Litigation Environments and Bank Lending: Evidence from the Courts

Transcription

1 Litigation Environments and Bank Lending: Evidence from the Courts Wei-Ling Song E. J. Ourso College of Business Louisiana State University Baton Rouge, LA Phone: Fax: , Haitian Lu School of Accounting & Finance The Hong Kong Polytechnic University Kowloon, Hong Kong Tel: (852) , Zhen Lei School of Accounting & Finance The Hong Kong Polytechnic University Kowloon, Hong Kong Tel: (852) , First draft: Jan 10, 2017 JEL Classification: G21; K22; K42; M41 Key Words: Litigation Environments, Securities Class Action Lawsuits, Financial Reporting Incentive, Bank Lending, Law and Finance 1

2 Litigation Environments and Bank Lending: Evidence from the Courts Abstract Using a large sample of bank loans during , we examine whether the likelihood of a court to dismiss a securities lawsuit affects banks lending decisions. We find that firms headquartered in more lenient district court jurisdictions pay significantly higher interest rates and borrow with significantly shorter maturities. However, there is no significant effect on the usage of covenants. Furthermore, for firms headquartered in districts with more securities lawsuits, banks are more likely to arrange institutional term loans, which subsequently can be sold in the secondary market or securitized. Overall, our findings highlight the interactions between legal environment and financial system. The results are consistent with the reporting disincentive hypothesis that when other type of monitoring on firms financial reporting incentive is weaker, banks use pricing to resolve the issue rather than non-pricing terms, which are exposed to manipulation and less effective to use. Our findings remain robust to court fixed effects. JEL Classification: G21; K22; K42; M41 Key Words: Litigation Environments, Securities Class Action Lawsuits, Financial Reporting Incentive, Bank Lending, Law and Finance 2

3 1. Introduction Financial system is a nexus of complex mechanisms. It is shaped by various regulations, economic developments, monitoring and incentive structures, and interactions among all these factors. Extant literature has documented how these factors, particularly legal environments, can affect the developments of capital markets (see, for example, La Porta et. al., 1997, 1998 and Djankov, Hart, McLiesh, and Shleifer, 2008) at the country level. Equally important is the direct evidence of such impacts at the firm level to avoid the issues that omitted country idiosyncrasies may drive the findings. However, due to the difficulty of having enough variation of legal environments within a country, few studies have achieved such a goal. To bridge this gap, we utilize the variation of pleading standards of U.S. federal district courts (USDC) on securities class action lawsuits 1 as a proxy of court leniency to examine how banks lend in such an environment. Securities lawsuits are considered the end stage monitoring mechanism of public securities investors. It is investors last resort to hold firms liable for misrepresentation in their financial information. Through the threat of litigation, it can provide preemptive effects and deter fraudulent behavior in the first place (Skinner, 1994). When firms headquartered in jurisdictions with lenient courts (to the defendant issuer), the expected penalty is lower. Therefore, it gives firms higher incentive to engage in misreporting. Although securities litigation is not designed to protect the interests of private lenders, such as banks, the effect of lenient courts on firms misreporting incentive can have material impacts on banks lending decisions. It is because banks are heavy users of financial reports. Most of the loan contract terms, such as financial covenants, also rely on specific accounting items (Ball, Li, and Shivakumar, 2015; Demerjian, Donovan, and Larson, 2016). Therefore, we hypothesize that 1 SEC Rule 10b-5 prohibits any act or omission resulting in fraud or deceit in connection with the purchase or sale of any security. The vast majority of securities class action lawsuits are based on this rule. 1

