Lenders lend more to firms with independent boards

19 June 2015

The more independent directors a company’s board has the more debt with longer maturity lenders are willing to give a firm, according to Warwick Business School research.

Under the watchful gaze of a strict board the firm’s management are also far more likely to be careful with the company’s cash flow. Such a level of control can help abate the agency cost of debt – the increase in the cost of debt when the interests of debtholders and management diverge – and therefore benefit all stakeholders suggests Onur Tosun, Assistant Professor of Finance at Warwick Business School.

Dr Tosun said: “Stronger internal monitoring via a more independent board of directors mitigates both debt agency and the issue of managers holding more power and influence than the board, plus it means companies have more debt with longer maturity.

“This better governance acts as a control mechanism on the CEO which benefits all the stakeholders. It also increases long-term debt and resolves cash flow problems.”

Without an independent and strong board overseeing the CEO lenders have used short-term debt as a potent controlling tool to keep them in check.

Dr Tosun added: “Short-term debt can be a powerful tool to monitor management and deter them from taking risks without worrying about the consequences by enabling lenders to detect the CEO’s risky behaviour. They can then renegotiate the terms of the debt for higher returns or simply pull out as the short-term maturity of the debt basically gives the lender check points to evaluate how the CEO is using the money.

“Therefore, the maturity structure of debt can substitute strong corporate governance, or vice versa, in terms of managerial control. When one increases, the other can decrease. In the presence of a powerful board with efficient control of the firm lenders don’t necessarily have to restrict themselves to short-term debt as monitoring the management is done by that strong independent board.

“Consequently, lenders may become more willing to issue longer term debt as firms have more independent and stronger boards.”

Trust issues: Board indepdendence increases and short-term debt drops after the SOX Act is introduced in 2003


For the paper Internal Control and Maturity of Debt - a working paper yet to be published - Dr Tosun and Lemma Senbet, of the Robert H Smith School of Business, looked at the debt of 1,300 US firms between 1996 and 2009. In 2003 new regulations were introduced requiring companies to have a majority of independent members on their board of directors, called the Sarbanes-Oxley Act (SOX Act), so the researchers looked at the firms seven years before and six years after the act.

The study found the average maturity of the firm’s debt was about three years and three months, while the average number of independent members on the board was 65 per cent.

Between 1996 and 2002 board independence increased by about two per cent, to 48 per cent, but right after the new act independence jumped 17 per cent to 65 per cent and kept rising up to 78 per cent by 2009.

Although short-term ratio debt generally increased from 35 per cent to 38 per cent before the new act, it started to decline rapidly to 31 per cent afterwards.

Dr Tosun added: “This reversed relation between these two variables around the new act clearly exhibits the impact of the corporate governance changes via the board independence after 2002 on the debt maturity decisions in the firms. We also looked at firms where the CEO is also chair of the board or has certain powers over the board and this relation with debt was again strong, but when lenders issued debt that converted into shares in that company the relation broke down as there was no need for a more independent board."

Before the SOX Act, the annual mean value of long-term debt ratio and weighted average maturity decreased from 51 per cent to 47 per cent and from 3.15 to three years, respectively, but after it both measures increased quickly. Long-term ratio debt rose to 56 per cent, while weighted average maturity increased to 3.4 years, denoting a rise in long-term debt and a fall in the short-term debt ratio. (See graph above).

“The relationship between board independence and the maturity structure of debt has never been researched before,” said Dr Tosun. “We provide findings that could solve both the moral hazard of CEOs – managerial agency - and the divergence of interests between the debtholders and the CEO over debt – debt agency.

“Our findings indicate that firms have debt with longer maturity as board independence increases and internal monitoring becomes stronger. Interestingly the results are even stronger for conglomerate firms.”

Onur Tosun teaches Advanced Corporate Finance on the MSc Finance and Corporate Finance on Warwick Business School's Undergraduate programme.

Join the conversation

WBS on social media