Friendly Boards and the Cost of Debt

Abstract

For a sample of public bond issues by U.S. firms between 2000 and 2019, sourced from the Securities Data Corporation (SDC) New Issues database, we examine the relationship between CEO-friendly boards and the cost of debt. To explore this relationship, we construct proxies for board friendliness based on social connections sourced from the BoardEx database, classifying a board as friendly if it includes at least one outside director who has a social connection with the CEO. Our regression analysis reveals a negative association between CEO-friendly boards and yield spreads and a positive association between CEO-friendly boards and credit ratings. These effects exist after controlling for firm and bond characteristics based on prior literature. The results are robust to an alternative measure of board friendliness and potential endogeneity. These findings imply that firms with a CEO-friendly board experience a lower cost of bond financing. This supports the argument that effective communication between CEOs and directors contributes to the enhancement of creditor interests. Our results carry a practical implication that firms heavily reliant on debt should actively employ CEO-friendly boards. Despite the burgeoning literature on CEO-friendly boards, there is a lack of research on the relationship between CEO-friendly boards and the cost of debt. Our results fill this gap in the extant literature on CEO-friendly boards.

1. Introduction

In this paper, we investigate how CEO-friendly boards affect the cost of debt. Prior studies on corporate governance indicate that it has a substantial impact on the cost of debt. For instance, Fields et al. (2012) and Ramly (2013) report on the negative association between corporate governance quality and the cost of debt. Jensen and Meckling (1976) posit that a firm can be viewed as a nexus of contracts, where the interests of various financial claim holders are not necessarily aligned. The agency cost of debt occurs when managers–shareholders prioritize their interests over those of bondholders. Incomplete contracts and information asymmetry between these parties may aggravate this cost1. Market participants play a crucial role in gauging and signaling the risks associated with the agency cost of debts across the bond markets, ultimately leading to higher risk premium demanded by creditors and increased cost of debt (Shleifer and Vishny 1997).

There is one reason why the cost of debt may be highly sensitive to the corporate governance of the borrowing firm. Creditors have strong reasons to closely scrutinize the characteristics of directors that can significantly influence their motivation to provide valuable services to creditors2. Consequently, the manner in which directors carry out their duties has a significant influence on creditors’ interests. Moreover, directors have a “creditor duty”, entailing a fiduciary responsibility to act in the best interests of both shareholders and creditors. They strive to achieve a balance between these two stakeholders. Creditors are highly attentive to the board of directors for another reason: the board significantly influences CEO entrenchment. Strong CEO entrenchment can increase the CEO moral hazard by weakening market discipline against a self-indulgent CEO, which is detrimental to creditors (Lel and Miller 2015). However, on the other hand, CEO entrenchment can signal to creditors that the current CEO will remain with the company, thereby making a credible commitment that suggests that creditors’ financial claims will be respected (Shleifer and Summers 1988).

In this paper, we investigate the influence of a particular board characteristic that has garnered significant attention from scholars—board friendliness—on the cost of debt. The impact of CEO-friendly boards on a company’s performance and the outcomes of corporate policies has recently received intense scrutiny in the existing literature (Bruynseels and Cardinaels 2014; Schmidt 2015; Kang et al. 2018; Intintoli et al. 2018; Khedmati et al. 2020; Bhuyan et al. 2022). We construct proxies for board friendliness using social connections. A board is deemed friendly if at least one outside director has a social connection with the CEO (Schmidt 2015; Bruynseels and Cardinaels 2014; Kang et al. 2018)3.

Previous studies suggest that CEO-friendly boards can markedly impact the interactions between directors and the CEO, the disclosure of information by the CEO, the utilization of this information in corporate policy formation, and the ongoing bargaining processes between directors and the CEO. Dominguez-Martinez et al. (2008) and Hermalin and Weisbach (1998) propose that directors, in assessing the quality of the CEO’s human capital, often unobservable, must depend on information voluntarily disclosed by the CEO. However, the CEO might be hesitant to share such information, as directors could use it to make decisions unfavorable to them. As a result, directors providing these services effectively enter into a bargaining game with the incumbent CEO, resembling a situation modeled in Holmstrom (1999).

In this context, Adams and Ferreira (2007) propose that CEO-friendly boards can be optimal because they encourage the CEO to share more information with them. Efficient communication between the CEO and directors can also benefit creditors. As directors have a “creditor duty”, being well-informed allows them to take actions that can positively affect creditors’ interests. On the other hand, CEO-friendly boards can harm creditor value by increasing the likelihood of collusion between shareholders and managers. So, investigating whether and how CEO-friendly boards affect creditors’ interests is an empirical matter.

Another line of literature supporting the idea that CEO-friendly boards can enhance creditors’ interests is Shleifer and Summers’ (1988) incomplete contract and CEO commitment theory. To survive and prosper, firms rely on continuous streams of (often irreversible) relationship-specific contributions from numerous stakeholders. Contracts regarding compensation between stakeholders and the company take the form of implicit agreements and resemble a repeated game structure. Even in cases where some stakeholders have contracted-on claims, due to the incomplete nature of contracts, their quasi-rents are exposed to opportunism by the company. Given that relationship-specific contributions are already sunk, stakeholders find themselves in a weaker bargaining position when dealing with the firm. By taking advantage of this favorable position, the firm may exploit stakeholders and capture their quasi-rents. In anticipation of this, stakeholders reduce their involvement in providing relationship-specific contributions to the firm, resulting in an undersupply of these contributions (commonly known as a “holdup problem”).