4 banks in the lenient jurisdictions are more likely to have concerns on the quality of financial reports, which increase the risk of lending and can prompt banks to charge higher interest rates, shorten maturities, and reduce loan amounts. The predictions on covenants, however, are not straightforward. It is because higher misreporting incentive make these accounting items less useful for contracting purposes. Although increasing lending risk should prompt banks to strengthen monitoring that leads to more usage of covenants (Rajan and Winton, 1995), the lower reporting incentive also means that firms can manipulate accounting reports to avoid covenant violations, which can make such a mechanism less effective. Therefore, the effects of less stringent legal environment on the inclusion of covenants are ambiguous and an empirical question. By analyzing a large sample of U.S. syndicated loans borrowed by firms headquartered in the jurisdictions with different court dismissal rates on securities lawsuits, we can shed light on the extent to which legal environment affects financial system. We find that banks charge significantly higher interest spreads (over LIBOR) and lend with significantly shorter maturities if firms headquartered in the jurisdictions with higher court dismissal rate. These findings are robust with the inclusions of borrower and loan characteristics, credit rating, loan type, time, and court fixed effects. We do not find any effects on the size of loan amounts and covenant inclusions except for net worth covenants. In model specifications without court fixed effect, we find that banks significantly reduce the usage of net worth covenants when borrowers headquarters are in the districts with higher court dismissal rates. However, the finding is not significant when we include court fixed effects. Because the magnitude of estimated coefficients are essentially the same with or without court fixed effects, we cannot completely dismiss the possible effect on net 2

5 worth covenants. In addition, we do not find any impact of court dismissal rate on banks decisions on which types of loans to lend. However, the likelihood of arranging institutional term loans (versus revolvers and traditional terms loans) are significantly higher where there are higher incidence of lawsuits. The main difference between institutional term loans and other types of loans is that institutional loans tend to be initiated with the intention to be sold in the secondary market or securitized. Therefore, banks have less risk exposure by syndicating institutional term loans. In summary, we provide strong evidence along the dimensions of interest spreads and loan maturities. The results are not only highly statistically significant, but also economically large. For example, in most of the interest spread regressions, the estimated coefficients on court dismissal rate are around 14. Given the average dismissal rate and facility amount, it means a quarter million dollars of higher interest payment per year. The findings are consistent with the reporting disincentive hypothesis. As a robustness test, we also analyze the interest spreads of subsamples. We focus on performance pricing provision because the usage of such a mechanism implies that banks cannot assess the average credit quality of borrowers during the life of the loan (see, for example, Asquith, Beatty, and Weber, 2005). To address this uncertainty and reduce unnecessary renegotiations, which can be costly for both lenders and borrowers, imposing a performance pricing grid can allow interest spreads to change with updated borrower information. Although we do not find that banks use more or less performance pricing provisions when facing courts with different pleading standards, the fact that banks impose such a provision on some borrowers suggests that there is more information uncertainty of these borrowers. Therefore, we can use it to further examine our hypothesis. We expect that, among borrowers with performance pricing 3

6 provisions, those headquartered in lenient jurisdictions should raise a lot more concerns than those in more stringent districts. On the other hand, among borrowers without performance pricing provisions, such differential should be smaller. As expected, in the interest spread regressions, the estimated coefficient on court dismissal rate are highly significant (23.69 with t- value of 5.05) in the performance pricing subsample and insignificant (7.36 with t-value of 1.06) for those without performance pricing. The subsample analyses further reinforce our full sample evidence. Overall, these results are consistent with the reporting disincentive hypothesis. We make several important contributions to the literature. First of all, our analysis circumvents empirical challenges in studying the relations between law and finance. As mentioned above, the main challenge of country level studies is the control for omitted country level factors that are correlated and time varying with interested country variables. By focusing on the variation of court leniency within the U.S., we can completely avoid such an issue. To our best knowledge, ours is the first to use court dismissal rate to capture ex ante litigation environment at district level. In the economics literature, variations of federal judge tendency (or biases ) are used to predict, for example, the effect of incarceration on individual s earnings prospect (Kling, 2006), the effect of patents on cumulative innovation (Galasso and Schankerman, 2015), and the effect of bankruptcy laws on personal lending behaviors (Dobbie, Goldsmith-Pinkham and Yang, 2016), etc. The second major difficulty in studying law and finance is that, for the setup within a country, it is tough to find truly exogenous factors that are free of endogenous selection issues. Firms are likely to choose an optimal response to interested factors. Therefore, the heterogeneity of firms can drive the observed seemly effects from interested factors. By linking firms headquarters to their district court jurisdictions with time varying pleading standards on 4

