Outside director protection, reduced monitoring, and capital structure decisions

Primary author: Yoonsoo Nam
Faculty sponsor: Douglas (DJ) Fairhurst

Primary college/unit: Carson College of Business
Campus: Pullman


I assess the effects of increased outside director protection from shareholder lawsuits on debt-to-assets ratio of U.S. industrial firms. Outside directors are non-employees of the firm. As increased director protection is considered to decrease directors’ monitoring efforts, it may reduce debt because mangers prefer having less debt to protect their undiversified human capital and would likely decrease debt in response to reduced monitoring. However, increased director protection may raise debt because firms could use debt as a controlling mechanism to counterbalance reduced monitoring because debt pressures managers to work hard to pay principal and interest payments. This study is important as it highlights this substituting effect of debt.
I use the staggered enactment of the Limited Liability Statutes by all 50 U.S. states between 1986 and 2002 to measure increased director protection. As different states enacted the laws during different time periods, this setting helps draw stronger causal inferences. I measure firm-level characteristics using Compustat database. I implement a difference-in-differences research design.
I find that the laws increase debt-to-assets ratio suggesting that firms raise debt to offset increased director protection. Specifically, firms where debt is more effective controlling mechanism, the interests of managers and shareholders are more closely aligned, managers have more incentives to maximize their human capital, and that are less financially constrained increase debt. Finally, I find that firms raising debt in response to increased director protection engage in activities likely raising firm value while firms that do not increase debt engage in activities likely reducing firm value.