PDF Ebook SOX, Corporate Transparency, and the Cost of Debt
We propose a new market'based measure of corporate transparency calibrated from a popular model of Credit Default Swaps (CDS) pricing. Less transparent firms according to this measure tend to have lower S&P Transparency and Disclosure ratings, and lower KLD or ISS corporate governance ratings. We use the measure to investigate the impact of the Sarbanes'Oxley (SOX) Act on corporate transparency and the cost of debt. Our tests show that corporate opaqueness and the cost of debt decrease significantly after SOX. Specifically, the typical firm in our sample experiences a 19bp reduction on its five'year CDS spread as a result of lower opaqueness following SOX, amounting to total annual savings of $ 1.65 billion for all firms in our sample. Furthermore, the reduction of opaqueness tends to be stronger for firms that were more opaque before SOX.
The effect of corporate transparency on securities markets is a key topic for researchers, market participants, and regulators. Although for different purposes, all share the need to measure corporate transparency in a consistent and reliable manner. Current measures of transparency use either linear regressions involving financial statement variables (see Jones 1991 and Dechow, Sloan and Sweeney 1995), linear regressions involving equity returns and financial statement variables (see Berger, Chen and Li 2006), or scores relying on expert judgment (see Botosan 1997 and Francis, Nanda and Olsson 2008). We propose an alternative measure of corporate transparency derived from the price level of debt contracts (not changes in levels).
Recently, Ball, Robin and Sadka (2008) provide evidence that the demand for timely and reliable financial reports arises primarily in debt markets rather than equity markets. This is because debt covenants are based on financial ratios calculated from balance'sheet or income statements, and a violation of a covenanted ratio triggers additional contractual rights to debt holders.
Similarly, topical research in finance underscores the importance of corporate transparency for the pricing of debt'related contracts. In their influential work, Dut e and Lando (2001) show that, because of the asymmetric nature of debt payoffs, more opaque corporations pay higher interest rates on debt even when lenders are risk'neutral. Interestingly, this theory can rationalize non'negligible short term credit spreads for investment grade corporations, a robust empirical phenomenon that is hard to explain in a full information framework1.
Our main goal in this paper is to propose an opaqueness measure that has a simple economic interpretation and can be easily estimated from market prices of debt contracts. A formal model of debt pricing is necessary to extract such a measure. Thus, we rely on the CreditGrades model, which delivers a simple, analytical debt pricing formula. The model, jointly developed by Goldman Sachs, JP Morgan and Deutsche Bank, has become a popular debt pricing tool amongst practitioners. Attesting to the popularity of the model, Yu (2006) and Duarte, Longstaff and Yu (2007), among others, use the CreditGrades model in recent academic studies. In contrast to models of debt pricing under full information, the Credit' Grades model explicitly incorporates a parameter representing uncertainty about the true level of a firmps liabilities. The logic underlying this extension is that the level of liabilities reported on a firmps balance sheet is potentially different from the fixed but unknown level of liabilities that will drive a corporation to default. The firm'period measure of corporate opaqueness we propose is the modelps parameter that captures uncertainty about the firmps true financial leverage, after controlling for all the other inputs of standard debt pricing structural models. We calibrate such parameter for each firm'period by minimizing the sum of squared differences between market and model'implied prices.
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PDF Ebook SOX, Corporate Transparency, and the Cost of Debt
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