7 securities lawsuits, we can ensure that the court leniency is an exogenous factor from the lenders perspective. Firms rarely change their headquarters, therefore, it is unlikely that a firm moves based on the leniency of a district court over time. Our paper also adds to literature in the area of law and finance, particularly on how legal environments affect financial contracting and bank lending decisions. These papers include Bae and Goyal (2009) and Qian and Strahan (2007) on the country level creditor protection environment. Specifically, Bae and Goyal (2009) show that banks in countries with stronger creditor rights charge lower loan spreads. Qian and Strahan (2007) study the impacts of laws and institutions on loan ownership, maturity and spreads. Focusing on collateral requirements, Liberti and Mian (2010) find that financial development helps to reduce collateral constraints. Lerner and Schoar (2005) document the impact of legal enforcement on contracting in private equity investments. Furthermore, our study is related to research on the usage of accounting information in debt contracting. For example, Bharath, Sunder, and Sunder (2008) use abnormal accounting accruals as a proxy of accounting report quality and find that firms with lower accounting quality tend to borrow bank loans versus public debt. They also borrow loans with shorter maturities, pay higher interest spreads and more likely to pledge collaterals. Ball, Li, and Shivakumar (2015) study the impacts of the adoption of IFRS, which increases managers financial reporting flexibility and the emphasis of fair value accounting. These properties reduce the transparency of financial reports and its contractibility leading to a reduction of accounting based debt covenants. Demerjian, Donovan, and Larson (2016) examine how increases in fair value accounting affect the practices of using financial covenants. They did not find evidence that the frequency of financial covenants in debt contracts changed following the expansion of fair value accounting. 5

8 However, they find that fair value accounting for liabilities is more likely to be excluded than that for assets. Furthermore, they find that borrowers with unreliable fair value estimates or with performance pricing provisions are more likely to have fair value estimates excluded from covenant calculations. Finally, we contribute to research showing that the mechanisms intended for one type of investors can spillover to other types, for example, Chava, Livdan, and Purnanandam (2009) on shareholder rights and cost of debt. Although the goal of the SEC is to protect investors from defrauding firms issuing public securities, the requirements for truthful disclosures and subsequent opportunity to penalize fraudulent firms through litigation can effect private lenders, such as banks ex ante lending decisions. It also shows that, despite the access to private borrower information, publicly disclosed financial information is also crucial for banks. Our analysis is unique and different from but complement to that by Graham, Li, Qiu (2008) who focus on ex post changes in lending decisions following firms financial restatements. The remainder of the paper is organized as follows. In Section 2, we develop testable hypotheses. Section 3 describes the data and variables. Section 4 presents the empirical results, and section 5 concludes the paper. 2. Hypotheses and Literature In the US securities law, the Rule 10b-5 is one of the most important rules targeting securities fraud promulgated by the SEC, pursuant to its authority granted under 10(b) of the Securities Exchange Act of The rule prohibits any act or omission resulting in fraud or deceit in connection with the purchase or sale of any security. The class action lawsuits concept, which emerged in 1960s, has proven to be an effective monitoring mechanism, whose value rests 6

9 in compensating victims and deterring financial misreporting (Alexander 1991; Field, Lowry and Shu 2005). The plaintiff under this rule are typically shareholders, and the defendants include the firm and any person whose fraudulent activity is in connection with the purchase or sale of a security by the plaintiff. Although securities lawsuits are considered the last resort type of monitoring, its potential impact on firms financial reporting incentives can affect many other monitoring mechanisms occur at earlier stages than lawsuits themselves. It is because financial reports are crucial information sources and routinely used by the boards, analysts, institutional investors, and lenders among others. To perform monitoring functions, it is essential to have timely and useful financial information. Vast majority of firms follow the accounting and disclosure rules to facilitate their communications with outsiders. Unfortunately, opportunistic behavior to defraud investors by misrepresenting financial reports occurs occasionally. In these cases, defrauded investors can sue companies for engaging in financial misreporting. Such a mechanism can ex post impose penalty on firms and, therefore, provide ex ante deterrence effect (See Habib et al., 2014 for a review). However, if the court dismisses lawsuits easily, this mechanism will likely to be weaker. Therefore, firms headquartered in such districts have a lower probability of facing the penalty, leading to higher incentive to engage in financial misreporting. In this sense, the leniency of a court does not only affect the cases on hand, but also many other parties that use financial reports. For instance, the bank lenders that we will analyze in this study. In the U.S., the federal courts enjoy exclusive jurisdiction to hear cases with respect to violations of the 1934 Securities Exchange Act. There are 94 district courts (5 outside the 50 states) 2, 12 regional appellate (Circuit) courts, and one Supreme Court throughout the country. 2 The five federal district courts located outside the 50 states are excluded from this study. They include those existed in Puerto Rico, the Virgin Island, the District of Columbia, Guam, and the Northern Mariana Islands. 7

