Unfriendly Creditors (with Miguel Ferreira and Beatriz Mariano)


We develop a theory of how debt financing affects, and is affected by, the composition of the board of directors. We argue that shareholders and creditors have different preferences for the degree of board independence from management. Although shareholders often prefer a management-friendly board in order to improve communication between managers and directors, creditors usually prefer an unfriendly board. The model provides a useful framework for understanding many empirical regularities related to capital structure and corporate governance. In line with the existing evidence, we show that the optimal capital and board structures are such that firms with high leverage choose less friendly boards. We also show that the optimal debt contract includes covenants that allocate rights to appoint board directors to creditors in states of financial distress. Using a large sample of debt covenant violations, we test this prediction with a regression discontinuity design and find a significant increase in board independence following a covenant violation. A covenant violation implies a net addition of one independent director to the board, which is a sizeable effect. We conclude that creditors use the threat of accelerating loan payments to enhance the monitoring role of the board and maximize the repayment of outstanding debt.

2013-02-16 18:56:04