Corporate governance and restrictions in debt contracts 1
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1 Corporate governance and restrictions in debt contracts 1 Xi Li a, İrem Tuna b, Florin P. Vasvari c a Fox School of Business, Temple University, 449 Alter Hall, 1801 Liacouras Walk Philadelphia, PA 19122, USA, xili@temple.edu b London Business School, Regent s Park, London, NW1 4SA, United Kingdom, ituna@london.edu c London Business School Regent s Park, London, NW1 4SA, United Kingdom, fvasvari@london.edu Current Draft: January, 2012 ABSTRACT We investigate the impact of corporate governance mechanisms on the presence of restrictions in bond and syndicated bank loan contracts. These mechanisms are in place to align the interests of equity holders and managers but they can also enhance the monitoring and enforcement of debt contracts. If this is the case, we expect lenders to accept fewer restrictions in debt contracts. Using a broad set of corporate governance indicators, we find that debt contracts have fewer restrictions when the board size is larger, members have more expertise, and the firm has more activist shareholders. However, lenders demand more restrictions when blockholders control the firms; an indication of a greater concern about the expropriation of debt-holder wealth typically associated with these shareholders. We also find that arms -length lenders (i.e., bondholders) rely more on borrowers corporate governance mechanisms when setting restrictions in debt contracts as compared to banks that do their own monitoring. Keywords: restrictions, covenants, debt, corporate governance, lender governance JEL Classification: G34, M10, O16 1 Irem Tuna and Florin Vasvari acknowledge the financial support from the London Business School RAMD Fund. We appreciate comments from the workshop participants at the AAA 2010 Annual Meeting, Shanghai Jiao Tong University, University of Exeter, University of Padova, University of Edinburgh, Temple University, Stockholm School of Economics, and Ewa Sletten (discussant).
2 1. Introduction Corporate governance is a set of mechanisms through which all capital providers are assured of receiving a reasonable return on their investments (e.g., Shleifer and Vishny, 1997). However, most of the literature on corporate governance takes a shareholder s perspective according to which good governance mechanisms ensure that managers make decisions in the interest of shareholders. Although the interest of lenders overlaps substantially with those of shareholders, there are potential conflicts that suggest a shareholder-focused governance mechanism might be detrimental to debt holders in some instances. In this paper, we investigate the extent to which lenders rely on corporate governance of the borrower when designing the debt contract. Debt holders own fixed claims that are more senior than the residual and limited liability claims of shareholders. However, their payoff structure has a limited upside potential that exposes them mainly to downward risks. As a result, debt holders and shareholders are likely to have diverging views on the role of corporate governance mechanisms. For instance, relative to debt holders, equity holders generally prefer corporate governance mechanisms that facilitate higher dividends and stock repurchases, riskier investment projects, and the financing of new investment projects with additional debt. These actions increase the value of the equity whose payoff is similar to that of a call option (Merton, 1973), but expropriate debt holders wealth and increase the riskiness of their claims (Jensen and Meckling, 1976). In order to reduce these risks, debt holders can require price protection by demanding higher spreads ex ante or can explicitly embed protective covenants in their lending agreements to limit borrowers opportunistic behavior ex post. 1 While a form of debt-holder-driven corporate governance via protective covenants can mitigate the impact of debt holder and shareholder conflicts, it can come with significant costs to debt holders. First, overly restrictive covenants ex ante can reduce operating flexibility and can preclude managers from undertaking investment projects that maximize the value of the firm ex post. Consequently, debt holders can inadvertently contribute to a decrease in the value of their own 1 Debt holders can also limit the wealth destroying effects of expropriation and asset substitution by simultaneously owning debt and equity (e.g., Jiang et al. 2010). In this paper, we do not investigate this alternative due to a lack of available data. 1
3 investments. Restrictive covenants might also be tripped due to conditions beyond the borrowers control by triggering technical defaults that require unnecessary renegotiations of debt contracts (Dichev and Skinner, 2002) or forced suboptimal debt restructurings. Second, writing, enforcing, and monitoring debt covenants are costly activities that involve significant information collection efforts. For instance, dispersed ownership in a debt issue makes information acquisition and monitoring activities very costly, in relative terms, for the marginal debt investor. Third, covenants can complicate renegotiations of debt contracts when unanticipated events occur. These events are likely because debt holders cannot address the entire range of contingencies through contractual means ex ante. Also, more covenants increase the likelihood of technical default even when the borrower is financially healthy. Fourth, each covenant generates additional prepayment risk for debt holders. Restrictive covenants provide incentives to borrowers to refinance the debt when lending conditions improve. When firms return the amounts borrowed, debt holders need to redeploy their funds at short notice. Finding alternative investment opportunities that provide similar returns over the same investment horizon can prove difficult. Therefore, debt holders can trade-off the existing corporate governance mechanisms with the degree of covenant requirements they demand in debt contracts and the pricing of the debt. 2 In particular, we expect governance mechanisms not only to limit managers ability to shirk responsibilities, consume private benefits, or make suboptimal investments to build empires; but also to help monitor the value of assets used as collateral in debt contracts, ensure that the company has the necessary liquidity to meet debt payments, enforce compliance with the requirements of debt agreements, and supply high quality accounting information to creditors. 