10 Even though a securities lawsuit technically can be filed in any of the district courts wherein the defendant is found or is an inhabitant or transacts business. 3 Multiple filings need to be consolidated in one case typically heard by the USDC where the defendant firm is headquartered (28 U.S.C (a) and 1406 (a)). 4 Cox, Thomas, and Bai (2009) report their interview with several well-known plaintiffs counsels consistently reflected that it is impractical to engage in forum shopping due to the strong likelihood that their choice of a venue will be immediately followed by a successful defendant s motion to relocate the suit. Hence, rather than engage in in futile act, they file suit initially in the defendant company s home district. Given securities lawsuits are typically heard by the district court where the firm s headquarter is located, the pleading standard of that court thus applies to all firms headquartered in its jurisdiction. District courts can differ in their pleading standards, thus offering various levels of litigation risk from the reporting firms perspective, which in turn can alter their reporting incentives. Two studies take the advantage of country differential pleading standards on financial reporting: Baginski, Hassell, and Kimbrough (2002) compare U.S. and Canadian firms propensity to issue management forecasts arguing these firms are under similar business environment but subject to substantially different securities litigation risk. More recently, Srinivasan, Wahid and Yu (2015) find U.S. listed foreign firms from countries with weak rule of law are less likely to restate than domestic firms and firms from strong rule of law countries. 3 Securities and Exchange Act of 1934, ch.404, sec.27, 48 Stat. 881, (codified as amended at 15 U.S.C 78aa (2006)) 4 Two statutory provisions: 28 U.S.C. 1404(a) and 1406(a) provided the basis for this identification. Section 1404(a) protects witnesses and parties from an undue expenditure of time and money. Because of the nature of claims in private securities lawsuits, substantially all of the witnesses and sources of proof are likely to be located at the firm s headquarters. Section 1406(a) allows for transfer of a case that has been brought in an improper forum. Thus, plaintiffs who file suit outside of the federal district of the firm s headquarter are highly vulnerable to either dismissal based on the well-established doctrine of forum non conveniences or transfer to the district court of the defendant firm s headquarter. 8

11 Among all the possible users of financial reports, we focus on bank lending because bank loans are the most frequent and important type of outside financing (Sufi, 2007). Bank loans are very different from public financing because banks can access to non-public information of borrowers and it is common for banks to communicate with top managers about firms performance and prospects (Diamond, 1984; Rajan, 1992; Santos and Winton, 2008). Among various types of investors, banks are the most resourceful in terms of information availability. Even so, financial reports should still be an important source of information of borrowers. When firms have a lower incentive to provide accurate information, it poses higher risk to banks. Therefore, we hypothesize that, when firms headquartered in a lenient court, banks are likely to charge higher interest rates. Graham, Li, and Qiu (2008) provide empirical evidence that banks increase interest spread following borrowing firms restatements particularly those committing fraud. Due to the unique role of banks regarding information availability, evidence from bank lending decisions can offer a strong statement of the effects of litigation environment on the users of financial reports. Although the prediction of loan pricing is rather straightforward, that of non-pricing loan terms is not. This is because many non-pricing terms, such as financial covenants and provisions may rely on accounting information that can be manipulated. On one hand, increasing risk should prompt banks using more and stricter covenants. On the other hand, if the benchmarks used in the covenants can be manipulated, then imposing such covenants is meaningless and deem ineffective. Several studies document how accounting reporting rules can affect the feasibility of banks using covenants. Ball, Li, and Shivakumar (2015) document declining usage of accounting-based debt covenants following mandatory adoption of International Financial Reporting Standards (IFRS). However, Demerjian, Donovan, and Larson (2016) show that 9

