SOX, Corporate Transparency, and the Cost of Debt

1. Background Research questions’In a nutshell’Empirical Strategy and EvidenceConclusions SOX, Corporate Transparency, and the Cost of Debt Sandro C. Andrade University of Miami Gennaro Bernile University of Miami and SEC Frederick M. Hood Virginia Tech Presentation by Gennaro Bernile Session B1 “Corporate Governance and the Cost of Debt" EFM 2009 Symposium on Corporate Governance and Control Cambridge, April 10, 2009 Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile

2. Background Research questions’In a nutshell’Empirical Strategy and EvidenceConclusions Disclaimer The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This presentation expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff. Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile

3. Background Research questions’In a nutshell’Empirical Strategy and EvidenceConclusions Background • Steady deterioration of the quality of accounting information since the late 80’s • Cohen, Dey, and Lys (2007) • Jorion, Shi, and Zhang (2007) • Series of high-profile accounting scandals starting in 2001 • Healy and Palepu (2003) • Public Company Accounting Reform and Investor Protection Act, aka Sarbanes-Oxley Act, signed into law on July 30th 2002 • Coates (2007) – Purpose of and provisions in the Act • Vast literature on the economic consequences of SOX • Won’t even try to do it justice here, for sake of brevity… • …except to note that the effects of SOX on debt markets have been largely overlooked Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile

4. Background Research questions’In a nutshell’Empirical Strategy and EvidenceConclusions SOX – Costs, Benefits…and a shameless ‘plug’  • Direct costs • Out-of-pocket compliance costs • Indirect (i.e. opportunity) costs a) Competitive disadvantage in product markets; b) Bargaining disadvantages with both suppliers and consumers; c) Litigation risk; d) Changing behavior of top managers • Benefits • Coates (2007): “rebuild the public’s trust in US capital markets” by improving investors’ confidence in firms’ financial reports • …and the ‘Plug’ • Stay tuned for what promises to be a uniquely enlightening study by the SEC’s OEA based on a wealth of data unavailable to-date… Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile

5. Background Research questions’In a nutshell’Empirical Strategy and EvidenceConclusions Our goal • We do not attempt a full-blown cost-benefit analysis of the Act • Rather, we investigate one particular, albeit arguably core benefit of the legislation: its effect on investors confidence in firms’ financial reports • We do so by focusing on debt markets, CDS’ in particular, and thus are able to provide an estimate of the effect of SOX on the cost of issuing debt Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile

6. Background Research questions’In a nutshell’Empirical Strategy and EvidenceConclusions Research Questions • Main question: • Did SOX improve corporate transparency and thus decrease the cost of debt financing? • If so, by how much? • We calibrate a firm-level opacity measure based on a structural debt pricing model with incomplete information and test 3 hypotheses: H1A: The calibrated firm-level opacity measure is related to more traditional measures of accounting information quality H2A: The calibrated firm-level opacity measure decreases following the passage of the Act H3A: The calibrated firm-level opacity measure decreases more for firms that are more likely to be affected by the passage of the Act Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile

7. Background Research questions’In a nutshell’Empirical Strategy and EvidenceConclusions We find that… • The market-based opacity measure calibrated from CDS spreads • is indeed related to traditional measures of corporate transparency (H1A) • decreases around the passage of the Sarbanes-Oxley Act (H2A) and the effect of improved transparency on the cost of debt is economically large • 19 bp reduction (given a typical post-SOX spread of 112 bp), with total savings of $ 1.65 billion per year • decreases more for firms that are more likely affected by SOX (H3A) • …and perform several additional tests to… • rule out plausible alternative stories we could think of • show our results are robust to using alternative calibration strategies Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile

8. Background Research questions’In a nutshell’Empirical Strategy and EvidenceConclusions Imperfect information and spreads • Duffie and Lando (2001) structural model of debt pricing • investors cannot observe the issuer's assets directly, and receive only noisy and delayed accounting reports => uncertainty about the firm’s true leverage • all else equal, higher credit spreads even when creditors are risk-neutral and all market participants have the same information. Same reported level of leverage Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile

9. Background Research questions’In a nutshell’Empirical Strategy and EvidenceConclusions CDS or bond spreads? • Theoretically related by arbitrage (Duffie 1999) • Highly correlated in data (Blanco et al. 2004) • Advantages of using CDS spreads: • quoted directly, no need to calibrate a risk-free term structure • much more liquid in recent years, especially at the 5-year maturity • “illiquidity” does not affect the level of the CDS spread (Longstaff, et al. 2004) • standardized time to maturity • Markit database: CDS spreads for hundreds of corporations on a daily basis since January 2001. Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile

10. Background Research questions’In a nutshell’Empirical Strategy and EvidenceConclusions CDS pricing model and Calibration • Relying on a structural CDS pricing formula we can • control for other determinants of spreads • account for non-linearities revealed by theoretical pricing models • We use the CreditGrades structural model of CDS pricing • Developed by Goldman Sachs, Deutsche Bank and JP Morgan; recently used by Duarte et al. (RFS, 2007) and Yu (FAJ, 2007) • Explicitly incorporates uncertainty about the reliability of firm’s reported liabilities (λ): CDS = CDS (λ ; S, D, σS, r, R, T) • For each firm, calibrate λ pre- and post-SOX • Pre-SOX: Jan/01 to Jul/02 ; Post-SOX: Aug/02 to Dec/03. • Minimum of 30 observations in each period => 252 firms in sample Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile

11. Background Research questions’In a nutshell’Empirical Strategy and EvidenceConclusions Pricing model • From CreditGrades Technical Report (2002) Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile

12. Background Research questions’In a nutshell’Empirical Strategy and EvidenceConclusions Data overview Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile

13. Background Research questions’In a nutshell’Empirical Strategy and EvidenceConclusions H1A: Calibrated λis related to (more traditional) measures of accounting information quality Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile

14. Background Research questions’In a nutshell’Empirical Strategy and EvidenceConclusions H1A: Calibrated λis related to (more traditional) measures of accounting information quality Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile

15. Background Research questions’In a nutshell’Empirical Strategy and EvidenceConclusions H2A: Calibrated λdecreases following the passage of SOX Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile

16. Background Research questions’In a nutshell’Empirical Strategy and EvidenceConclusions H2A: Calibrated λdecreases following the passage of SOX Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile

17. Background Research questions’In a nutshell’Empirical Strategy and EvidenceConclusions What is the economic significance of the change in λ post-SOX? • For each firm, compute model-implied spreads in the post-SOX period (i.e., using post-SOX S, D, σS, r, R) • with post-SOX λ’s • with pre-SOX λ’s CDS (λpre-SOX ; S, D, σS, r, R, 5) ─ CDS (λpost-SOX; S, D, σS, r, R, 5) • Median spread difference: 19 bp (substantial drop compared to the median post-SOX spread, 112 bp) • Annual savings on interest-bearing debt: - Median: $6.55 million • Total annual savings in our sample: $1.65 billion Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile

18. Background Research questions’In a nutshell’Empirical Strategy and EvidenceConclusions H3A: Calibrated λ decreases more for firms that are more likely to be affected by the passage of the Act • Conditional on pre-SOX disclosure quality: Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile

19. Background Research questions’In a nutshell’Empirical Strategy and EvidenceConclusions H3A: Calibrated λ decreases more for firms that are more likely to be affected by the passage of the Act • Conditional on Chhaochharia and Grinstein (2007) pre-SOX governance quality: Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile

20. Background Research questions’In a nutshell’Empirical Strategy and EvidenceConclusions H3A: Calibrated λ decreases more for firms that are more likely to be affected by the passage of the Act • Conditional on Chhaochharia and Grinstein (2007) pre-SOX governance quality and disclosure quality: Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile

21. Background Research questions’In a nutshell’Empirical Strategy and EvidenceConclusions Robustness check #1: Systematic risk? There should be a direct relation with risk factor loadings Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile

22. Background Research questions’In a nutshell’Empirical Strategy and EvidenceConclusions Robustness check #2: Other publicly available information? There should be an inverse relation with Rating and a direct one for the other (finer) measures of financial leverage Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile

23. Background Research questions’In a nutshell’Empirical Strategy and EvidenceConclusions Robustness check #2: Other publicly available information? There should be an inverse relation with Rating and a direct one for the other (finer) measures of financial leverage Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile

24. Background Research questions’In a nutshell’Empirical Strategy and EvidenceConclusions Robustness check #3: Supply of default insurance? There should be a inverse relation with number of quoting dealers. Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile

25. Background Research questions’In a nutshell’Empirical Strategy and EvidenceConclusions Robustness check #4: Time in TRACE? There should be a inverse relation with the amount of time corporate bonds are in the TRACE system Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile

26. Background Research questions’In a nutshell’Empirical Strategy and EvidenceConclusions Robustness check #5 (H3A): Is the decrease in λ larger for firms more likely to be affected by SOX? Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile

27. Background Research questions’In a nutshell’Empirical Strategy and EvidenceConclusions Robustness check #6: Sensitivity to calibration procedure • Assume a unique expected default barrier (50% of total liabilities), rather than a barrier calibrated industry by industry • Restrict the sample to non-corner solutions of the calibration, by dropping observations for which the pre-SOX and/or the post-SOX calibrated λ is equal zero or λMAX • Sample drops from 252 to 162 • ALL our previous results are confirmed Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile

28. Background Research questions’In a nutshell’Empirical Strategy and EvidenceConclusions Conclusion • First paper to check impact of SOX on debt prices  • Use formal CDS pricing model to control for other spread determinants and account for non-linear relationships.  • Methodology generates market-based measure of corporate transparency, which can be used to examine other issues  • Large effect: 19 bp and savings of $ 1.65 billion per year for our 250 sample firms.   • Hard to control for “everything else” that happened in the sample period. - we rule out all plausible alternative stories we could think of, and will be happy to check other stories.  Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile

29. Background Research questions’In a nutshell’Empirical Strategy and EvidenceConclusions Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile