Board Ties and the Cost of Corporate Debt

• Author: Tuugi Chuluun,John Puthenpurackal,Andrew Prevost
• Published date: 01 September 2014
• DOI: http://doi.org/10.1111/fima.12047
• Date: 01 September 2014

Board Ties and the Cost of Corporate

Debt

Tuugi Chuluun, Andrew Prevost, and John Puthenpurackal∗

We examine the impact of firms’ board ties on bond yield spreads. Prior literature associates

board connectedness with improved access to resources due to visibility and reputation arising

from greater board capital. Consistent with the board capital hypothesis, we find that better

connected firms are associated with greater media coverage and more ties to financial firms.

Additionally, greaterconnectedness is linked with statistically and economically significant lower

bond yield spreads, especiallyfor f irms with high informationasymmetry. Our main result appears

robust and includes significant negative (positive) changes in yield spreads to announcements of

additions (departures) of highly connected directors.

John Bryan, who retired last year as CEO (Chief Executive Officer) of Sara Lee, says there

are benefits from choosing . . . active directors. “They are good in many respects because of

the broad experience they get,” Bryan said. In his view, “no-name people working hard” do not

necessarily make a board strong. “There are some perfectly useless people whospend all kinds of

hours poring over your books. You want people who’ve been around the business world,” Bryan

said.1

The subject of board connections and interlocks has become the focus of considerable aca-

demic research. Several studies in this rapidly growing area have examined this subject from a

corporate governance perspective and,overall, appear to find a negative impact of board connect-

edness on corporate governance including lower pay-performancesensitivity (Barnea and Guedj,

2009), higher CEO pay (Larcker et al., 2008; Liu, 2010), and aggressive earnings management

(Hwang and Kim, 2009). Other studies also find that board networks propagate information and

certain corporate practices, such as corporate f inance policies (Fracassi, 2012), dividend policy

(Bouwman and Xuan, 2010), private equity deal exposure (Stuart and Yim, 2010), earnings man-

agement (Chiu, Teoh, and Tian, 2013), and other governance practices (Davis and Greve, 1997;

Bouwman, 2011).

This and other streams of the literature emphasize the role of boards as a link to the external en-

vironment. Resource dependence theory (Pfeffer and Salancik, 1978) posits that highly connected

directors provide resources to the firm, such as legitimacy, skills, information, and links to capital

We thank seminar participants at Ohio University, Loyola University Maryland, University of Auckland, University of

Toledo,University of Windsor, the 2010 FinancialManagement Association Annual Meeting, and the 2010 CRSP Forum

for comments and suggestions. The authors acknowledge the valuable comments provided by an anonymous referee

and Raghavendra Rau (Editor) that significantly extended the paper. All errors are our responsibility. Tuugi Chuluun

acknowledges financial support fromsummer research grants from Loyola University Maryland and the SellingerSchool

of Business and Management. John Puthenpurackalacknowledges financial support from the Beam Research Fellowship

awarded by the Lee Business School at UNLV.

∗TuugiChuluun is an Assistant Professor in the Department of Financein the Sellinger School of Business and Management

at Loyola University Maryland in Baltimore,MD. Andrew Prevost is an Associate Professorin the Department of Finance

in the College of Business at Ohio University in Athens, OH. John Puthenpurackal is an Associate Professor in the

Department of Finance in the Lee Business School at the University of Nevada – Las Vegas in Las Vegas, NV.

1Allison, M., “Chicago Executive Spreads Himself Thin on Corporate Boards,” The Chicago Tribune,June 17, 2001.

Financial Management •Fall 2014 •pages 533 - 568

534 Financial Management rFall 2014

providers, suppliers, customers, and other relevant entities. According to Hillman and Dalziel

(2003), the antecedent of the board’s provision of resources to the firm is its board capital, which

encompasses human capital related to experience, expertise, and reputation (Coleman, 1988),

as well as relational capital associated with social ties to other firms’ directors (Jacobs, 1965).

Hillman and Dalziel (2003) also note that these resources directly affect performance by reducing

dependency between a firm and its external contingencies, lowering uncertainty and transaction

costs, and improving the likelihood of the firm’s long-term viability. Certo (2003) also notes

the intangible benefits of having prestigious boards wherein investors form perceptions of firm

quality based on the board’s aggregated human capital and social capital. Empirically, Larcker,

So, and Wang (2013) find that highly connected firms experience higher stock returns and larger

increases in profitability relative to less connected firms. Reeb and Zhao (2010) conf irm that

director capital is positively related to corporate disclosure quality.

Our paper examines the impact that the board capital of highly connected boards has on the

cost of debt capital. Since well-connected directors are more visible, firms with more connected

directors are also likely to be more visible to investors. Media coverage is likely to be greater

for firms with reputed, well known directors and this coverage facilitates investor recognition

(Merton, 1987; Fang and Peress,2009). Reputed directors also provide legitimacy and prestige and

bolster the public reputation of firms (Selznick, 1949; Pfeffer and Salancik, 1978; Certo, 2003).