3 If corporate governance provides debt holders with these benefits, then it should be associated with fewer potentially costly restrictions in debt contracts. Our empirical investigation separately analyzes the presence of covenants in 2 Smith and Warner (1979) suggest that debt holders also use the price of the firm s debt to reflect difficulties associated with suboptimal covenant packages. In our empirical tests, we control for this substitute contracting mechanism as well as for other debt contracting features. 3 Beasley (1996), Dechow et al. (1996), Carcello and Neal (2000) and Klein (2002), among others, document a relation between board characteristics and the quality of the accounting information reported. Sengupta (1998) finds a negative association between the quality of corporate disclosure and bond yields, but Shivakumar et al. (2011) find that voluntary management-forecast disclosures affect credit-default spreads. Thus governance mechanisms that improve the quality of disclosures can reduce the information asymmetry with lenders by lowering firms borrowing costs. 2
4 public bond and syndicated bank-loan contracts. These two sets of debt holders receive differential access to information and have different capabilities for monitoring borrowers. Although banks can use both public and private information sources through their long-term relationships with borrowers and monitor debt contracts very closely, bondholders rely solely on public sources of information and have a limited ability to engage in active monitoring. Hence, we expect banks and bondholders to differ in the extent to which they rely on the existing corporate governance mechanisms in the design of debt contracts. We examine the role of corporate governance in the presence of restrictions in debt contracts by using a broad array of corporate governance proxies. As argued by Larcker et al. (2007), researchers still do not have a proper understanding of the appropriate measurement of good corporate governance indicators or of the number of dimensions (or constructs) that are necessary to provide a comprehensive assessment of the quality of corporate governance. Using a data set compiled from Equilar and Risk-Metrics (formerly IRRC) over the time period 1998 to 2009 and employing an exploratory Principal Component Analysis, we compute indicators of corporate governance for a large sample of firms that issue public bonds and syndicated loans. Our indicators cover two sources of variables in corporate governance: (1) board governance such as board size, independence, and expertise; and (2) shareholder governance as captured by the extent of blockholder and activist shareholders involvement. 4 We find that borrowing firms which have larger boards and more expert board members, two indicators of board governance, receive fewer restrictions in both bond and syndicated loan contracts suggesting that boards with larger size and more expertise are perceived by lenders to have better monitoring capacities. In terms of shareholder governance, for both types of debt contracts, we document that the existence of blockholders is associated with more restrictions. This finding is consistent with blockholders perceived influence in extracting higher payouts for shareholders. We also find that greater involvement from activist shareholders is rewarded with fewer restrictions indicating that debt holders perceive a benefit from activists monitoring activities. Furthermore, we document that differential access to 4 For a smaller subsample, we also use corporate governance measures based on the executive compensation mix (from Execucomp) and anti-takeover provisions (from Risk-Metrics), and our inferences do not change. We discuss this test in subsection
5 private information by banks versus public bondholders matters with respect to the presence of insiders and their power. Firms with more insider power on the board receive a larger number of restrictions in public bond contracts but not in syndicated loan agreements. This latter result is consistent with our expectations that banks access to private information mitigates the information asymmetry generated by the presence of insiders on the board. Our results hold after controlling for an extensive set of both firm- and debtcontract-specific controls and by estimating the effects of corporate governance indicators on covenant restrictions in a reduced model that only comprises firm controls and year fixed effects. This mitigates the concern that debt contract features such as covenants, spreads, maturity, or size that are simultaneously determined might produce biased estimates for our corporate governance proxies when added as explanatory variables (e.g., Melnik and Plaut, 1986; Qian and Strahan, 2007). The results continue to be robust when we use alternative measures that capture debtcontract restrictions. They are also robust when we run tests that mitigate the impact of endogeneity due to the fact that a borrower s corporate governance mechanisms might be jointly determined with its debt contracts and debt mechanisms. Prior literature suggests that private and public debt markets have significant institutional differences (e.g., Bharath et al. 2008). To examine whether the lenders reliance on corporate governance differs in these two markets, we compare the results across the samples of private loans and public bonds by examining a set of covenants common to both types of debt contracts. We find that the association between the likelihood of adding covenants on dividend restrictions, the fixed charge coverage, and the leverage ratio, and corporate governance is more pronounced in the publicbond sample. The stronger reliance on borrowers existing corporate governance mechanisms by public bondholders is potentially a reflection of the free-riding problem caused by dispersed lending ownership. Consistent with this argument, we find that the association between debt restrictions and corporate governance is more pronounced in a subsample of private debt contracts when the lending ownership is highly dispersed. Further, we conduct a subsample analysis by partitioning borrowers based on their public information environments and credit ratings. We find that the association between debt restrictions and corporate governance is more pronounced for borrowers 4
