Much of the governance literature centers on the alignment of the incentives of management and shareholders (Shleifer and Vishny, 1997; Becht et al., 2003). It is often assumed that if left to their own devices, managers/directors will pursue activities that benefit themselves at the expense of the firm’s security holders. Although self-serving behavior may reduce the wealth of shareholders, it is not clear that all such behavior will also have an adverse effect on the firm’s bondholders. For example, shirking would be harmful to both bond holders and shareholders.
Taking on low-risk projects or engaging in conglomerate mergers, however, may benefit bondholders due to their concave payoff structure and the coinsurance effect associated with diversified acquisitions (Billett et al., 2004). Although there is debate in the literature regarding the risk-taking preference of managers/directors (Amihud and Lev, 1981; Holmstrom and Costa, 1986; Hirshleifer and Thakor, 1992; Adams et al., 2005), the evidence largely supports the proposition that managers/directors prefer conservative investment strategies that are suboptimal from shareholders’ perspective, due to their concerns for the private benefits from control and their non-diversified firm-specific human capital (Bertrand and Mullainathan, 2003; John et al., 2008; Kempf et al., 2009; Laeven and Levine, 2009; Pathan, 2009).
Coincidentally, low-risk operating strategies may result in a reduction of the “agency costs of debt” (Jensen and Meckling, 1976; Myers, 1977), which ultimately would inure to shareholders’ benefit. Indeed, it could well be the case that such reduction in the cost of debt equals or exceeds the costs of suboptimal corporate conduct and shirking by managers/directors, which would explain why some firms may tolerate managerial/directorial self-serving behaviors, which are expected if the firm is weakly governed. The rationale and effects of weak governance are similar to the rationale and effects of bond covenants in that shareholders restrict their own actions in exchange for a lower cost of debt.
In this paper we study a particular type of governance mechanism that has received little attention in the finance literature, but may have strong incentive effects on corporate managers/directors. We study the effects of limited liability provisions and the indemnification of directors, henceforth “LLI”, as specified in corporate charters, bylaws, or contracts written directly with directors. The importance of these provisions for directors is suggested by the annual survey by Tillinghast-Towers Perrin (2004, 2005, 2006), that approximately 20% of the directors of American corporations have been the target of at least one legal action over the past 10 years. Though still not commonplace, recent experience illustrates that directors can suffer enormous losses of their personal wealth from stockholder litigation. As a result, we expect the protection from shareholder suits as afforded by LLI provisions may have a strong effect on directors’ incentives to pursue their own interests. In contrast, the incentives provided by stock and stock options, which received far more attention in the literature, may be relatively small. Yermack (2004) reports that among the Fortune 500 companies, outside directors’ wealth increases by only 11 cents per $1,000 increase in firm value.
Our sample consists of the S&P 1,500 firms from 2002 to 2007 that have publicly-traded, senior unsecured bonds outstanding. Our proxy for the strength of the LLI provisions at the firm level is an index – the “L-index” – which is the sum of three indicator variables: (1) the existence of liability limitation provisions in corporate charters or bylaws, (2) the indemnification of litigation expenses provided by corporate charters or bylaws, and (3) the existence of indemnification contracts with individual directors. The data for these provisions are taken from Risk Metrics (formerly IRRC), which is the same database used by Gompers et al. (2003) (hereafter “GIM”) to construct their G-index.
