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The Non-monotonic Effect of Board Independence on Credit Ratings

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Abstract

Using the Sarbanes-Oxley Act of 2002 as a natural experiment, we document a non-monotonic relation between board independence and credit ratings. Ratings are upgraded with an exogenous increase of board independence only when independence is low, which is consistent with the costs as well as benefits of having independent directors. Further analysis suggests that these costs may include the deficiency of the industrial expertise of independent directors, the cost of information acquisition for independent directors to become informed to monitor management, and the risk-taking incentive of these directors that may adversely affect the credit risk of a financially distressed firm.

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Notes

  1. For a review on academic studies, see Hermalin and Weisbach (2003) and Adams et al. (2010); for publications by rating agencies, see, e.g., Standard and Poor’s (2002), Moody’s (2003) and Fitch Ratings (2004).

  2. In contrast, inside or executive directors are directors who are employees of the firm, and grey or linked directors are directors who, though not the employees of the firm, have some business transactions with the firm. One example of a grey director is an executive of the supplier of the firm sitting as one of its directors.

  3. Chen (2008) documents that higher firm performance brings more independent directors who are active executive directors of other firms. Crutchley et al. (2002) and Fahlenbrach et al. (2010) show that independent directors often leave financially troubled firms. Since higher credit ratings are often associated with better firm performance, these studies suggest that the addition (departure) of independent directors may be a result of higher (lower) ratings.

  4. Though rating agencies generally favor higher board independence, they also recognize the potential costs of “nominal” independence. For example, Moody’s (2004, p.6) states “there can also be tension between a board’s need for independence and its need for industry, or even company-specific, knowledge and experience.” Fitch Ratings (2004, p.10) also regards the flow of information between management and the board as important for the effectiveness of a board. Because higher independence may compromise such information flow (Adams and Ferreira 2007), independent directors may be costly. Finally, Moody’s (2003, p.6) states that “some director compensation arrangements that are substantial and rely heavily on stock options or other relatively ‘risky’ pay elements also may merit comment as potentially encouraging risk-taking that could be excessive from a creditor standpoint.” Therefore, independent directors compensated with options and/or stocks may also be costly to creditors.

  5. In undocumented analysis, we also employ stand-alone FE models to examine a non-monotonic relationship between independence and ratings. We entertain specifications with either the squared term of board independence or piecewise linear functions of independence similar to Morck et al. (1988). Our results are similar. Compared with the DID models which mainly rely on the change of independence around the event date, the FE specification relies on the time-series variation of independence during the entire sample period. We also document a dramatic change of results on a monotonic relationship between independence and ratings with or without the control of fixed firm effects, which suggests that the results obtained in the extant literature are sensitive to model specifications.

  6. Ruling out the possibility that the relation between board independence and credit ratings may merely reflect the models that rating agencies employ, which may have little to do with the actual credit risk of a firm, in untabulated analysis we demonstrate a similarly non-monotonic effect of board independence on bond spreads, which are another proxy of credit risk. Our data for bond spreads come from a proprietary database of S&P.

  7. See, for example, the Shareholder Bill of Rights Act introduced in the U.S. Senate in May, 2009, in which it states that “among the central causes of the financial and economic crises that the United States faces today has been a widespread failure of corporate governance.” The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 also prescribes that all compensation committee members be independent directors, and that shareholders may use a company’s proxy solicitation materials to nominate their own directors.

  8. There is a growing strand of literature on the effectiveness of credit ratings and rating agencies (e.g., Alp 2012; Baghai et al. 2012; Becker and Milbourn 2011; Bolton et al. 2012; Jiang et al. 2012). As a result of their alleged role in facilitating the recent financial crisis, the Dodd-Frank Act of 2010 tightened the monitoring of rating agencies.

  9. Most criticisms to the rating agencies for their potential role in the recent financial crisis are focused on ratings of structured products such as mortgage-backed securities, rather than industrial firms.

  10. One of these monitoring benefits as suggested by Andrade et al. (2009) is that independent directors may potentially reduce corporate opacity caused by unreliable corporate reporting. But our results remain after including the opacity measure of Andrade et al. (2009) in the regressions.

  11. The NYSE further requires all its listed firms to have fully independent compensation and nomination committees. Though it is not required that firms listed in the NASDAQ and the American Exchange (AMEX) have the two committees, these two committees have to be fully independent if firms choose to have them.

  12. For example, the NYSE requires independent directors to be non-employees, to have no prior employment with the firm or to have terminated the employment at least 3 years before they serve as directors, and to have no substantial business transactions with the firm. RiskMetrics goes further by requiring independent directors to have no prior employment and business transactions with the firm at all.

  13. The compliance statistics in Panel A of Table 2 show that by year 2005 still 3 % of the firms were not compliant, which is puzzling. This puzzle is also observed in Chhaochharia and Grinstein (2009) and Kim and Lu (2012). Similar to these studies, we also find based on manual search of proxy statements, that the vast majority of these non-compliant firms actually declared that they were compliant. Therefore, it appears that most of these non-compliant cases are due to the stricter definitions of independence according to RiskMetrics.

