary Duties, Regulation

JEL Classification: G30, G32, G38, K22