6 facing a poorer information environments and credit ratings in the public-bond sample, but this result does not exist in the private-loan sample. This finding further suggests that banks have access to borrowers private information and are active monitors. Our paper contributes to the finance and accounting literature along several dimensions. First, we contribute to the literature that investigates the design of debt contracts. Existing studies generally focus on a single contract-based restriction. For example, El-Gazzar and Pastena (1991) explore factors affecting the presence and initial tightness of accounting-based covenants in private debt contracts and find that the borrower s leverage ratio, loan maturity, and the use of collateral are important determinants; Cook and Easterwood (1994) examine the presence of a poison-put covenant in public debt contracts and find that the issuance of poison-put debt protects managers and bondholders at the expense of stockholders. 5 To the best of our knowledge, our study is the first one to examine a comprehensive set of restrictions present in both public bonds and syndicated bank loans and how that interacts with the enforcement and monitoring provided by corporate governance mechanisms. It also highlights that corporate governance mechanisms, traditionally viewed as mitigating the agency conflicts between shareholders and managers, also are perceived by creditors to mitigate the conflicts between shareholders and creditors. Second, prior literature has analyzed the effect of corporate governance on debt yields and implicitly on the value of debt claims. Papers such as Bhojraj and Sengupta (2003), Klock et al. (2005), Anderson et al. (2004) and Ashbaugh-Skaife et al. (2006) examine the relation between bondholder wealth and corporate governance and find a negative relation between various corporate governance mechanisms and the debt yields or credit ratings. Our analysis investigates the role of corporate governance on another important contracting mechanism that is available to debt holders, covenant restrictions. Furthermore, results from prior research that investigates the effect on the value of debt holders claims are consistent with an alternative explanation that the observed relation between corporate governance and 5 In addition, Begley and Feltham (1999) examine the association between the use of covenants restricting dividends and additional borrowing in public senior debt contracts and managerial incentives; Frankel et al. (2008) examine the association between the borrower s goodwill and the presence of net-worth covenants in private lending agreements. 5
7 debt yields is driven by firm performance. 6 By investigating the presence of covenant restrictions in debt contracts, which are less likely to be driven by firm performance, the results of our paper are less exposed to this criticism. Third, our results contribute to the discussion about the appropriate measurement of corporate governance quality, a complex and multi-dimensional construct. As pointed out by Larcker et al. (2007), most studies that investigate the role of corporate governance use a limited set of corporate governance mechanisms that generally create correlated omitted-variable problems. A factor contributing to this approach is the very limited theoretical work that provides little guidance on the measurement of the construct. 7 By using a broad set of corporate governance indicators, we reduce the potential measurement error and are able to highlight the governance characteristics that are relevant in a debt contract setting. The remainder of the paper is organized as follows. In Section 2, we review the literature. In Section 3, we describe the data and sample selection. Section 4 discusses the main results, and Section 5 discusses the results for additional analyses. Section 6 concludes the paper. 2. Literature review and hypothesis development In this paper, we examine whether the debt-contract terms, namely the restrictions in debt contracts, are designed as a function of existing corporate governance in the borrowing firm. Earlier research provides mixed results with respect to the impact of corporate governance in the debt setting. On the one hand, a stream of papers documents that various corporate governance attributes lower the credit risk of a firm. Bhojraj and Sengupta (2003) and Anderson et al. (2004) find that the cost of debt is lower for companies with higher board independence; and Ashbaugh-Skaife et al. (2006) find that credit ratings are positively associated with board independence, the proportion of directors that hold company stock, and the proportion of directors that have board seats at other companies. On the other hand, Cremers et al. (2007) find that corporate governance that mainly serves shareholders 6 One could argue that corporate governance improves the quality of managerial decision-making and leads to better expected firm performance. In turn, better expected firm performance lowers yield spreads. 7 Harris and Raviv (2008) and Hermalin and Weisbach (1998) are two exceptions that only provide theoretical insights into the structure of board. 6
8 can either increase or decrease bondholder risk depending on the takeover vulnerability of the borrower. They are the first to document that corporate governance can have divergent and economically important effects on bondholders. However, the potential effect of corporate governance on covenant restrictiveness, another important contracting feature present in debt agreements, has received very limited attention in the prior literature. One closely related paper, Chava et al. (2010), investigates the effects of managerial agency risk on the design of bond covenants. This research documents that factors enhancing managerial entrenchment have a positive relation to the likelihood of adding investment-related covenants and restrictions for mergers and acquisitions, and a negative relation to the likelihood of including dividend payout covenants, subsequent financing restrictions, and eventspecific covenants. However, their main purpose is to understand how bond contracts are designed by bondholders to reflect the agency risk associated with one corporate governance mechanism, the existence of powerful management. Our paper, instead, focuses on the