This study investigates how the level of board co-option might affect a borrowing firm's ex ante covenant intensity and ex post covenant violations. As the fraction of co-opted directors (those who joined the board after the CEO assumed office) increases, creditors include more covenant restrictions in their loan contracts, indicating that more co-opted boards are considered as weaker monitors. The results remain robust to various approaches accounting for endogeneity, and are not driven by alternative explanations such as CEO tenure, director inexperience, or CEO's involvement in the nominating committee. Ex post tests reveal that firms with more co-opted boards are more likely to violate loan covenants after controlling for covenant intensity. Non-co-opted independent directors appear to be the most effective monitors in mitigating covenant violations among revolving loans and loans to unrated borrowers.

Examining a sample of U.S. commercial loans originated between 1996 and 2017, we find that the propensity to employ performance pricing provisions (PPPs) in private loan contracts increases by about 10% when lenders are dual holders, that is, when they simultaneously hold equity in the borrowing firm. This finding supports the monitoring efficiency channel and is robust after accounting for the endogeneity bias from lenders’ dual holding. We also observe a substitution effect between PPP usage and covenant tightness, and the strength of this effect in dual-holder loans varies between spread-increasing and spread-decreasing PPPs. Borrowers of dual-holder loans are more likely to improve their accounting performance within one year of loan origination. These findings are consistent with dual holders’ incentive alignment role, which helps reduce monitoring costs, improve lenders’ monitoring effectiveness, and promote managerial flexibility.