12 adopting fair value accounting does not affect the usage of accounting based covenants. Therefore, it is an empirical question how the litigation environment can affect banks usage of covenants. The novelty of our empirical design is the exogenous nature of key explanatory variable USDC dismissal rate. The past dismissal rate of USDC in 10b-5 lawsuits incorporates information about the court s pleading standards thus the level of investor s legal protection in its jurisdiction. By dismissal rate, we mean the proportion of 10b-5 lawsuits that are dismissed by the relevant USDC (in other words, the defendant s motion to dismiss is granted by the court 5 ). Because most cases end up either dismissed or settled, prior work typically uses passing the motion to dismiss as one proxy for plaintiff win (Choi 2007; Choi, Nelson, and Pritchard 2008; Dyck, Morse and Zingales, 2010). It follows, higher dismissal rate means more lenient litigation environment for the defendant firms. From each lender s perspective, this factor is strictly exogenous to other borrowers characteristics. By examining lending decisions within a country, we can better hold other regulatory and economic environments constant and avoid unobserved country differences that could drive certain empirical relations. However, different USDC are residing in different states, which can have fundamental differences in business culture and dealings. Therefore, we also control for court fixed effects to address the unobserved heterogeneity of geographic areas. 5 A motion to dismiss is essentially an argument by the defendants that, even if all of the facts alleged in the complaint were assumed to be true, those facts would not be sufficient to give rise to liability under SEC Rule 10b-5. If the court determines that the facts alleged in plaintiffs complaint are sufficient to uphold a Rule 10b-5 claim, the court will enter an order denying the motion to dismiss, which then gives class plaintiffs the right to obtain discovery from the defendants which is the right to demand documentary evidence in the defendants possession concerning the facts at issue, and the right to require officers of the company, as well as any experts or other third parties, to sit for depositions. If a motion to dismiss is denied by the Court, the costs of litigation will increase substantially and there is now a much greater chance of a recovery on behalf of the class. However, if a motion to dismiss is granted, the case is over and will be closed by the Court. 10

13 3. Sample and Variables 3.1. Sample selection Our sample of bank loans are from the DealScan database of Thomson Reuters LPC. Because the main explanatory variable court dismissal rate are available from 2000 and onwards, we obtain loan deals from 2001 to To ensure the homogeneity of loan sample, we only include loans that the country of syndication is USA and the distribution method is syndication. There are 15,620 loan facilities without further screening for firm characteristic availability in Compustat. Panel A of Table 1 reports sample distribution by deal year. In general, the number of loan facilities are pretty evenly distributed across years with the exception of the periods surrounding the 2008 Financial Crisis. Panel B reports the frequency of sample by S&P domestic long term issuer credit rating of borrowers. Among the 15, 620 facilities, 46.6% of loans are borrowed by firms without credit rating. The largest credit rating group appears to be BBB; while the smallest is SD with only one observation. Panel A of Table 2 presents the summary characteristics of loan terms. More detailed variable descriptions are in Appendix A. The median interest spread (above LIBOR) is 200 basis points. The median size of facility is 195 million. The median maturity is 56 months. The average level of covenants index is 2.1. Average facility contains 0.86 sweep type of covenants and 1.44 financial covenants. Thirty-four percent of loans are secured with collaterals; half have dividend restriction; Seventeen percent contains net worth covenants, and forty-five percent have performance pricing provision. The vast majority (60%) of loans are multi-year revolvers, followed by traditional term loans (17%), then institutional term loans (12%). Line of credit with less than one year maturity consists of eleven percent of sample. 3.2.Explanatory variables and descriptive statistics 11