effects of multiple corporate governance mechanisms on the general restrictiveness of debt contracts, both for public bonds and syndicated loans. Bhojraj and Sengupta (2003) define two types of risk that creditors are concerned about when designing a debt contract. First, creditors aim to protect themselves from agency risk, namely the risk that the manager will behave in a way that is inconsistent with the interests of the creditors. They use restrictions that limit the managers ability to make unprofitable investments to grow the size of the company (Murphy, 1985) and alleviate horizon problems under which managers trade-off short-run profits for long-run returns (Dechow and Sloan, 1991). To the extent that creditors perceive existing corporate governance mechanisms to be useful in reducing agency risk, restrictions in debt contracts and corporate governance mechanisms can be viewed as interchangeable. If this is the case, we expect the debt contracts to be less restrictive for borrowing firms whose existing corporate governance mechanisms are perceived by the creditors to be more effective in mitigating agency risks. Creditors also aim to protect themselves from information risk, namely the risk that managers might have private information about the probability of default. Sengupta (1998) documents that bond ratings are higher and bond yields are lower for companies with disclosure scores of higher quality. Also, Shivakumar et al. (2011) 7
9 document that the publication of management forecasts, a common voluntary disclosure that firms provide, triggers significant adjustments of credit spreads, especially during the recent credit-crisis period when the uncertainty of information about defaults was elevated. These findings indicate that concerns about information risk could potentially play a role in the design of debt contracts. Therefore, to the extent that creditors perceive corporate governance mechanisms to mitigate information risk by ensuring the timely release of credit-relevant information, we expect creditors to place fewer restrictions in debt contracts for borrowing firms. Nevertheless, the conventional emphasis on corporate governance design seems to be on the protection of the interests of shareholders. For example, the board has a fiduciary duty to ensure that management is in line with the interests of the shareholders. Although it is not clear whether the board ensures that the management also is in line with the creditors incentives or whether the alignment between the management and the shareholders exacerbates the agency conflicts between the creditors and the shareholders, the empirical evidence discussed above suggests that creditors perceive the existing governance mechanisms as useful monitors of the management s actions as lower bond yields indicate. We study syndicated loan contracts separately from public bond contracts. Banks, by virtue of their exclusive relationship with borrowers, have access to private information and therefore are less exposed to adverse selection and moral hazard problems (e.g., Leland and Pyle, 1977; Diamond, 1984). They also have strong links with borrowers through cash management or advisory activities. Because of this informational advantage, banks are better able to monitor borrowers and renegotiate loan agreements at a lower cost if necessary. Hence, bank loans usually come with elaborate sets of affirmative and negative covenants that cover everything from minimum cash receipts to timely delivery of audited financial statements. When a covenant is breached, the bank is able to exercise de facto control rights such as replacing the CEO of the company, restructuring the company, or imposing restrictions on further borrowings and investment activities (e.g., Roberts and Sufi, 2009; Nini et al. 2009; DeFond and Jiambalvo, 1994). As a result, we expect restrictions in bank-loan contracts to be less affected by the borrowers existing corporate governance mechanisms. 8
10 On the other hand, bondholders typically do not have access to private information, and the dispersed ownership mechanisms make bond-contract renegotiations very costly. In general, they can do little until a corporation defaults on debt payments or violates a covenant. Thus, bond contracts tend to have fewer covenant restrictions, especially financial ones, and those available tend to cover mainly event risks such as additional borrowings, changes in ownership, or cash payouts to shareholders. Bondholders are less likely to play an active monitoring role and, instead, are expected to rely more on the firms existing corporate governance mechanisms, if they perceive them to be useful in mitigating agency conflicts from debt. As documented in Larcker et al. (2007), corporate governance is a difficult construct to measure. Furthermore, there is no clear theory that focuses on specific governance mechanisms that facilitate the resolution of agency conflicts between shareholders and creditors. Therefore, we take an agnostic approach to our analysis and focus on corporate governance that results from two sources of monitoring in our main analyses board governance and shareholder governance. In order to capture the first source, we consider three board characteristics: board size, board independence, and board expertise. The relation between board size and corporate governance quality is ambiguous. On the one hand, large boards are often associated with better monitoring capacities. For example, Baranchuk and Dybvig (2009) argue that the diverse preferences and new information that extra directors bring to the board improves the monitoring performance. One the other hand, the associated costs, such as slower decision making, less-candid discussions of managerial performance, and biases against risk taking can potentially make large boards less effective (e.g., Lipton and Lorsch, 1992; Yermack, 1996). Board independence is generally regarded as positively associated with the quality of corporate governance for debt holders. For example, Bhojraj and Sengupta (2003) find that the proportion of outside directors is positively associated with bond ratings and negatively associated with debt yields. Ashbaugh-Skaife et al. (2006) also document a positive relation between the percentage of outside independent directors on the board and firms credit ratings. Further, boards comprised of members who are more competent or knowledgeable are likely to be more capable at monitoring and preventing borrowers from defaulting. For example, Fama and Jensen (1983) argue 9