One potential solution to this issue is to entrench the current CEO, as suggested by Shleifer and Summers (1988). Since it is understood that the current CEO’s utility is positively linked to maintaining existing stakeholder relationships, stakeholders can be assured that their quasi-rents will be safeguarded from the firm’s opportunism as long as the current CEO remains in office. CEO-friendly boards can help entrench the CEO, complementing contractual incompleteness and promote stakeholders to make relationship-specific contributions. In this context, CEO-friendly boards may enhance creditors’ interests by providing an incentive for entrenched CEOs to honor current creditors and maintain positive relationships with stakeholders, which, in turn, increases the economic value of creditors’ interests.

In this paper, we present and examine two contrasting hypotheses regarding the impact of CEO-friendly boards on the cost of bond financing: the “conflicts of interest” hypothesis and the “creditor wealth enhancing” hypothesis. The “conflicts of interest” hypothesis is based on agency theory. A CEO-friendly board may have weaker incentives to oversee and monitor the CEO. This may lead creditors to believe that the CEO is more likely to pursue private benefits at the expense of creditor wealth. Additionally, under a CEO-friendly board, the CEO may become more entrenched, which could weaken the disciplinary effect of the takeover market on the CEO. Therefore, according to the “conflicts of interest” hypothesis, CEO-friendly boards can significantly increase the cost of debt. On the other hand, “the creditor wealth enhancing hypothesis” suggests that a CEO-friendly board can reduce the cost of debt through several channels. Firstly, according to Shleifer and Summers (1988), the current CEO has a psychological tendency to satisfy stakeholders with whom they currently have relationships, aiming to maintain these relationships. Therefore, if the current CEO is retained due to a CEO-friendly board, creditors can expect the CEO to respect their financial claims within the firm. Additionally, CEO-friendly boards can facilitate information flows between the board and the CEO, allowing directors to fulfill their “creditor duty” more efficiently.

We find evidence supporting the creditor wealth enhancing hypothesis. By employing at-issue yield spreads as a proxy for the cost of new debt, we find a negative association between CEO-friendly boards and the cost of new debt. Bondholders seem to view friendly boards positively for their wealth, leading them to seek lower yields from firms with a friendly board. We also find a positive association between CEO-friendly boards and credit ratings. This result suggests that credit rating agencies view the presence of CEO-friendly boards in a borrowing firm favorably. Furthermore, to mitigate potential endogeneity concerns, we utilize a two-stage least squares (2SLS) estimation. This analysis confirms that there is a negative relation between board friendliness and the cost of debt.

Our paper contributes significantly to the existing literature in several respects. Firstly, it enriches the expanding body of literature on the impact of CEO–director social connections on firm financial policies and firm value. Despite the growing body of literature on the financial implications of CEO-friendly boards, the current state of research has not yet reached a consensus on whether CEO-friendly boards have a positive or negative impact on the financial claims value of shareholders or creditors. Our research sheds critical light on this important question by showing that CEO–director social connections add value by significantly lowering the cost of debt.

Secondly, we contribute to the extensive research on factors influencing the cost of debt (Bhojraj and Sengupta 2003; Anderson et al. 2003; Klock et al. 2005; Ortiz-Molina 2006; Ashbaugh-Skaife et al. 2006; Cremers et al. 2007; Liu et al. 2010; Jiraporn et al. 2013; Seo et al. 2017). Our findings indicate that social connections between the CEO and board members significantly influence the cost of bond financing.

Finally, while previous studies have examined the impact of corporate governance on the cost of debt, the evidence regarding the overall influence of corporate governance mechanisms on the cost of debt remains limited and inconclusive (Bhojraj and Sengupta 2003; Klock et al. 2005; Ortiz-Molina 2006; Ashbaugh-Skaife et al. 2006; Cremers et al. 2007; Liu et al. 2010; Jiraporn et al. 2013). Fracassi and Tate (2012) contend that board friendliness constitutes an important governance mechanism that influences agency costs. Our contribution to this field lies in presenting evidence that social connections between the CEO and board members influence the cost of debt, thereby affirming its significance as a corporate governance mechanism, in line with the proposition by Fracassi and Tate (2012).

The rest of the paper is structured as follows: Section 2 presents the literature review, Section 3 outlines the hypotheses, Section 4 details the sample selection and defines the variables used, Section 5 presents the empirical findings, and finally, Section 6 provides the conclusions.

2. Literature Review

In this section, we review the literature related to our research topic and hypotheses. The initial body of literature to be reviewed pertains to agency theory, which serves as the cornerstone for both corporate finance literature and the foundational framework of this paper. Jensen and Meckling (1976) propose that firms are legal fictions, serving as a nexus for contracting relationships among stakeholders. Conflicts of interest inherent to these relationships arise through managerial moral hazard (Jensen and Meckling 1976), generous payoffs to stockholders (Brennan 1995), differing time horizons between managers and stockholders (Healy 1985), and excessive managerial risk aversion (Denis 2001). Himmelberg et al. (1999) argue that firms strategically substitute various governance mechanisms to control agency costs, depending on their contracting environment. These mechanisms include the managerial labor market (Fama 1980), corporate boards (Hermalin and Weisbach 2003; Demsetz and Villalonga 2001), executive compensation (Yermack 1997), monitoring and constraining by debt contracting (Easterbrook 1984), and financial market discipline (Franks and Mayer 2005).

