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SOX, Corporate Transparency, and the Cost of Debt Sandro C. Andrade University of Miami  Gennaro Bernile University of Mia...
Disclaimer The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any...
Background <ul><li>Steady deterioration of the quality of accounting information since the late 80’s </li></ul><ul><ul><ul...
SOX – Costs, Benefits…and a shameless ‘plug’   <ul><li>Direct costs </li></ul><ul><ul><li>Out-of-pocket compliance costs ...
Our goal <ul><li>We do not attempt a full-blown cost-benefit analysis of the Act </li></ul><ul><li>Rather, we investigate ...
Research Questions <ul><li>Main question: </li></ul><ul><ul><li>Did SOX improve corporate transparency and thus decrease t...
We find that… <ul><li>The market-based opacity measure calibrated from CDS spreads  </li></ul><ul><ul><li>is indeed relate...
Imperfect information and spreads <ul><li>Duffie and Lando (2001) structural model of debt pricing </li></ul><ul><ul><li>i...
CDS or bond spreads? <ul><li>Theoretically related by arbitrage (Duffie 1999) </li></ul><ul><li>Highly correlated in data ...
CDS pricing model and Calibration <ul><li>Relying on a structural CDS pricing formula we can  </li></ul><ul><ul><li>contro...
Pricing model <ul><li>From CreditGrades Technical Report (2002) </li></ul>Background  Research questions   ’In a nutshell’...
Data overview Background  Research questions   ’In a nutshell’   Empirical Strategy and Evidence   Conclusions Presentatio...
H1A: Calibrated  λ   is related to (more traditional) measures of accounting information quality Background  Research ques...
H1A: Calibrated  λ   is related to (more traditional) measures of accounting information quality Background  Research ques...
H2A: Calibrated  λ   decreases following the passage of SOX Background  Research questions   ’In a nutshell’   Empirical S...
H2A: Calibrated  λ   decreases following the passage of SOX Background  Research questions   ’In a nutshell’   Empirical S...
What is the economic significance  of the change in  λ  post-SOX? <ul><li>For each firm, compute model-implied spreads in ...
H3A: Calibrated  λ  decreases more for firms that are more likely to be affected by the passage of the Act <ul><li>Conditi...
H3A: Calibrated  λ  decreases more for firms that are more likely to be affected by the passage of the Act <ul><li>Conditi...
H3A: Calibrated  λ  decreases more for firms that are more likely to be affected by the passage of the Act <ul><li>Conditi...
Robustness check #1: Systematic risk? There should be a  direct  relation with risk factor loadings Background  Research q...
Robustness check #2: Other publicly available information? There should be an  inverse  relation with Rating and a  direct...
Robustness check #2: Other publicly available information? Background  Research questions   ’In a nutshell’   Empirical St...
Robustness check #3: Supply of default insurance? There should be a  inverse  relation with number of quoting dealers. Bac...
Robustness check #4: Time in TRACE? There should be a  inverse  relation with the amount of time corporate bonds are in th...
Robustness check #5  (H3A ) :  Is the decrease in  λ  larger for firms more likely to be affected by SOX? Background  Rese...
Robustness check #6: Sensitivity to calibration    procedure <ul><li>Assume a unique expected default barrier (50% of tota...
Conclusion <ul><li>Use formal CDS pricing model to control for other spread determinants and account for non-linear relati...
Background  Research questions   ’In a nutshell’   Empirical Strategy and Evidence   Conclusions Presentation of “SOX, Cor...