11 that multiple board appointments can signal director quality, and the appointment to numerous boards might be the result of the superior performance enjoyed earlier by the firm for which the individual serves as a director or as an executive. 8 From a debt holder s perspective, Ashbaugh-Skaife et al. find that the percentage of outside board members that sit on boards of other companies is positively associated with the firm s credit rating. However, there is also an argument that busy directors are less effective monitors. Fich and Shivdasani (2006) find that firms with busy boards exhibit lower market-to-book ratios, weaker profitability, and lower sensitivity of CEO turnover to firms performance; an indication that such directors might not spend enough time to ensure proper monitoring of the management. In order to capture the second source, namely shareholder governance, we consider two types of governance from shareholders: monitoring by blockholders and monitoring by activist shareholders. Concentrated ownership is typically regarded as a good governance mechanism, as blockholders have significant power over managers and can limit suboptimal managerial actions. However, powerful shareholders can exercise undue influence over management, such as forcing managers to take risky investments or paying out excessive dividends, which adversely affects debt holders wealth (Shleifer and Vishny, 1997; Bhojraj and Sengupta, 2003). For instance, Ashbaugh-Skaife et al. (2006) find that the number of blockholders and institutional owners is negatively associated with firms credit ratings. Activist shareholders have been associated with significantly positive changes in the financial and governance policies of the firms (Brav et al., 2008). Activists have proven to be successful in getting existing management to acquiesce to their demands and are particularly successful at gaining board representation on the target firm (Klein and Zur, 2009). Because there is no clear theoretical prediction on whether existing corporate governance mechanisms alleviate or exacerbate agency conflicts between shareholders and creditors; and, if so, which governance mechanisms are more effective in the resolution of the conflicts, we tackle this question empirically. Assuming that debt contracts are efficient, we analyze the restrictions in debt contracts in conjunction with the borrower s existing corporate governance, and infer 8 Consistent with this reputation-effect argument, Ferris et al. (2003) find that firm performance has a positive effect on the number of appointments held by a director. 10
12 from the results which governance mechanisms the creditors deem useful in alleviating the agency conflicts with the shareholders. 3. Data and sample selection We use four categories of data in this paper: public bonds, syndicated bank loans, corporate governance mechanisms, and firm-specific variables. Below, we discuss each of these categories in detail. We also provide a discussion of the sample selection process Public bonds We obtain the data for public bonds from the Mergent Fixed Income Securities Database (FISD). FISD is a comprehensive database providing issue-level information on covenants, pricing, maturity, size, and other features for publicly traded bonds in the United States. Restrictive covenants in bond contracts are designed to protect bondholders by limiting borrowing firms ability to take opportunistic actions against bondholders interests. A bond contract can cover several types of covenants. For example, a negative pledge covenant limits the borrower s ability to issue additional secured debt that might dilute the claims of existing bondholders. Covenants on investments, dividends, and asset sales prevent issuers from transferring wealth from bondholders to shareholders through risky investments, excessive cash payouts, or asset substitution. Also, the presence of put, convertibility, and asset-backed features offer bondholders extra protections against the issuer s value-destroying behavior. A put feature provides bondholders with the option to sell the bonds back to the issuer at a specified price and time. The convertibility feature gives bondholders the option of converting the bonds into common stocks, thus allowing them to participate in the upside of the issuing company and increasing their returns. The asset-backed feature provides bondholders with unrestricted claims to the ownership of the pledged assets, and therefore lowers their risks by improving the recovery of their claims if liquidation is necessary. We use the total number of covenants in the bond contract and the presence of put, convertibility and asset-backed features as the primary measures for the restrictiveness of public bond contracts. 11
13 3.2. Syndicated bank loans We obtain the data for syndicated bank loans from DealScan. Similar to public bonds, we retrieve information on covenants and other features for syndicated loans issued by public firms in the United States. One special characteristic of syndicated loans is that they are usually structured in packages of multiple loans with different maturities and repayment schedules. However, loan agreements within the same package (or deal) are typically attached with the same set of covenants and other restrictive features. Therefore, our measures for the restrictiveness of syndicated loan contracts are calculated at the package level. Consistent with prior research, we use the characteristics of the largest facility within each package as additional controls in our empirical tests (e.g., loan yield spread, maturity, and credit rating). Similar to covenants in public bond contracts, both financial and general covenants in syndicated loan contracts are designed to protect lenders interests. Mandatory prepayment covenants, such as the asset-sale sweep, the debt-issuance sweep, or the equity-issuance sweep require that proceeds from selling assets and issuing new debt and equity are used to repay the outstanding senior bank debt; financial covenants, such as the minimum interest, coverage ratio, and maximum debt to net-worth ratio prevent the borrowers from deviating too far from the interests of lenders by establishing performance benchmarks. 9 The performance pricing provision links the interest rate of the loan to the change in the borrower s credit quality (either captured by credit ratings or by an accounting ratio). By allowing ex post settling up, this provision mitigates adverse selection and moral hazard problems that typically occur in this setting (e.g., Asquith et al. 2005). Similar to asset-backed bonds, security provisions in syndicated loan agreements protect lenders through unrestricted claims to the ownership of the pledged assets. 9 To check the quality of the covenant data provided by DealScan, we manually collect information on financial covenants for a subsample of syndicated loan contracts. Based on our analysis, we conclude that DealScan does a reasonable job in recording the presence of financial covenants, although particular covenants are occasionally misclassified. However, this misclassification does not have any impact on our analysis as our restriction measures are based on the total number of covenants included in the contract. Consistent with the findings of Nini et al. (2009), we also observe that DealScan significantly understates the frequency of capital expenditure covenants, which are often written in a separate section from the main section that covers financial covenants in the loan agreement. In unreported analyses, we replace the number of financial covenants provided by DealScan with the number we get based on our manual collection process and find that our results are not affected. 12
14 We use the total number of restrictions that comprise financial and general covenants, the presence of a performance pricing provision, and the presence of the secured feature as the primary measures for the restrictiveness of syndicated loan contracts Corporate governance mechanisms In our main analysis, we focus on two sources of corporate governance board governance and shareholder governance. We obtain the data for board characteristics from Equilar and Risk-Metrics (formerly IRRC) and the institutional ownership data from Thomson-Reuters Institutional (13F) Holdings Board governance We measure board governance by looking at three aspects: board size, board independence, and board expertise. Our board size variables are the total number of directors serving on the board (#Director), the number of directors serving on the audit committee (#AC), and the number of directors serving on the compensation committee (#CC). More directors serving on the board or on the audit and/or compensation committees indicate a larger board size. We use several measures commonly used in the literature to capture board independence (we code them as inverse measures of board independence): the percentage of the board comprised of inside directors (%Board Inside), the percentage of the audit committee comprised of affiliated directors (%AC Affiliated), the percentage of the compensation committee comprised of affiliated directors (%CC Affiliated), a dummy variable that indicates the chairperson of the audit committee is affiliated (AC Chair Affiliated), a dummy variable that indicates the chairperson of the compensation committee is affiliated (CC Chair Affiliated), the percentages of outside and affiliated directors who were appointed by existing insiders (%Outsider Appt and %Affiliated Appt), the percentages of outstanding shares held by the average outside, affiliated, and inside directors (%Outsider Own, %Affiliated Own, and %Insider Own), and the percentages of outstanding shares held by the average top and non-top inside directors (%Insider Top Own and %Insider Non-top Own). The presence of inside and/or affiliated directors on the board and various committees, the presence of outside and/or affiliated directors who were appointed by incumbent management, and the stock holdings of various nonindependent directors are argued as 13
15 compromising the independence of the board (e.g., Klein, 1998; Yermack, 1996; Larcker et al. 2007). We use the percentages of outside and affiliated directors who serve on four or more boards (%Outsiders Expert and %Affiliated Expert); the percentage of inside directors who serve on two or more boards (%Insiders Expert); and the percentages of outside, affiliated, and inside directors who are older than 70 (%Outsiders Old, %Affiliated Old and %Insiders Old) to capture board expertise. Multiple board appointments are likely to be associated with the directors competence, and age is often regarded as positively associated with a person s experience and knowledge. On the other hand, the above expertise measures can also be regarded as proxies for inattentiveness, as some studies find that busy and old boards are less effective monitors due to limited attention (e.g., Core et al. 1999) Shareholder governance We measure shareholder governance from two aspects: blockholder governance; and activist governance. Our blockholder governance variables are the percentage of outstanding shares owned by blockholders (%Block Own), the number of blockholders (#Block), and the percentage of shares owned by the largest institutional owner (%Largest Own). Our activist governance variables are the number of activists (#Activists) and the percentage of outstanding shares owned by activists (%Activists Own). 10 A larger number of blockholders or activists, or a higher percentage of their stock ownership indicates greater shareholder influence over a borrowing firm s activities. Following the approach in Larcker et al. (2007), we conduct an exploratory Principal Component Analysis on the above corporate governance mechanisms. This method and the results of the analysis are in Appendix A.1. We generate eight variables representing different aspects of corporate governance from the analysis. With respect to board governance, F-BoardSize captures board size; F-InsiderPower, F-Affiliated, and F-InsiderAppt are inverse measures for board independence; and F- Expert and F-Old capture board expertise. For shareholder governance, F-Block reflects the blockholder influence, and F-Active reflects the activist influence. 10 We define a blockholder as a shareholder who holds more than five percent of the outstanding shares. Institutions with the following manager numbers are defined as activists: 12000, 12100, 12120, 18740, 38330, 81590, 49050, 54360, 57500, 58650, 63600, 63850, 63895, 66550, 66610, 66635, 82895, 83360, 90803, and (for more details please see Larcker et al. 2007). 14