14 Our key explanatory variable is court dismissal rate, which is defined by the number of cases dismissed within five years prior to a borrowing firm s fiscal year end divided by that of cases filed during the same period. 6 Note that it may take several years for a case to have any sort of resolution, while other cases may be dismissed much faster. Therefore, cases dismissed within five years may not correspond to cases filed during the same period. However, to address different federal courts may have very different number of firms and lawsuit filings, we believe that this scaling method is reasonable. We further control for the extent of lawsuit intensity (lawsuit filing rate), which is the number of lawsuits filed within prior 5 years scaled by the number of firms in the same district. To control for borrower characteristics, the analysis mainly uses listed company available in Compustat, which further reduces the sample to 12,357 loan observations if all firm characteristics are considered. Panel B, of Table 2 reports descriptive statistics of variables used in the regression analysis. The average dismissal rate is 37% and lawsuit filing rate is 11%. Mean log version of borrower total assets (firm size) is 7.31, Tobin s q 1.65, cash holdings 9.41% of total assets, profitability 11.97% of total assets. Average current ratio is 1.83, leverage 63.14% of total assets. Forty percent of assets are tangible on average and 54% of sample pay dividends. Average interest coverage ratio is 7.69 times of operating profits. Mean capital expenditure scaled by total assets is 5.18%, R&D scaled by sales is 0.07% with 54% of firms without R&D information. 4. Empirical Tests Before we conduct formal regression analysis, Table 3 presents univariate tests of loan terms by level of dismissal rate. Court districts with above median dismissal rate are classified as high 6 Note the U.S. Congress enacted the Private Securities Litigation Reform Act (PSLRA) in Our court dismissal rate starts from 2000 to allow for five years previous court ruling data in the post-pslra period. 12

15 level. Every single loan term compared in Table 3 is significantly different between high and low dismissal rate courts. Mean interest rate, facility amount, and maturity are all significantly higher in the high dismissal district courts than low ones. On the contrary, the extent of all covenants is significantly lower. However, to reach any conclusions, we proceed with multivariate regressions with different sets of control variables Interest spreads The first loan term we examine is loan price, i.e., interest spreads (in basis points) charged above LIBOR or prime rate. The spreads include interest costs if the funds are drawn and annual fees. For loans not based on LIBOR, Thomson Reuters LPC converts the spreads into LIBOR terms by adding or subtracting a differential adjusted periodically. Table 4 reports five different model specifications ranging from the fewest controls to the full controls that include firm and loan characteristics as well as various fixed effects. To avoid multicollinearity between time and court fixed effects, we group loans based on the following four periods marking very different interest rate environments: (1) years , which follows the burst of Internet bubble and a period of discovering many corporate financial scandals; (2) years , which is an easy credit period that facilitates housing bubble; (3) years , which covers the financial crisis; (4) years , which continues the quantitative easing by the Federal Reserve. Regardless of model specifications, the coefficient estimates on court dismissal rate are very stable and highly significant in both statistical and economic senses. The numbers hover around 14 basis points in most of the model specifications. Given the average dismissal rate and facility amount, it means about a quarter million dollars of higher interest payment per year. The findings are consistent with the reporting disincentive hypothesis that firms headquartered in the districts with lenient courts have a higher likelihood of misrepresenting financial reports, hence 13

16 increases lenders risk exposure. The estimates on control variable, lawsuit filing rate, are all insignificantly different from zero. Among firm characteristics, larger, high Q, high current ratio, high profitability, R&D firms pay significantly lower interest rate than otherwise firms. Firms paying dividends or without R&D information also pay significantly lower interest rate. These results are consistent with prior literature, such as Chava, Livdan, and Purnanandam (2009) and Graham, Li, and Qiu (2008). Loans with longer maturity or having performance pricing provisions also have significantly lower interest rate. Loans require collaterals have significantly higher interest rate. This is consistent with previous research, such as Berger and Udell (1990) who find that riskier borrowers use more collateral Loan maturity and amounts In this section, we examine the effects of court dismissal rate on loan maturity and amounts. We did not find any significant impacts on the size of loans. Therefore, we do not report the results for brevity. However, the estimated coefficients on court dismissal rate for loan maturity are again very stable and robust. The significant negative estimates reported in Table 5 indicate that banks in the jurisdictions with more lenient courts arrange loans with shorter maturities. The magnitude of estimate is also economically significant as it is comparable to that of firm size. It takes one unit increase in firm size (natural log of total assets) to offset one unit increase in court dismissal rate. Shorter loan maturities have been recognized as an effective monitoring mechanism to address information problem because of more frequent information disclosure and renegotiation of contract terms. Through the debt renewal processes, banks also obtain a stronger bargaining position (see, for example, Barclay and Smith (1995) and Rajan and Winton (1995)). 14

