Corporate governance and the cost of debt: Evidence from director limited liability and indemnification provisions

Abstract

We find that firms that provide limited liability and indemnification for their directors enjoy higher credit ratings and lower yield spreads. We argue that such provisions insulate corporate directors from the discipline from potential litigation, and allow them to pursue their own interests by adopting low-risk, self-serving operating strategies, which coincidentally redound to the benefit of corporate bondholders. Our evidence further suggests that the reduction in the cost of debt may offset the costs of directorial shirking and suboptimal corporate policies occasioned by this insulation, which may explain why stockholders have little incentive to rescind these legal protections.

Is corporate governance risk valued? Evidence from directors' and officers' insurance

“…O'Sullivan (1997) successfully tested Holderness' (1990) hypothesis using a sample of 366 British public firms. An alternative explanation to understand why shareholders are willing to pay to protect directors is formulated in recent work by Bradley and Chen (2011). They show that directors whose firms provide them with limited liability and indemnification adopt lower risk strategies, which in turn lower their firm's yield spreads and increase their credit ratings, thus ultimately benefiting shareholders.…”

Board Accountability and Risk Taking in Banking: Evidence from a Quasi-Experiment

“…In contrast, outside directors insulated from litigation might, from the shareholders point of view, follow too conservative business strategies. The reason is that directors might be predominantly concerned about preserving their private benefits from control and their firm-specific human capital (Bradley and Chen 2011). Then, a better alignment of outside directors' interests to the shareholders via tightened liability might induce higher firm risk.…”

“…Counting the number of cases that led to outof-pocket liability of outside directors might serve as a good starting point but reveals little about incentives: a low number of cases, as documented by Black and Cheffins (2006), is equally consistent with strong incentive effects (supervisory board members chose high effort levels to avoid liability) and irrelevance (liability risks are practically nonexistent). Bradley and Chen (2011) examine empirically contractual liability provisions and indemnification clauses of U.S. publicly traded firms. According to their results, firms providing more director protection are less risky and enjoy lower costs of debt.…”

Credit Ratings and CEO Risk-Taking Incentives

“…There is a sequence of work on the association between corporate governance attributes and credit risk and/or credit spreads (see, e.g., Ashbaugh-Skaife et al 2006;Bradley and Chen 2011). Our study is part of the 3.…”

“…Studies investigate the sophistication of rating agencies in incorporating complex accounting information (such as disclosures of employee stock options) in risk assessments (Lee 2008), the effects of corporate governance quality on credit rating evaluation (Ashbaugh-Skaife et al 2006;Bradley and Chen 2011), and the interaction between securities analysts and credit risk analysts in monitoring and supervision (Cheng and Subramanyam 2008). The evidence suggests that credit risk analysts include value-relevant accounting information in risk assessments, that weak corporate governance impairs firms' creditworthiness, leading to lower rating results, and that the rating agencies play an important role in monitoring and deterring managerial misbehavior.…”