s for rating firms’ corporate governance structures and practices
(Standard & Poor’s 2002). The S&P Corporate Governance Scoring systemfocuses on four majorcomponents: Ownership Structure and Influence, Financial Stakeholder Rights and Relations, Financial
Transparency and Information Disclosure, and Board Structure and Processes The governance attributeswe examine within each of these components are designed to increase the monitoring of management’s
actions to promote effective decision making, limit their opportunistic behavior and reduce theinformation asymmetry between the firm and its lenders. We investigate what effect, if any, thesegovernance features have on firms’ overall credit ratings.Our analysis yields several key findings. First, we find variables that capture each of the four major
components of corporate governance enumerated above help explain overall credit ratings aftercontrolling for firm characteristics that prior research has shown to be related to debt ratings.Specifically, we find that firms’ overall credit ratings are: (1) negatively associated with the number ofblockholders that own at least a 5% ownership in the firm; (2) positively related to weaker shareholderrights in terms of takeover defenses; (3) positively related to the degree of financialtransparency; and (4)positively related to over-all board independence, board stock ownership, board expertise, and negativelyrelated to CEO power on the board. To provide an indication of the economic significance of our results,we find that moving from the lower quartile to the upper quartile of the governance variables nearly
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doubles a firm’s likelihood of receiving an investment grade credit rating--from .48 to .92.1 During thetime frame of our analysis, the average yield for firms with investment grade debt with a ten year maturitywas approximately 6.00%. In contrast, the average yield for firms with speculative grade debt with a tenyear maturity was approximately 14.0%. This 800-basis point spread translates into an annual interestcost differential of $74.7 million for the median firm in our sample with $934 million of outstanding debt.Our results suggest that weak governance can result in firms incurring higher debt financing costs. Sowhy are some firms willing to bear additional debt costs by not practicing good governance? Weapproach this question by considering how CEOs can appropriate rentsfrom weak governance. One wayCEOs can appropriate these rents is through excess compensation. To investigate this conjecture, weestimate CEO excess compensation following the work of Core, Holthausen and Larcker (1999). Wedocument that CEOs of firms with weaker governance (greater CEO power or managemententrenchment) receive more excess compensation relative to the CEOs of firms with stronger governance(less management entrenchment). Furthermore, we show that firms with speculative grade debt have agreater propensity to overcompensate their CEOs than do firms with investment grade debt. For firmswith speculative grade credit ratings, we then compare CEO excess compensation to their share ofadditional debt costs that these firms bear due to weak governance. We find that the median excess
compensation far outweighs the CEO’s share of the additional after-taxinterest cost from havingspeculative grade debt versus investment grade debt, thus providing one explanation for why all firms do
not practice good governance.This paper makes several c
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