16 3.4. Firm characteristics We obtain data for firm characteristics from the Compustat North America Fundamentals Annual database. We compute several firm-specific variables, which are likely to be associated with debt-contract terms such as the leverage ratio (longterm debt divided by total assets), firm size (natural logarithm of market value of equity), return on assets (earnings before interest and taxes divided by average total assets), market-to-book ratio (market value of equity divided by book value of equity), tangible ratio (net PP&E divided by total assets), and interest coverage ratio (earnings before interest and taxes divided by the interest expense) Sample selection Our sample selection process consists of the following three main steps. First, we obtain information on boards for the years 2002 to 2006 from Equilar and then augment this data set with information from Risk-Metrics to generate a sample of 29,694 firm-year observations spanning the years from 1998 to We then obtain institutional ownership data from Thomson-Reuters Institutional (13F) Holdings filings. After matching and requiring non-missing data on all corporate governance variables, the final sample to conduct the Principal Component Analysis comprises 27,985 firm-year observations from 1998 to Second, we obtain information on public-bond issuance from FISD and information on syndicated loan issuance from DealScan. We also obtain information on firm characteristics from Compustat North America Fundamentals Annual. Third, for each bond or loan issue, we keep the information on corporate governance and firm characteristics for the year before the issuance date. We require each observation to have non-missing data for all the variables used in the regression analysis. If a firm issues multiple bonds or loans within the same year, we keep the issue with the largest offering amount. These data requirements generate a final public-bond sample consisting of 1,826 firm-year observations with new bond issues and a syndicated-loan sample consisting of 3,823 firm-year observations with new loan issues, spanning the period from 1998 to We winsorize all continuous variables used in the regressions at the top and bottom one percentile levels. 11 The Risk-Metrics data starts from However, the information on director shareholding and committee chair is not available until
17 4. Results In this section, we examine separately the association between corporate governance and the restrictions in public bond and syndicated loan contracts Corporate governance and restrictions in public bond contracts Due to the fact that the number of restrictions in the bond contracts is a discrete variable, we use the following Negative Binomial regression model to examine the impact of corporate governance mechanisms on the restrictiveness of public bond contracts. 12 NegBin(Restrictions ) = α Corporate governance factors it, it, β Firm specific controls γ Bond specific controls + Year dummies, (1) where the dependent variable is the number of restrictions in the bond contract of firm i issued during year t. To make sure that bond contracts incorporate information about borrowers existing corporate governance and firm characteristics, we use corporate governance variables and firm-specific controls in the year before the bond issuance (i.e., year t-1). We cluster the standard errors at the firm level to remove the effects of intrafirm cross-correlations and heteroscedasticity. In the above model, we control for a series of firm-specific variables, which are likely to be associated with bond-contract restrictions, including the leverage ratio, firm size, return on assets, market-to-book ratio, tangible ratio, and interest coverage ratio. We define these variables in subsection 3.4. Because higher leverage leads to a higher probability of default, bondholders are likely to require more restrictions for highly levered borrowers either to reduce the ex ante likelihood of default or to increase the ex post recovery rate. Similarly, firms with higher growth opportunities are riskier, thus bond contracts are likely to be more restrictive for firms with higher market-to-book ratios. Larger firms are more likely to obtain favorable contract terms given their reputation and larger asset base that can be used as collateral. The return on assets, the tangible ratio, and interest coverage ratio capture the borrower s ability to repay the debt, and therefore are likely to be negatively associated with the restrictiveness of bond contracts. it, 1 it, 12 We use a Negative Binomial model instead of a Poisson model due to over-dispersion (variance significantly larger than the mean) of the dependant variable. 16
18 We also control for a large set of bond-specific variables, comprising a subordinated bond indicator, bond maturity, bond-yield spread, bond size, and the bond's credit rating. Subordinate is a dummy variable equal to one if the bond issue is subordinated and zero otherwise. Subordinated bonds are those ranked after other debt instruments in case of liquidation. Due to the limited claims on the borrower s assets ex post, subordinated bondholders have a lower incentive to monitor the borrower s behavior through restrictive contracts, and instead might ask for a higher yield spread as compensation ex ante. Maturity measures the number of years from the date of bond issuance until the date of maturity. Because bonds with longer maturities are often riskier, maturity is expected to be positively associated with the restrictiveness of bond contracts. Spread is measured as the yield-to-maturity spread above the riskfree rate at bond issuance. On the one hand, the level of the spread reflects the riskiness of the borrower and therefore should be positively associated with the strength of the restrictions in the contracts. On the other hand, a high bond-yield spread can also be used as compensation for loose contract terms. Bond size is measured as the total offering amount. A large bond increases the default risk but reduces liquidity risk in the secondary over-the-counter bond market. Therefore, the net effect of bond size on restrictions is ambiguous. Bond credit rating is the average rating provided by four rating agencies: Standard & Poor's, Moody s, Duff & Phelps, and Fitch for each bond issue. 