The second literature relevant to this study is the body of work on the financial implications of CEO-friendly boards. Previous literature has primarily emphasized agency theory and the monitoring role of the board of directors, focusing on whether directors are independent or affiliated. However, this binary approach has inherent limitations in capturing the complex interactions between the CEO and the board in practice.

Literature on the financial implications of CEO-friendly boards focuses on the social connections between CEOs and directors. For instance, Cohen et al. (2008), Fracassi and Tate (2012), Duchin and Sosyura (2013), and Khedmati et al. (2020) have argued that social connections between CEOs and directors might lead to a lack of objectivity among outside directors, potentially hindering their ability to question the CEO’s decisions or identify misconduct. Such connections have been associated with compromised board effectiveness and an increased risk of CEO opportunism, resulting in suboptimal investment strategies and distorted corporate decisions. Furthermore, Fan et al. (2021) show that social connections between CEOs and directors can increase managerial risk-taking by enhancing the likelihood of CEO retention and by serving as a power-enhancing mechanism.

On the other hand, Cao et al. (2015), Adams and Ferreira (2007), Cai et al. (2015), and Seo et al. (2024) argue that social connections between CEOs and directors can be advantageous for shareholders. Adams and Ferreira (2007) suggest that a CEO optimally determines the extent of private information disclosure to the board. A more informed board can benefit the CEO by providing better advisory services and can also discipline the CEO more effectively through stricter monitoring. Consequently, CEOs are often reluctant to reveal information to independent directors who have limited ties with them and a stronger incentive to monitor their actions. The amount of information a CEO optimally chooses to disclose increases when the directors are friendly and have closer relationships with the CEO. This enhanced exchange of valuable information between the CEO and the board may improve decision-making processes. Additionally, Seo et al. (2024) suggest that such social ties can serve as a commitment mechanism, reducing the likelihood of the firm breaching trust with creditors.

The aforementioned arguments concerning the impact of a CEO-friendly board on firm value can also apply to the impact of a CEO-friendly board on the value of creditors’ financial claims on the firm. Another strand of literature pertinent to our investigation is the “bonding mechanism” literature, which significantly relates to our “creditor wealth enhancing” hypothesis. Williamson (1979) and Klein et al. (1978) argue that stakeholders, including creditors, are exposed to post-contract opportunism by a firm. Before entering into a contract to provide funds, creditors possess strong bargaining power over the firm. However, once the contract is implemented and funds are under the control of the firm, the firm gains strong bargaining power over the creditors due to legal limitations on the creditors’ ability to intervene in the firm’s use of funds. Thus, the bargaining power of creditors drastically deteriorates around the time of contract making and implementation. This situation would be acceptable if creditors could anticipate all possible scenarios and include provisions for the firm’s actions in those cases. However, contracts are inherently incomplete, exposing creditors to firm opportunism after the debt contracting. Consequently, creditors correctly anticipate this risk and become reluctant to provide funds to the firm ex ante. As discussed above, this problem cannot be resolved through explicit contracts alone. An incentive-compatible bonding mechanism that restrains the firm’s behavior is necessary to alleviate this issue.

Shleifer and Summers (1988), Coates (2001), and Stout (2002) suggest that retaining the current CEO is one such mechanism. They argue that the current CEO has an incentive to avoid opportunistic behavior in order to maintain the firm’s existing stakeholder relationships. For instance, Shleifer and Summers (1988, p. 40) argue that “It is probably most likely that prospective managers are trained or brought up to be committed to stakeholders…. They find stakeholder welfare has now entered their preferences, thus making them credible upholders of implicit contracts.” Thus, by committing to not replacing the current CEO, a firm can credibly signal to stakeholders, including creditors, that it will not breach trust and will honor their claims. Consequently, upon observing this commitment, stakeholders are more willing to make larger and more valuable contributions to the firm.

A bonding mechanism that complements incomplete contracts must credibly entrench the current CEO to encourage stakeholders to make valuable contributions to the firm. Johnson et al. (2015), Cen et al. (2016), Cremers et al. (2017), and Field and Lowry (2022) focus on takeover defenses as a bonding mechanism and empirically investigate whether these defenses encourage stakeholder contributions and enhance firm value. All of the aforementioned studies provide results confirming this argument. This “bonding hypothesis” can also be applied to a firm’s relationship with creditors.

