Classified Boards, the Cost of Debt, and Firm Performance

The following post comes to us from Dong Chen of the Finance Department at the University of Baltimore.

In the paper, Classified Boards, the Cost of Debt, and Firm Performance, which was recently made publicly available on SSRN, I analyze the effects of classified boards on bondholders’ wealth and the cost of debt, as well as the implications on firm performance. The empirical results suggest that classified boards are strongly associated with a lower cost of debt, and the effect is robust to the inclusion of other governance variables the literature has shown to be relevant to the cost of debt, especially the G-index.

I find that the antitakeover effect of classified boards may not explain their reduction in the cost of debt. The results are consistent with the notion that the exemption from annual elections afforded by board classification entrenches directors, while at the same time promotes their independence from management. The resulting incentives of directors from these effects of classified boards inure to bondholders’ benefit.

Perhaps because of the antitakeover effect and self-serving incentives of classified boards, I show that on average this board structure is associated with lower firm performance, consistent with the findings in the literature. However, I also provide evidence that under scenarios that are characterized by substantial expected agency costs of debt, classified boards improve firm performance, presumably due to the more significant saving of interest costs under a classified board structure when the divergence of interests between shareholders and bondholders is amplified.

The full paper is available for download here.

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