ions 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 shareholder
rights in terms of takeover defenses; (3) positively related to thedegree of financial transparency; and (4)positively related to over-all board independence, board stock ownership, board expertise, and negatively
related 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
2
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 rents from weak governance. One way
CEOs can appropriate these rents is through excess compensation. Toinvestigate this conjecture, weestimate CEO excess compensation following the work of Core, Holthausen and Larcker (1999). We
document 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 a
greater 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 excesscompensation far outweighs the CEO’s share of the additional after-tax interest cost from havingspeculative grade debt versus investment grade debt, thus providing one explanation for why all firms donot practice good governance.
This paper makes several contributions to the extant literature on corporate governance. Much of theprior literature that investigates the effect of various corporate governance mechanisms focuses on equity
financing (McConnell and Servaes, 1990; Yermack, 1996; Karpoff,Malatesta and Walkling, 1996;
1 For purposes of this analysis, we hold the firm characteristic variables (ROA, LEV, SIZE, etc.) constant at themean values for the sample. For those governance attributes fo
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