The Effects of Corporate Governance on Firms' Credit Ratings

Using a framework for evaluating corporate governance recently developed by Standard & Poor's, this study investigates whether firms that exhibit strong governance benefit from higher credit ratings relative to firms with weaker governance. We document, after controlling for risk characteristics, that firm credit ratings are: (1) negatively associated with the number of blockholders that own at least a 5% ownership in the firm; (2) positively related to weaker shareholder rights in terms of takeover defenses; (3) positively related to the degree of financial transparency; and (4) positively related to over-all board independence, board stock ownership and board expertise, and negatively related to CEO power on the board. We also provide evidence that CEOs of firms with speculative grade credit ratings are overcompensated to a greater degree than their counterparts at firms with investment grade ratings, and that the overcompensation exceeds the CEO's share of additional debt costs related to lower credit ratings. Our study provides insights into the characteristics of governance that are likely to affect the cost of debt financing and provides one explanation for why some firms continue to operate with weaker governance when doing so may mean lower credit ratings.