CREDITOR CONTROL AND CORPORATE GOVERNANCE

Abstract

Agency theory suggests that conflicts of interest between managers and the suppliers of finance (shareholders and debt-holders) can cause considerable costs on the firm. This study investigates the role of financial contracts and corporate governance in mitigating agency conflicts. Chapter 1 examines the effect of creditor control on CEO compensation. We present evidence that creditor control has significant impact on CEO compensation. CEOs experience a sharp cut of 17% of excessive pay following financial covenant violations. Differences-in-differences test shows that the reduction in abnormal CEO compensations is only associated with violation firms, not with their matched non-violation peers during the same time period. Furthermore, we find that the cut in excessive pay upon violations is greater in firms facing stronger creditor control, i.e., firms borrowed from banks with which they have a stronger prior lending relationship or high reputation banks. Despite the fact that the prior literature has documented greater CEO compensations in firms with weaker shareholder governance, we find that shareholder governance has little significant impact on the reduction of abnormal CEO compensations following debt covenant violations. In addition, we find that managerial pay-risk sensitivity (vega) is significantly reduced after covenant violation, particularly in the presence of greater creditor control power. In contrast, covenant violations are not associated with any significant change in managerial pay-performance sensitivity (delta). Chapter 2 investigates the impact of creditor control on corporate innovation via the lens of corporate events - debt covenant violation, where control right is shifted from equity-holders to creditors. By employing differences-in-differences tests, we document that firms experience a significant cut in corporate innovation following financial covenant breaches, especially in innovation intensive industries. Furthermore, we show that creditor control plays a direct role in curbing corporate innovative activities upon covenant violations. We find that in the presence of stronger bank control, violation firms experience a significantly larger reduction in both the quantity (as measured by number of patents) and quality (as measured by non-self citations received) of innovations. Interestingly, we find that banks' expertise in certain innovative industry can moderate the adverse effect of creditor control on innovations in those industries. These results are consistent with the argument that banks are less tolerant of failures and debt covenants restrict manager flexibilities. Our findings also suggest that banks' experience, knowledge, and expertise in certain innovative industries allow them to have a better assessment about borrowers' innovative projects, and thereby mitigating the agency conflict. Chapter 3 examines the association between managerial time horizon and corporate hedging. We document that CEO's managerial time horizon has a significant effect on firms corporate hedging policy. CEOs are more likely to use derivatives and use significantly more derivatives when they approach retirement, i.e., when they have a short horizon. Propensity score matching method suggests that this finding is not driven by sample selection problem. We find that increases in derivative hedging are results of CEOs' pension entitlement. Considering future pension payments, CEOs have greater incentive to limit firm risk so as to reduce the probability of bankruptcy as they approach retirement. Furthermore, we find that increase in hedging activities is restricted in firms with strong corporate governance (e.g., weak anti-takeover provision, non-dual CEO and high institutional investor holding), suggesting that increased hedging does not benefit shareholders.