In addition, board capital provides access to resources and channels of information between the

firm and external organizations. We find that connectedness is associated with ties to financial

firms, thereby facilitating access to external capital markets and providing potential conduits of

information to investors, among other benefits. Since greater board capital may be associated with

higher investor recognition, greater ties to financial firms, a superior information environment,

and higher perceived firm quality and reputation, we hypothesize that highly connected boards

mayl owerthe cost of the debt capital of their fir ms since investorscan more accurately evaluate the

likelihood of default and perceivehigher f irm quality (Sengupta, 1998; Miller and Puthenpurackal,

2002; Certo, 2003; Mansi, Maxwell, and Miller, 2011). Moreover, the marginal impact of board

capital is likely to be greater for firms with relatively higher information asymmetry (Botosan,

1997; Butler, 2008; Mansi et al., 2011).

To measure the connectedness of firms’ boards, we use social network analysisto calculate the

measures of board connectedness that capture both direct, as well as indirect, board ties within

board networks (Hochberg, Ljungqvist, and Lu, 2007). We use corporate bond yield spreads as a

proxy for the marginal cost of debt since bond yields reflect expected bond returns. An advantage

of examining yield spreads is that unlike the cost of equity, the determinants of bond risk premia

are well defined and explain a significant portion of cross-sectional variation in spreads. In

addition, related research demonstrates that information is efficiently priced by bond market

participants (Sengupta, 1998; Miller and Puthenpurackal, 2002; Butler, 2008; Zhou, 2010; Mansi

et al., 2011).

Weuse a sample of 13,037 yield spread observations of industrial issuers from 1994 to 2005. We

compute firm-level network centrality measures based on 3,032 firms that appear in the S&P 1500

Index from 1994 to 2005. In addition to the individual network centrality measures, we also use

a composite network measure obtained using principal component analysis. To examine whether

board ties have a greater impact on the yield spreads of firms with high information asymmetry,

we use stock bid-ask spreads, the number of analystsposting forecasts, analyst forecast dispersion,

and analyst accuracy as proxies for asymmetry (Krishnaswami and Subramanium, 1999; Duchin,

Matsusaka, and Ozbas, 2010).

We find evidence that better connected firms are associated with greater media coverage, after

controlling for firm size and other relevant variables, suggesting that more connected firms are

Chuluun, Prevost, & Puthenpurackal rBoard Ties and the Cost of Corporate Debt 535

more visible thus facilitating investor recognition. We also determine that connectedness is posi-

tively associated with connections to financial firms. Consistent with our primary hypothesis, we

find that higher board connectedness is associated with lower bond yield spreads after controlling

for firm- and bond-specif ic variables. We also confirm that the marginal effect of connected-

ness increases with information asymmetry. For firms at the median and 75th percentile bid-ask

spread, a one standard deviation increase in board connectedness is associated with a reduction

of 9.4 basis points and 18.1 basis points in bond yields, respectively. Our primary findings are

generally robust to the use of different network measures and various proxies for information

asymmetry. We explicitly control for the possibility that yield spreads and connectedness are

jointly determined and find our main results continue to hold. Supporting these results, we

also find a significant decrease (increase) in yield spreads when highly connected directors join

(leave) a firm’s board. Overall, we interpret our findings to suggest that the board capital of

better connected firms lowers the cost of debt capital due to investor perceptions of firm quality

and reputation and resources arising from board capital, thus reducing the information risk and

default risk components of yield spread.

The rest of the paper is organized as follows. We present our hypotheses and discuss our

measures of connectedness and information asymmetry in Section I. In Section II, the sample

selection criteria and data description are provided. Our empirical analysis is reported in Section

III. We provide our conclusions in Section IV.

I. Hypotheses, Measures of Connectedness, and Information

Asymmetry

A. Hypotheses

Despite increasing levels of both mandated and voluntary information disclosure by US firms,

information asymmetry still exists between managers and investors.Board capital can help resolve

adverse selection problems by improving the availability and reliability of information flow to

the market and by enhancing investor recognitionand conf idence. Media coverageis likely to be

better for highly connected firms due to greater visibility and the reputation of its directors, which,

in turn, facilitates the recognition of such firms by investors. Greater investor recognition would

potentially lower the cost of debt, following the arguments of Merton (1987). Fang and Peress

(2009) provide corroborating empirical evidence bydemonstrating that stocks with higher (lower)

media coverage earn lower(higher) returns due to lower (higher) risk premiums. In addition, more

reputed directors add to the legitimacy and prestige of the firm. According to Mizruchi (1996,

p. 276), “by appointing individuals with ties to other important organizations, the firm signals to

potential investors that it is a legitimate enterprise worthy of support.” Certo (2003) argues that

board prestige serves as a signal of organizational legitimacy since investors form perceptions

of firm quality based on the board’s aggregated human capital and social capital which helps

mitigate information asymmetry. Certo (2003) provides evidence indicating less initial public

offering (IPO) underpricing for firms with prestigious boards suggesting that board prestige has

an impact on security pricing.

Board capital can also add value through connections to financial firms since connections to

financial fir ms are likely to improve access to external capital markets. For example, Mizruchi

and Stearns (1994) find that f irms with ties to financial firms are more likely to employ higher

levels of external financing than those without it. Additionally, connections to financial firms

may result in other benefits, such as greater prestige (Mizruchi, 1996), strategic advice and