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  1. 1. 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&quot; 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 Background Research questions ’In a nutshell’ Empirical Strategy and Evidence Conclusions
  2. 2. 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. Background Research questions ’In a nutshell’ Empirical Strategy and Evidence Conclusions Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile
  3. 3. Background <ul><li>Steady deterioration of the quality of accounting information since the late 80’s </li></ul><ul><ul><ul><li>Cohen, Dey, and Lys (2007) </li></ul></ul></ul><ul><ul><ul><li>Jorion, Shi, and Zhang (2007) </li></ul></ul></ul><ul><li>Series of high-profile accounting scandals starting in 2001 </li></ul><ul><ul><ul><li>Healy and Palepu (2003) </li></ul></ul></ul><ul><li>Public Company Accounting Reform and Investor Protection Act, aka Sarbanes-Oxley Act, signed into law on July 30 th 2002 </li></ul><ul><ul><ul><li>Coates (2007) – Purpose of and provisions in the Act </li></ul></ul></ul><ul><li>Vast literature on the economic consequences of SOX </li></ul><ul><ul><ul><li>Won’t even try to do it justice here, for sake of brevity… </li></ul></ul></ul><ul><ul><ul><li>… except to note that the effects of SOX on debt markets have been largely overlooked </li></ul></ul></ul>Background Research questions ’In a nutshell’ Empirical Strategy and Evidence Conclusions Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile
  4. 4. SOX – Costs, Benefits…and a shameless ‘plug’  <ul><li>Direct costs </li></ul><ul><ul><li>Out-of-pocket compliance costs </li></ul></ul><ul><li>Indirect (i.e. opportunity) costs </li></ul><ul><ul><li>a) Competitive disadvantage in product markets; b) Bargaining disadvantages with both suppliers and consumers; c) Litigation risk; d) Changing behavior of top managers </li></ul></ul><ul><li>Benefits </li></ul><ul><ul><li>Coates (2007): “rebuild the public’s trust in US capital markets” by improving investors’ confidence in firms’ financial reports </li></ul></ul><ul><li>… and the ‘Plug’ </li></ul><ul><ul><li>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… </li></ul></ul>Background Research questions ’In a nutshell’ Empirical Strategy and Evidence Conclusions Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile
  5. 5. Our goal <ul><li>We do not attempt a full-blown cost-benefit analysis of the Act </li></ul><ul><li>Rather, we investigate one particular, albeit arguably core benefit of the legislation: its effect on investors confidence in firms’ financial reports </li></ul><ul><li>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 </li></ul>Background Research questions ’In a nutshell’ Empirical Strategy and Evidence Conclusions Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile
  6. 6. Research Questions <ul><li>Main question: </li></ul><ul><ul><li>Did SOX improve corporate transparency and thus decrease the cost of debt financing? </li></ul></ul><ul><ul><li>If so, by how much? </li></ul></ul><ul><li>We calibrate a firm-level opacity measure based on a structural debt pricing model with incomplete information and test 3 hypotheses: </li></ul><ul><li>H1A: The calibrated firm-level opacity measure is related to more traditional measures of accounting information quality </li></ul><ul><li>H2A: The calibrated firm-level opacity measure decreases following the passage of the Act </li></ul><ul><li>H3A: The calibrated firm-level opacity measure decreases more for firms that are more likely to be affected by the passage of the Act </li></ul>Background Research questions ’In a nutshell’ Empirical Strategy and Evidence Conclusions Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile
  7. 7. We find that… <ul><li>The market-based opacity measure calibrated from CDS spreads </li></ul><ul><ul><li>is indeed related to traditional measures of corporate transparency ( H1A ) </li></ul></ul><ul><ul><li>decreases around the passage of the Sarbanes-Oxley Act ( H2A ) and the effect of improved transparency on the cost of debt is economically large </li></ul></ul><ul><ul><ul><li>19 bp reduction (given a typical post-SOX spread of 112 bp), with total savings of $ 1.65 billion per year </li></ul></ul></ul><ul><ul><li>decreases more for firms that are more likely affected by SOX ( H3A ) </li></ul></ul><ul><li>… and perform several additional tests to… </li></ul><ul><ul><li>rule out plausible alternative stories we could think of </li></ul></ul><ul><ul><li>show our results are robust to using alternative calibration strategies </li></ul></ul>Background Research questions ’In a nutshell’ Empirical Strategy and Evidence Conclusions Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile
  8. 8. Imperfect information and spreads <ul><li>Duffie and Lando (2001) structural model of debt pricing </li></ul><ul><ul><li>investors cannot observe the issuer's assets directly, and receive only noisy and delayed accounting reports </li></ul></ul><ul><ul><li>=> uncertainty about the firm’s true leverage </li></ul></ul><ul><ul><li>all else equal, higher credit spreads even when creditors are risk-neutral and all market participants have the same information. </li></ul></ul>Same reported level of leverage Background Research questions ’In a nutshell’ Empirical Strategy and Evidence Conclusions Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile
  9. 9. CDS or bond spreads? <ul><li>Theoretically related by arbitrage (Duffie 1999) </li></ul><ul><li>Highly correlated in data (Blanco et al. 2004) </li></ul><ul><li>Advantages of using CDS spreads: </li></ul><ul><ul><li>quoted directly, no need to calibrate a risk-free term structure </li></ul></ul><ul><ul><li>much more liquid in recent years, especially at the 5-year maturity </li></ul></ul><ul><ul><li>“ illiquidity” does not affect the level of the CDS spread (Longstaff, et al. 2004) </li></ul></ul><ul><ul><li>standardized time to maturity </li></ul></ul><ul><li>Markit database: CDS spreads for hundreds of corporations on a daily basis since January 2001. </li></ul>Background Research questions ’In a nutshell’ Empirical Strategy and Evidence Conclusions Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile
  10. 10. CDS pricing model and Calibration <ul><li>Relying on a structural CDS pricing formula we can </li></ul><ul><ul><li>control for other determinants of spreads </li></ul></ul><ul><ul><li>account for non-linearities revealed by theoretical pricing models </li></ul></ul><ul><li>We use the CreditGrades structural model of CDS pricing </li></ul><ul><ul><li>Developed by Goldman Sachs, Deutsche Bank and JP Morgan; recently used by Duarte et al. (RFS, 2007) and Yu (FAJ, 2007) </li></ul></ul><ul><ul><li>Explicitly incorporates uncertainty about the reliability of firm’s reported liabilities ( λ ): CDS = CDS ( λ ; S, D, σ S , r, R, T) </li></ul></ul><ul><li>For each firm, calibrate λ pre- and post-SOX </li></ul><ul><ul><li>Pre-SOX: Jan/01 to Jul/02 ; Post-SOX: Aug/02 to Dec/03. </li></ul></ul><ul><ul><li>Minimum of 30 observations in each period => 252 firms in sample </li></ul></ul>Background Research questions ’In a nutshell’ Empirical Strategy and Evidence Conclusions Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile
  11. 11. Pricing model <ul><li>From CreditGrades Technical Report (2002) </li></ul>Background Research questions ’In a nutshell’ Empirical Strategy and Evidence Conclusions Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile
  12. 12. Data overview Background Research questions ’In a nutshell’ Empirical Strategy and Evidence Conclusions Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile
  13. 13. H1A: Calibrated λ is related to (more traditional) measures of accounting information quality Background Research questions ’In a nutshell’ Empirical Strategy and Evidence Conclusions Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile
  14. 14. H1A: Calibrated λ is related to (more traditional) measures of accounting information quality Background Research questions ’In a nutshell’ Empirical Strategy and Evidence Conclusions Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile
  15. 15. H2A: Calibrated λ decreases following the passage of SOX Background Research questions ’In a nutshell’ Empirical Strategy and Evidence Conclusions Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile
  16. 16. H2A: Calibrated λ decreases following the passage of SOX Background Research questions ’In a nutshell’ Empirical Strategy and Evidence Conclusions Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile
  17. 17. What is the economic significance of the change in λ post-SOX? <ul><li>For each firm, compute model-implied spreads in the post-SOX period (i.e., using post-SOX S, D, σ S , r, R) </li></ul><ul><ul><li>with post-SOX λ ’s </li></ul></ul><ul><ul><li>with pre-SOX λ ’s </li></ul></ul><ul><li>CDS ( λ pre-SOX ; S, D, σ S , r, R, 5) ─ CDS ( λ post-SOX ; S, D, σ S , r, R, 5) </li></ul><ul><li>Median spread difference: 19 bp (substantial drop compared to the median post-SOX spread, 112 bp) </li></ul><ul><li>Annual savings on interest-bearing debt: </li></ul><ul><ul><li>- Median: $6.55 million </li></ul></ul><ul><ul><li>Total annual savings in our sample: $1.65 billion </li></ul></ul>Background Research questions ’In a nutshell’ Empirical Strategy and Evidence Conclusions Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile
  18. 18. H3A: Calibrated λ decreases more for firms that are more likely to be affected by the passage of the Act <ul><li>Conditional on pre-SOX disclosure quality: </li></ul>Background Research questions ’In a nutshell’ Empirical Strategy and Evidence Conclusions Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile
  19. 19. H3A: Calibrated λ decreases more for firms that are more likely to be affected by the passage of the Act <ul><li>Conditional on Chhaochharia and Grinstein (2007) pre-SOX governance quality: </li></ul>Background Research questions ’In a nutshell’ Empirical Strategy and Evidence Conclusions Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile
  20. 20. H3A: Calibrated λ decreases more for firms that are more likely to be affected by the passage of the Act <ul><li>Conditional on Chhaochharia and Grinstein (2007) pre-SOX governance quality and disclosure quality: </li></ul>Background Research questions ’In a nutshell’ Empirical Strategy and Evidence Conclusions Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile
  21. 21. Robustness check #1: Systematic risk? There should be a direct relation with risk factor loadings Background Research questions ’In a nutshell’ Empirical Strategy and Evidence Conclusions Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile
  22. 22. 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 Background Research questions ’In a nutshell’ Empirical Strategy and Evidence Conclusions Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile
  23. 23. Robustness check #2: Other publicly available information? Background Research questions ’In a nutshell’ Empirical Strategy and Evidence Conclusions Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile There should be an inverse relation with Rating and a direct one for the other (finer) measures of financial leverage
  24. 24. Robustness check #3: Supply of default insurance? There should be a inverse relation with number of quoting dealers. Background Research questions ’In a nutshell’ Empirical Strategy and Evidence Conclusions Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile
  25. 25. Robustness check #4: Time in TRACE? There should be a inverse relation with the amount of time corporate bonds are in the TRACE system Background Research questions ’In a nutshell’ Empirical Strategy and Evidence Conclusions Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile
  26. 26. Robustness check #5 (H3A ) : Is the decrease in λ larger for firms more likely to be affected by SOX? Background Research questions ’In a nutshell’ Empirical Strategy and Evidence Conclusions Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile
  27. 27. Robustness check #6: Sensitivity to calibration procedure <ul><li>Assume a unique expected default barrier (50% of total liabilities), rather than a barrier calibrated industry by industry </li></ul><ul><li>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 λ MAX </li></ul><ul><ul><li>Sample drops from 252 to 162 </li></ul></ul><ul><li>ALL our previous results are confirmed </li></ul>Background Research questions ’In a nutshell’ Empirical Strategy and Evidence Conclusions Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile
  28. 28. Conclusion <ul><li>Use formal CDS pricing model to control for other spread determinants and account for non-linear relationships. </li></ul><ul><li>First paper to check impact of SOX on debt prices </li></ul>  <ul><li>Methodology generates market-based measure of corporate transparency, which can be used to examine other issues </li></ul><ul><li>Hard to control for “everything else” that happened in the sample period. </li></ul><ul><li>- we rule out all plausible alternative stories we could think of, and will be happy to check other stories. </li></ul>   <ul><li>Large effect: 19 bp and savings of $ 1.65 billion per year for our 250 sample firms. </li></ul> Background Research questions ’In a nutshell’ Empirical Strategy and Evidence Conclusions Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile
  29. 29. Background Research questions ’In a nutshell’ Empirical Strategy and Evidence Conclusions Presentation of “SOX, Corporate Transparency, and the Cost of Debt” by Gennaro Bernile

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