3. Hypothesis Development

In this section, we formulate the hypotheses that we will empirically investigate in this paper. Our first hypothesis is the “conflicts of interest” hypothesis. As proposed by Jensen and Meckling (1976), information asymmetry and contractual incompleteness give rise to conflicts of interest between managers–shareholders and creditors within a firm. Information asymmetry and contractual incompleteness make it impossible to preclude conflicts of interest through perfect contractual solutions. Jensen and Meckling (1976) propose the asset-substitution effect, wherein shareholders–managers engage in moral hazard behaviors to transfer wealth from creditors to themselves. Shareholders, by opting for risky projects, may transfer wealth from creditors to themselves, and the presence of CEO-friendly boards could exacerbate this issue. Managers are generally more risk-averse compared to stockholders (Denis 2001). However, for the asset substitution effect to occur, managers must undertake risks at the level desired by shareholders. In the presence of a CEO-friendly board, managers are more likely to assume higher risks. Furthermore, as Adams and Ferreira (2007) suggest, CEO-friendly boards are less inclined to discipline the CEO, which worsens the CEO’s moral hazard problem. A CEO with private interests in increasing stock option values may deliberately choose risky projects that decrease creditors’ interests (Shue and Townsend 2017). Thus, the presence of a CEO-friendly board can impair creditors’ interests through various mechanisms. Creditors, correctly anticipating this, will demand a larger risk premium, ultimately increasing the firm’s cost of debt (i.e., higher yield spread). The aforementioned arguments form the basis for our “conflicts of interest” hypothesis, which predicts a positive association between the presence of a CEO-friendly board and yield spreads.

Our second hypothesis is the “creditor wealth enhancing” hypothesis. CEO-friendly boards will encourage the CEO to share information more effectively, facilitating seamless collaboration between the CEO and directors (Adams and Ferreira 2007). This will benefit creditors, who will correctly reflect the value of these advantages of a CEO-friendly board in the reduced cost of debt they require from the firm. The board of directors has an incentive to take actions that benefit creditors, as they may legally assume personal liability for creditors under certain conditions (Scheler et al. 2020). Thus, CEO-friendly boards, with better access to information, will choose to more efficiently fulfill their “creditor duty.”

Furthermore, CEO-friendly boards can assist in entrenching the current CEO, enabling them to commit to honoring existing stakeholder relationships, including the firm’s contractual relationships with creditors. In this context, CEO-friendly boards function as an effective bonding mechanism. This, in turn, promotes creditors’ willingness to provide more funds at lower costs, as they believe their financial claims are better protected and less exposed to managerial opportunism. As credit rating agencies and prospective bond investors correctly assess the impact of board friendliness on creditors’ interests, we expect these effects to be reflected in credit ratings and yield spreads. The aforementioned arguments form the basis for our “creditor wealth enhancing” hypothesis, which predicts a negative association between the presence of a CEO-friendly board and yield spreads. These considerations lead to the development of the following two hypotheses.

Hypothesis 1.

The conflicts of interest hypothesis suggests a negative association between CEO-friendly boards and credit ratings. On the other hand, the creditor wealth enhancing hypothesis suggests a positive association between CEO-friendly boards and credit ratings.

Hypothesis 2.

The conflicts of interest hypothesis suggests a positive association between CEO-friendly boards and yield spreads. On the other hand, the creditor wealth enhancing hypothesis suggests a negative association between CEO-friendly boards and yield spreads.

4. Sample and Variable Construction

4.1. Sample Construction

Our initial sample comprises public straight bond issues by U.S. firms from 2000 to 2019, sourced from the Securities Data Corporation (SDC) New Issues database. Because the friendly board measure begins in 1999, our sample period for debt issues spans from 2000 to 2019.4 We exclude financial firms (SIC code 6000-6999) and utilities (SIC code 4900-4999). Additionally, we remove issues with missing information on the yield spread. Following Anderson et al. (2004) and Cremers et al. (2007), if a firm issues multiple bonds in a given year, we create a single observation by computing the proceeds-weighted average of all the issues.

We then match the bond issue data with the BoardEx database, which has coverage starting from 1999. The BoardEx database includes data on board structures and the comprehensive profiles of individual executives and board members. Information for each director in the BoardEx database encompasses current and past employment histories, educational backgrounds, affiliations with not-for-profit organizations, and club memberships. Our final sample consists of 3074 bond issues by 828 firms from 2000 and 2019. We obtain accounting and financial variables from Compustat and CRSP for those observations as of the fiscal year-end prior to the bond issuance.

Table 1. Sample distribution by year.

Year	Firms with	Firms with	Total	% of Firms with
	Friendly Board	no Friendly Board		Friendly Board
2000	17	6	23	73.91%
2001	86	61	147	58.50%
2002	78	53	131	59.54%
2003	69	73	142	48.59%
2004	70	55	125	56.00%
2005	52	56	108	48.15%
2006	64	44	108	59.26%
2007	77	43	120	64.17%
2008	66	31	97	68.04%
2009	106	85	191	55.50%
2010	110	90	200	55.00%
2011	89	76	165	53.94%
2012	124	103	227	54.63%
2013	99	110	209	47.37%
2014	107	90	197	54.31%
2015	102	97	199	51.26%
2016	93	81	174	53.45%
2017	110	103	213	51.64%
2018	67	62	129	51.94%
2019	80	89	169	47.34%
Total	1666	1408	3074	54.20%

This table presents the distribution of our sample according to the year of issue. The sample contains 3074 straight bond issues by 828 firms over the period 2000–2019.

shows the distribution of our sample by issue year. It also categorizes sample firms as firms with a friendly board and firms without a friendly board within any given year.

4.2. Variable Construction

4.2.1. Measuring the Cost of Bond Financing

We employ the yield spread and credit ratings to assess the cost of bond financing. Following Ortiz-Molina (2006), we define the yield spread as the difference, measured in basis points, between the yield-to-maturity of the bond and that of a U.S. Treasury bond with a similar maturity. If a firm has multiple bond issues in a given year, we use the proceeds-weighted average of all the issues.

