Unfriendly Creditors: Debt Covenants and Board Independence

Daniel Ferreira, London School of Economics, Great Britain

2nd May 2014  11:30 am - Room 214/215, Economics and Business Building (H69)

Abstract: We develop and test a theory of the relation between debt financing and the composition of the board of directors. We argue that, when firms are close to financial distress, shareholders and creditors can have different preferences over the degree of board independence from management: shareholders prefer a management-friendly board, while creditors prefer an unfriendly board. Our model shows that the equilibrium board composition is state contingent: in states of low cash flows, creditors use their enhanced control rights to promote the appointment of independent directors. We empirically test this prediction using data on covenant violations and board composition. We find a net increase in the number of independent directors of roughly two directors in the first two years following a debt covenant violation.