Lenders are more willing to lend over the long term to companies that have lots of independent directors, Warwick Business School research reveals.
According to a working paper by the business school, which is yet to be published, the more independent directors a company’s board has, the more debt with longer maturity lenders are willing to give to a firm.
This is apparently because management is more likely to be careful with the company’s cash flow if it is operating under the gaze of a strict board.
Such a level of control can help abate the agency cost of debt – the increase in the cost of debt when the interests of debt holders and management diverge – and therefore benefit all stakeholders, suggests Onur Tosun, assistant professor of finance at Warwick Business School.
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.”
Where there is not an independent and strong board overseeing the CEO, lenders have tended to use short-term debt as a potent controlling tool to keep management in check.
Tosun explained: “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 checkpoints to evaluate how the CEO is using the money.”
For the paper, entitled Internal Control and Maturity of Debt, 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, the Sarbanes-Oxley Act was introduced, requiring companies to have a majority of independent members on their board of directors, so the researchers looked at the firms seven years before and six years after the act.
The study found the average maturity of the firms’ debt was about three years and three months, while the average number of independent members on the board was 65%.
Between 1996 and 2002, board independence increased by about 2%, to 48%, but right after the new act, independence jumped 17% to 65% and kept rising up to 78% by 2009.
Although short-term ratio debt generally increased from 35% to 38% before the new act, it started to decline rapidly to 31% afterwards.
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.”