Following Klock et al. (2005), credit ratings are determined by converting Moody’s bond ratings into numerical values through a conversion process, with Aaa-rated bonds assigned a value of 22 and D-rated bonds assigned a value of 1. If a firm has multiple bond issues in a given year, we use the proceeds-weighted average of all the issues.

Table 2. Bond rating conversion table.

Conversion Numbers	Moody’s Ratings
22	Aaa
21	Aa1
20	Aa2
19	Aa3
18	A1
17	A2
16	A3
15	Baa1
14	Baa2
13	Baa3
12	Ba1
11	Ba2
10	Ba3
9	B1
8	B2
7	B3
6	Caa1
5	Caa2
4	Caa3
3	Ca
2	C
1	D

This table presents the bond rating conversion codes for Moody’s ratings utilized in the analysis.

shows our bond rating conversion.

4.2.2. Board Friendliness

Inspired by Schmidt (2015) and Kang et al. (2018), a board is classified as friendly if at least one of the outside directors has a social connection with the CEO. We classify the CEO and a board member as socially connected if they attended the same school and graduated within two years of each other. Furthermore, we consider two individuals to be socially connected if they currently share or previously shared membership in the same charity, club, or other non-profit association (Bruynseels and Cardinaels 2014). We use a binary indicator variable as a proxy for social connections, assigning a value of one when the board is considered friendly and zero otherwise.

4.3. Descriptive Statistics

In

Table 3. Descriptive Statistics.

	Firms with Friendly Board		Firms with no Friendly Board
	(N = 1666)		(N = 1408)
	Mean	Median	Mean	Median
Issue Characteristics
Yield Spread	214.66	157.56	327.23 ***	292.01 ***
Bond Rating	14.10	14.00	11.46 ***	11.00 ***
Maturity	11.09	10.14	9.57 ***	8.28 ***
Proceeds	1661.92	747.90	922.09 ***	450.00 ***
Firm Characteristics
Assets	31,700.94	12,125.20	11,721.26 ***	4064.10 ***
ROA	0.06	0.06	0.04 ***	0.05 ***
Leverage	0.32	0.30	0.37 ***	0.34 ***
Coverage Ratio	18.31	9.95	15.27	7.03 ***
StdRet	0.34	0.29	0.40 ***	0.34 ***
Capital Intensity	0.61	0.54	0.60	0.46 ***
Governance Variables
Institutional Ownership	18.40	15.69	20.98 **	19.32 ***
Insider Ownership	1.08	0.11	2.28 ***	0.34 ***

This table presents the summary statistics for the variables used in the study. Variable definitions are provided in the Appendix A. The significance of the mean (median) difference is evaluated using a t-test (Wilcoxon test). The labels *, **, and *** denote statistical significance at the 1%, 5%, and 10% levels, respectively.

, we compare the issue and issuer characteristics for the subsample of firms with a friendly board and those for the subsample of firms without a friendly board. The comparison of issue characteristics show that friendly boards are associated with lower costs of bond financing. Specifically, a bond has an average spread of 214.66 basis points in excess of the Treasury yield for firms with a friendly board, whereas a bond has an average spread of 327.23 basis points for firms without a friendly board. Also, the average credit rating is approximately 14 (Baa2) for firms with a friendly board and 11 (Ba2) for firms without a friendly board, respectively.

The comparison of firm characteristics reveals that firms with a friendly board are larger than those without one. Additionally, firms with a friendly board exhibit a higher ROA and lower leverage. Furthermore, these firms have lower institutional and managerial ownership compared to firms without a friendly board.

5. Empirical Results

In this study, a multivariate regression model is used with the cost of bond financing as the dependent variable to examine the impact of friendly boards on the cost of bond financing. Based on prior literature, we account for various variables that also affect the cost of bond financing (e.g., Ashbaugh-Skaife et al. 2006; Ortiz-Molina 2006; Liu and Jiraporn 2010).

We account for issue-specific characteristics, specifically by controlling for issue maturity (Log Maturity) and issue size (Log Proceeds). We also account for various firm characteristics. We include firm size (Log Assets), which is defined as the logarithm of total assets. Larger firms typically exhibit lower risk profiles. Hence, we anticipate a negative relationship between firm size and the cost of bond financing. To control for default risk, we include the return-on-assets (ROA), interest coverage (Coverage Ratio), and debt-to-assets (Leverage). We expect the ROA and coverage ratio to be negatively related to the cost of bond financing, while we expect leverage prior to bond issuance to be positively related to the cost of bond financing. We also control for firm risk by including the annualized standard deviation of stock returns over the year prior to the bond issue (StdRet). Firms whose stock returns are more volatile are typically perceived as riskier and, consequently, are expected to face higher costs of bond financing. We include a dummy variable that is set to one if the firm has subordinated debt and zero otherwise (Subord). Firms with subordinated debt are perceived as riskier because of the prioritization of claims to assets by different debt providers. Consequently, these firms are anticipated to face higher costs of bond financing. We also include firms’ capital intensity (Capital Intensity). As firms with greater capital intensity present a lower risk to debt providers, we expect firms’ capital intensity to be negatively related to the cost of bond financing.

Other control variables that we include are Insider Ownership and Institutional Ownership. Insider Ownership is defined as the percentage ownership of common stocks held by top five executives, and Institutional Ownership is defined as percentage ownership of shares held by institutional investors who own at least 5% of outstanding shares. Ortiz-Molina (2006) suggests that managerial ownership provides insights into future risk decisions made by management. As a result, prospective bondholders would likely integrate this information into the pricing of new bond issues.

5.1. Friendly Boards and Credit Rating

In this section, we examine the relationship between friendly boards and credit ratings. Because credit rating categories represent ordinal risk assessments, we employ an ordered probit model. A positive coefficient indicates that the variable is associated with higher credit ratings.

Table 4. Friendly boards and credit ratings.

Dependent Variable: Credit Ratings	(1)	(2)
Friendly Board	0.125 ***	0.089 *
	(2.90)	(1.88)
Log Assets	0.714 ***	0.710 ***
	(24.94)	(24.84)
ROA	5.084 ***	5.092 ***
	(19.12)	(16.93)
Leverage	−1.535 ***	−1.642 ***
	(−11.83)	(−10.82)
Coverage Ratio	0.002 ***	0.002 ***
	(4.55)	(4.29)
Subord	−0.637 ***	−0.600 ***
	(−10.27)	(−8.10)
StdRet	−2.005 ***	−3.096 ***
	(−14.87)	(−16.94)
Capital Intensity	0.380 ***	0.425 ***
	(6.88)	(5.92)
Log Maturity	0.157 ***	0.082
	(3.34)	(1.64)
Log Proceeds	−0.048	−0.076 **
	(−1.63)	(−2.37)
Institutional Ownership		−0.008 ***
		(−4.23)
Insider Ownership		0.001
		(0.15)
Year Dummies	Yes	Yes
Industry Dummies	Yes	Yes
N	2917	2423
Pseudo R2	21.19%	19.91%

This table presents the results of the ordered probit regression of credit ratings on the friendly board. Variable definitions can be found in the Appendix A. For firms with multiple issues in a given year, bond characteristic variables are calculated as the proceeds-weighted average across all issues. All control variables are measured at the end of the fiscal year preceding the bond issuance. Z-statistics are reported in parentheses below each estimate. All regressions include year dummies and two-digit SIC industry dummies. The labels *, **, and *** denote statistical significance at the 1%, 5%, and 10% levels, respectively.

presents the regression results of Credit Ratings on Friendly board. The dependent variable is Credit Ratings. As shown in columns (1) and (2), the coefficient on Friendly board is positive and statistically significant at the 1% and 10% level, respectively. The results in Table 4 indicate that firms with a friendly board have higher credit ratings and thus experience lower costs of bond financing. The results are consistent with the creditor wealth enhancing hypothesis (H1).

In terms of other control variables, firm size and capital intensity are positively related to credit ratings. The estimated coefficients on ROA and the coverage ratio are significantly positive, while the coefficient on leverage is significantly negative. The results indicate that a higher default risk lowers the credit ratings. As expected, higher stock volatility and subordinated debt lower credit ratings.

5.2. Friendly Boards and Yield Spreads

In this section, we examine the relationship between friendly boards and the yield spread. One potential concern when including raw credit ratings in yield spread regression analysis is that these ratings might already encapsulate information from specific control variables. In line with Liu et al. (2010), we orthogonalize credit ratings with respect to other explanatory variables to mitigate potential issues of collinearity. In particular, we conduct a regression of credit ratings on Friendly board, Log Assets, ROA, Leverage, Coverage Ratio, Subord, StdRet, Capital Intensity, Log Maturity, and Log Proceeds. The residual from this regression captures credit rating information that is independent of these control variables. Subsequently, we employ this residual (Orthrating) as the variable representing credit ratings in our yield spread regressions.

Table 5. Friendly boards and yield spread.

Dependent Variable: Yield Spread	(1)	(2)
Friendly Board	−31.715 ***	−31.990 ***
	(−7.08)	(−7.08)
Log Assets	−54.147 ***	−44.680 ***
	(−22.33)	(−18.46)
ROA	−609.893 ***	−572.822 ***
	(−20.82)	(−18.71)
Leverage	129.097 ***	137.081 ***
	(9.40)	(10.23)
Coverage Ratio	−0.070 ***	−0.056 **
	(−2.89)	(−2.06)
Subord	28.218 ***	40.553 ***
	(4.06)	(5.21)
StdRet	213.128 ***	246.112 ***
	(13.20)	(14.27)
Capital Intensity	3.752	6.838
	(0.63)	(0.98)
Log Maturity	−17.589 ***	−7.037 *
	(−4.02)	(−1.71)
Log Proceeds	15.147 ***	13.796 ***
	(5.38)	(5.47)
Orthrating	−29.824 ***	−28.789 ***
	(−27.40)	(−25.17)
Institutional Ownership		0.458 **
		(2.37)
Insider Ownership		−0.490
		(−1.12)
Year Dummies	Yes	Yes
Industry Dummies	Yes	Yes
N	2917	2423
Adjusted R2	73.99%	73.20%

