Empirical Evidence on Debt Governance

Abstract

A large theoretical literature suggests that debt can mitigate agency problems, yet empirical evidence is limited due to identification problems. To provide evidence, I examine whether firms implement independent directors as a substitute when debt governance becomes ineffective. Key to my analysis are two central features of debt as a governance device: first, it is only effective with bankruptcy penalties, second, it only matters for firms close to default. Consistent with debt inducing discipline, across countries, board independence is negatively related to bankruptcy penalties, and especially so among risky firms. For them, a change from strictest to softest penalties is associated with a 46% increase in the number of independent directors. Comparing changes in board independence of risky firms to those of safe firms around bankruptcy reforms confirms the cross-country results. My findings underline the role of agency problems in explaining corporate capital structure, and can further account for several unresolved issues in corporate governance (e.g., differences in bankruptcy penalties can explain 37% of the 37 percentage point “board independence gap” between the US and the UK). Moreover, my findings have important implications for optimal bankruptcy design: in the absence of bankruptcy penalties, management may have difficulties to credibly commit to forgo inefficient actions and thus to secure financing.

Keywords: Debt, corporate governance, bankruptcy, board independence

JEL Classification: G32, G33, G34, G38, K22