  14. In undocumented analysis, we also confirm the statistical similarity between the rating changes of the non-compliant and compliant firms between 2002 and 2003.

  15. In unreported analysis, we also confirm an overall significantly positive effect of independence on ratings based on the full sample but from 1996 to 2003, rather than from 1996 to 2005 as in Model 1.

  16. It is notable that our DID results crucially depend on whether we control for fixed firm effects or not. Without the fixed-effects, all the significant results disappear. This is consistent with our observation in Panel C of Table 2 that the non-compliant and compliant firms are similar on the observational characteristics. Therefore, controlling for the non-observable fixed-effects is important in our study.

  17. If rating agencies are forward-looking in assigning ratings (Hovakimian et al. 2009), then the rating upgrades for the very non-compliant firms should also be more significant than those of the barely non-compliant firms, because the independence of the very non-compliant firms is lower to start with. However, this “forward-looking hypothesis” cannot account for the fact that despite a more significant increase of board independence for the barely non-compliant firms relative to the compliant firms, their rating changes are not significantly different from each other. In unreported analysis, we find that a further significant increase of independence of the very non-compliant firms after 2003 continues to improve their ratings, which is also inconsistent with the forward-looking hypothesis. This is because if rating agencies are forward-looking, they should already have factored the ultimate effect of independence on ratings in 2003, and hence should not further upgrade the ratings afterwards.

  18. We also consider the balance of these different aspects of expertise within a board. In addition, we use the number of outside directorships to represent the expertise of a director, since a more talented director may sit on more boards. But rating changes of the non-compliant firms are not statistically different from each other based on these proxies of director expertise.

  19. Results using Fama-French 48-industry classifications are similar. Results that focus on independent directors who are active executive directors of other firms in the same industries are also similar.

  20. Results using the numbers of different types of independent experts, rather than their fractions are similar.

  21. Results are similar based on the earnings forecasts for the next fiscal year. We thank John Matsusaka for suggesting these measures of information asymmetry.

  22. Following Duchin et al. (2010), we use the residuals of the regressions of the number of analysts on the book value of total assets as the measure of the availability of analyst coverage. This takes into account the fact that larger firms often have more analysts following, and firm size is also directly related to credit ratings.

  23. Following Chhaochharia and Grinstein (2009), we use the Herfindahl index of institutional shareholdings to measure the concentration of institutional shareholdings. Results are similar using the percent of institutional blockholdings with at least 5 % ownership or a dummy for the presence of an institutional blockholder with at least 5 % ownership. We use the G-index to measure the strength of takeover defense (Gompers et al. 2003). We use the CEO cumulative shareholdings to measure executive shareholdings. Results using CEO incentive compensation, including stocks and options are similar.

  24. We also use the Altman’s Z-score and interest coverage ratio to indicate a firm’s distance to financial distress, and find insignificant difference between the rating changes for firms with different Z-scores or interest coverage ratios. In addition, we follow Johnson (1998) and use the ratio of fixed assets to total assets to proxy for the tendency of risk-shifting (asset substitution) by shareholders. But the results are also insignificant.

  25. Unlike executive compensation, EXECUCOMP does not provide the Black-Scholes value of options for directors. We follow Farrell et al. (2008) and approximate this value by the per grant Black-Scholes value of CEO’s option awards multiplied by the number of annual director options. If the CEO is not granted any options in a given year, we calculate the average per grant Black-Scholes value of the other top four executives, and multiply this value by the number of annual director options. We calculate the value of director stock grants by multiplying the number of annual stock grants by the share price at the end of the previous fiscal year.

  26. For completeness, we also include the interaction terms Low Director incen comp * Dummy (per_ind < 0.5 ‘02) * Post-SOX and Low Director ownership * Dummy (per_ind < 0.5 ‘02) * Post-SOX respectively in the two models. We thank an anonymous referee for pointing this out.

  27. Our results are qualitatively similar if matching based on one-digit SIC or Fama-French 48 industries.

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  1. University of Baltimore, 1420 N Charles St, Baltimore, MD, 21201, USA

    Dong Chen

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Correspondence to Dong Chen.

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This paper was previously titled “Board Independence and Credit Ratings”. I thank an anonymous referee for very helpful comments. I thank Frederick Hood, John Matsusaka, Haluk Ünal (the editor), and the participants of FMA 2009 and SWFA 2010 conferences for valuable comments and suggestions. I thank Frederick Hood for providing the corporate opacity data. I owe a debt of gratitude to Michael Bradley for his many insightful comments for the original draft that improved the paper significantly. As always, all the errors are my own.

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Chen, D. The Non-monotonic Effect of Board Independence on Credit Ratings. J Financ Serv Res 45, 145–171 (2014). https://doi.org/10.1007/s10693-012-0158-7

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