This table presents the regression results of yield spread on friendly board. Variable definitions can be found in the Appendix A. For firms with multiple issues in a given year, bond characteristic variables are calculated as the proceeds-weighted average across all issues. All control variables are measured at the end of the fiscal year preceding the bond issuance. The t-statistics, reported in parentheses below each estimate, are constructed using heteroscedasticity-robust standard errors. All regressions include year dummies and two-digit SIC industry dummies. The labels *, **, and *** denote statistical significance at the 1%, 5%, and 10% levels, respectively.

reports the regression results of Yield Spread on Friendly board. The dependent variable is Yield Spread. As shown in columns (1) and (2) of Table 5, the coefficient on Friendly board is negative and statistically significant at the 1% level, suggesting that firms with a friendly board have lower costs of bond financing. In column (2), the coefficient estimate of Friendly board is −31.990. This means that firms with a friendly board would pay 31.990 basis points less on their debt issues than firms without a friendly board. The results are consistent with the creditor wealth enhancing hypothesis (H2). The remaining control variables exhibit signs that are generally aligned with previous literature. Specifically, the estimated coefficients for firm size, ROA, and coverage ratio are significantly negative, whereas the estimated coefficients for leverage, subordinated debt, and stock volatility are significantly positive.

5.3. Robustness Checks

We conduct additional tests to verify the robustness of our main results using an alternative measure of CEO-friendly boards. The alternative measure of CEO-friendly boards is the proportion of outside directors who are socially connected to the CEO based on education or other friendship activities, instead of using a binary indicator variable. In

Table 6. An alternative measure of CEO-friendly boards and credit ratings/yield spread.

	Dependent Variable: Credit Ratings		Dependent Variable: Yield Spread
	(1)	(2)	(3)	(4)
CEO-Director Ties	0.382 ***	0.310 **	−45.854 ***	−41.356 ***
	(3.35)	(2.50)	(−4.09)	(−3.74)
Log Assets	0.713 ***	0.706 ***	−56.002 ***	−46.419 ***
	(28.95)	(24.66)	(−22.70)	(−18.62)
ROA	5.093 ***	5.102 ***	−612.247 ***	−575.255 ***
	(19.15)	(16.96)	(−20.87)	(−18.85)
Leverage	−1.545 ***	−1.650 ***	130.768 ***	137.461 ***
	(−11.89)	(−10.85)	(9.47)	(10.09)
Coverage Ratio	0.002 ***	0.002 ***	−0.064 **	−0.051 *
	(4.47)	(4.23)	(−2.57)	(−1.81)
Subord	−0.643 ***	−0.602 ***	30.220 ***	42.377 ***
	(−10.36)	(−8.13)	(4.33)	(5.33)
StdRet	−1.997 ***	−3.083 ***	214.360 ***	251.227 ***
	(−14.81)	(−16.84)	(13.19)	(14.51)
Capital Intensity	0.387 ***	0.433 ***	1.128	3.069
	(7.02)	(6.04)	(0.18)	(0.44)
Log Maturity	0.163 ***	0.085 *	−19.266 ***	−8.115 *
	(3.46)	(1.70)	(−4.35)	(−1.93)
Log Proceeds	−0.052 *	−0.080 **	15.596 ***	14.030 ***
	(−1.77)	(−2.48)	(5.50)	(5.48)
Orthrating			−29.358 ***	−28.176 ***
			(−26.91)	(−24.64)
Institutional Ownership		−0.008 ***		0.458 **
		(−4.28)		(2.36)
Insider Ownership		0.0002		−0.320
		(0.04)		(−0.74)
Year Dummies	Yes	Yes	Yes	Yes
Industry Dummies	Yes	Yes	Yes	Yes
N	2916	2422	2916	2422
Pseudo R2	21.19%	19.87%
Adjusted R2			73.63%	72.70%

This table presents the effects of an alternative measure of CEO-friendly boards on credit ratings and yield spread. Variable definitions can be found in the Appendix A. For firms with multiple issues in a given year, bond characteristic variables are calculated as the proceeds-weighted average across all issues. All control variables are measured at the end of the fiscal year preceding the bond issuance. Z-statistics are reported in parentheses below each estimate in columns (1) and (2). The t-statistics, derived using heteroscedasticity-robust standard errors, are reported in parentheses below each estimate in columns (3) and (4). All regressions include year dummies and two-digit SIC industry dummies. The labels *, **, and *** denote statistical significance at the 1%, 5%, and 10% levels, respectively.

, we present the results indicating a positive and statistically significant relationship between the alternative measure of CEO-friendly boards and credit ratings in columns (1) and (2), as well as a negative relationship between this alternative measure and yield spreads in columns (3) and (4). Our findings demonstrate consistent results when employing the alternative measure of CEO-friendly boards.

5.4. Endogeneity of Board Structure

Thus far, the findings indicate a negative association between friendly boards and the cost of bond financing. We propose that CEO-friendly boards can enhance creditors’ interests, thereby reducing the cost of issuing new bonds. However, it is possible that causality could run in the opposite direction; firms with lower bond financing costs might seek to appoint friendly directors to their boards. In such a scenario, we could potentially observe a spurious relation between friendly boards and the cost of bond financing. This relation may not necessarily arise from friendly boards lowering the cost of bond financing but rather from their association with firms that inherently have lower costs of bond financing. However, our research design makes reverse causality less likely. In our empirical tests, our proxy for a friendly board relies on board structure data from the year prior to the bond issue. Thus, the board structure in the earlier period could not have been affected by the bond financing costs in the subsequent period.