13 If the rating information is missing, we replace it with the average issuer rating, which is computed using the latest available rating on the issuer before the issuance date. For a very small subset of bonds for which the average issuer rating is missing, we use the latest S&P long-term issuer rating before the issuance date obtained from the Compustat Ratings data set. The literature suggests that different aspects of debt contracting terms are likely to be simultaneously determined. For example, there might be a trade-off between the number of restrictions and the bond-yield spread (e.g., Smith and Warner, 1979). The correlation coefficients between our restriction measures and the bond spread and credit rating are higher than 50% in our sample. In addition, several 13 We use the numeric transformation of the lettered ratings suggested by the Mergent FISD manual. A score of 1 corresponds to the highest credit rating (AAA for S&P, Duff & Phelps, and Fitch or Aaa for Moody s) and a score of 25 corresponds to the lowest credit rating (D for S&P, Moody s, and Fitch or DD for Duff & Phelps). 17
19 previous studies document that bond characteristics, such as the yield spread and credit rating, are also associated with the borrower s corporate governance (e.g., Cremers et al. 2007). We use two different approaches to address the simultaneity issue. First, we use the residuals in a regression of credit ratings or yield spreads on corporate governance factors to replace the raw spread and rating variables in regression (1). By doing this, we are able to isolate the effect of corporate governance on bond restrictions from that on the bond-yield spread and credit rating. We call this approach the full model. Second, we use a reduced-form model where endogenous variables (bond-specific controls) are omitted from equation (1). This reduced-form model isolates the total impact of the exogenous variables (corporate governance variables and firm characteristics) on bond restrictions. In the main analysis, we report results from both models. Given that we obtain similar results when we use the reduced-form model, we report only the results on the full model in subsequent robustness analyses. Descriptive statistics for corporate governance variables, firm-specific control variables, and bond-specific control variables are reported in Panel A of Table 1. The average bond contract in our sample contains around 6.9 restrictions (#Rstrs). Only 1.2% of bonds in our sample are subordinated. The average bond contract in the sample has a maturity of 10.7 years, a yield spread of 246 basis points, and an offering amount of $438 million. The average credit rating for bond issues in the sample is 9 (BBB for S&P, Fitch, and Duff&Phelps, Baa or Baa2 for Moody s). In Panel A of Table 2, we report Pearson correlation coefficients between corporate governance variables, bond-contract restriction variables, and control variables. Bond restriction measures are positively correlated with F-InsiderPower, F-Block, F-Affiliated, and F- Old that suggest insider-controlled and old boards as well as concentrations of institutional ownership are regarded as poor corporate governance mechanisms by public bondholders. The negative correlations between bond restriction measures and F-BoardSize, F-Active, and F-Expert suggest that large boards and boards with more experts as well as activist shareholders are regarded as good corporate governance mechanisms. This panel also indicates that issuers with lower leverage, larger size, higher profitability, higher market-to-book ratio, and more tangible assets are able to obtain less restrictive contracting terms. In addition, subordinated bonds, bonds with longer maturities, and larger offering amounts contain fewer restrictions. As discussed 18
20 before, both the bond-yield spread and the credit rating are highly correlated with bond restrictions, consistent with the interpretation that the restrictions are positively associated with bondholder risk. To examine whether issuers facing different levels of bond restrictions are fundamentally different, we conduct a univariate test in Table 3. We sort all observations into six portfolios based on the number of restrictions and the spread level. Along the number of restrictions dimension, we divide the observations into three groups based on the number of restrictions. A bond contract is defined as restriction-free if it does not contain any restriction, restriction-light if the number of restrictions it contains is between one and six (sample median), and restrictionheavy if a bond contract has more than six restrictions (i.e., above the sample median). We have 180 restriction-free, 934 restriction-light, and 712 restrictionheavy bond contracts in our sample. Along the spread-level dimension, we divide the observations into two groups based on the median spread level. As the bond spread is a continuous variable, we have the same number of observations for the low and high yield groups. Due to the positive correlation between the number of restrictions and the bond-yield spread, the number of observations is not evenly distributed among these six groups. Columns (1) to (6) report the average values of the corporate governance variables, the corresponding component raw variables and firm-specific variables for each group. Columns (7) to (9) report the t-statistics for tests that compare the mean between different columns. The univariate tests suggest that, relative to the restriction-heavy group, restriction-free issuers are characterized by boards with significantly lower insider power, higher independence, larger size, more experts, and younger age. These issuers are also characterized by lower blockholder but higher activist ownership. In addition, we also find that restriction-free issuers have lower leverage, higher market-to-book, higher tangibility, and are larger in size. In sum, this preliminary set of analyses suggests that regardless of the yield-spread level, which controls to some extent for the credit quality of the borrower, bondholders demand fewer restrictions in the bond contracts for borrowers characterized by boards with lower insider power, larger size, and higher independence, which bondholders seem to think represent better governance quality. In the first two columns of Table 4, we present multivariate regressions that take into account the partial effects of all covariates for public bonds. We report the 19
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