To mitigate potential endogeneity issues, we utilize two-stage least squares (2SLS) estimation. The instrumental variable should be related to Friendly Board, with the remaining unrelated to bond yields except through Friendly Board. We consult the literature and identify an appropriate instrumental variable. Several recent studies employ industry-level governance as an instrumental variable (Liu and Jiraporn 2010; Jiraporn et al. 2013). We select the industry median value of a friendly board dummy variable as our instrument for Friendly Board. This instrumental variable is more likely to be exogenous for the following reasons: due to potential reverse causality, a firm’s bond yields might influence its board structure. However, firm-level bond yields are unlikely to be related to an industry-level board structure. While boards can influence their own firm’s policies, they have little to no impact on other firms.

Table 7. Two-stage least square (2SLS) regression of friendly boards on yield spread.

	First Stage	Second Stage
	Dependent Variable: Friendly Board	Dependent Variable: Yield Spread
Industry Median Friendly Board	0.158 ***
	(4.82)
Predicted Friendly Board		−29.835 ***
		(−6.14)
Log Assets	0.129 ***	−53.432 ***
	(14.47)	(−20.64)
ROA	0.173	−665.578 ***
	(1.59)	(−22.72)
Leverage	−0.112 **	113.853 ***
	(−2.15)	(8.61)
Coverage Ratio	−0.00002	−0.044
	(−0.19)	(−1.01)
Subord	−0.058 **	30.649 ***
	(−2.17)	(4.37)
StdRet	0.042	181.950 ***
	(0.88)	(15.09)
Capital Intensity	0.059 ***	9.381 *
	(2.94)	(1.92)
Log Maturity	0.059 ***	−30.708 ***
	(2.91)	(−5.72)
Log Proceeds	−0.030 **	17.842 ***
	(−2.43)	(5.35)
Orthrating	−0.001	−29.441 ***
	(−0.29)	(−29.64)
N	2917	2917
Adjusted R2	13.65%	61.61%

This table presents the 2SLS estimation results of the yield spread on friendly board. Variable definitions can be found in the Appendix A. For firms with multiple issues in a given year, bond characteristic variables are calculated as the proceeds-weighted average across all issues. All control variables are measured at the end of the fiscal year preceding the bond issuance. The t-statistics, reported in parentheses below each estimate, are computed using heteroscedasticity-robust standard errors. The labels *, **, and *** denote statistical significance at the 1%, 5%, and 10% levels, respectively.

shows the two-stage least squares (2SLS) regression results. Column (1) shows the result of the first-stage regression. As expected, our instrumental variable is positively and significantly related to the likelihood of firms having a friendly board. The result from the second-stage regression is presented in column (2). The result shows that the coefficient of Predicted Friendly Board is negative and statistically significant at the 1% level, reinforcing our earlier findings.

6. Conclusions

In this paper, we explore a relatively overlooked issue—the influence of CEO-friendly boards on the cost of debt. While many studies have explored how CEO-friendly boards influence conflicts of interest between shareholders and CEOs, to the best of our knowledge, no study has examined the effect of CEO-friendly boards in terms of conflicts of interest between shareholders and creditors. This represents a significant gap in the literature and highlights the necessity for an empirical analysis to understand the financial implications of CEO-friendly boards. Our paper addresses this significant gap in the existing literature regarding the financial implications of CEO-friendly boards. We test two opposing hypotheses—the conflicts of interest hypothesis and the creditor wealth enhancing hypothesis. Our empirical findings indicate that board friendliness is associated with a lower cost of new debt, as measured by at-issue yield spreads and higher credit ratings. These results align with the creditor wealth enhancing hypothesis, supporting the argument that directors fulfill their “creditor duty”, and efficient communication between CEOs and directors enhances creditor interests.

Our paper has important practical implications that can shed new light on a firm’s strategic decisions regarding the composition of its board of directors. Our findings indicate the importance of considering the economic value of effective directorship from a comprehensive standpoint, moving beyond a narrow focus on outside–inside directorship dynamics. Furthermore, our paper suggests the following policy recommendations: when a firm increasingly relies on debt financing and lacks alternative bonding mechanisms, it should consider employing a CEO-friendly board. Furthermore, when directors of a firm have a superior ability to create value with more information and when a firm lacks alternative bonding mechanisms, the firm should consider employing a CEO-friendly board.

Our paper has the following limitations. First, while empirically exploring the effects of CEO-friendly boards on creditors’ financial claims in the firm, we do not consider non-pricing terms, such as maturity, collateral requirements, and various debt covenants, in debt contracts. Our focus is solely on the cost of debt. Second, the effects of CEO-friendly boards on the cost of debt may be influenced by country-specific variables. Our study focuses exclusively on U.S. firms and does not extend to an international context. Third, we do not identify the exact mechanism behind the creditor wealth enhancement hypothesis. Is it enhanced information that flows between the CEO and the board of directors, or is it a credible commitment by the CEO-friendly board to honor creditors’ financial claims in the firm? Future research on the financial implications of CEO-friendly boards may find these areas to be an interesting research agenda.