17 Unlike the results for interest spreads (Table 4), the estimates on lawsuit filing intensity in Table 5 are also significantly negative in all model specifications except for the one with court fixed effects. The evidence suggest that banks are concerned by shortening loan maturities when the jurisdictions have more securities lawsuits. This is consistent with the findings of Graham, Li, and Qiu (2008) that banks shorten loan maturities following borrowers restatement events. Among the control variables, firms that are more profitable, pay dividends, invest more in R&D borrow loans with longer maturities. However, firms with more tangible assets have shorter maturity loans. Loans with performance pricing provision also have longer maturities. 4.3 Covenants Besides the size and maturity of loans, we also examine covenants of loan contracts. Although covenants reduce agency costs of debt, it comes with the costs of reduced flexibility (Smith and Warner, 1979) and in some cases leads to inefficient investment decisions. Therefore, it is in both lenders and borrowers interests to use covenants carefully without imposing undue burden on borrowing firms while providing ample lender protections. In general, riskier firms that have a higher potential of agency problem tend to borrow with more covenant restrictions. However, most of covenants are built on accounting information. If a court has lenient pleading standard, it can reduce borrowing firm s financial reporting incentives which then reduce the usefulness of accounting information for loan contracting purpose. Therefore, the effects of court dismissal rate on covenant inclusions are ambiguous. We analyze all types of covenants available in DealScan databases. However, all analyses indicate that court dismissal rate has no impact on the usage of covenants except for net worth covenants. Even so, the finding is not robust when court fixed effects are included. We report the probit regression results in Table 6. We caution the interpretation of our findings because 15

18 including court fixed effects can introduce collinearity resulting in larger standard errors for estimates. Because the magnitude of estimates are essentially the same between models with and without court fixed effects, therefore, we cannot completely rule out the possibility of impact on net worth covenants. The significantly negative estimates in Table 6 suggests that banks are less likely to impose net worth covenants in the jurisdictions with lenient courts. The most common allegation of securities lawsuits is inflating stock prices and most of the accounting manipulation is on earnings, which has a direct impact on the level of net worth. Therefore, the limited evidence is consistent with the disclosure disincentive hypothesis that when the accounting items are less reliable, banks are less likely to use such items for loan contracting. However, all other types of covenants are not affected. For brevity, we only report selective regression results in Table 7, which includes performance pricing, collateral requirement (secured), aggregated covenant index, and the number of financial covenants. The insignificant findings also suggest that when there are concerns on financial reporting, mechanisms that rely less on accounting information, such as higher interest spreads and shorter maturities can be more effective and provide better protection for lenders. As a robustness test, we also examine interest spreads of subsamples. In the first column of Table 8, we only include loans with performance pricing provisions. If banks are uncertain about borrowers quality and outlook, they can impose performance pricing to address such uncertainties (Asquith, Beatty, and Weber, 2005). Although we do not find that banks are more likely to lend with performance pricing provision, the subsample of loans with such a provision are likely to be the borrowers that banks cannot gauge their credit quality more precisely upon loan initiation. If one major source of such information problem is related to financial reporting 16

19 incentives, we will see interest spreads are positively associated with court dismissal rate. Despite much fewer observations, the estimated coefficient on court dismissal rate in Column (1) remains highly significantly positive. The estimated coefficient on court dismissal rate is (t-value is 5.05), which is much larger than that of full sample. On the contrary, the estimated coefficient on court dismissal rate is 7.36 (t-value is 1.06) for the subsample of loans without performance pricing provisions. These findings confirm our conjecture that among borrowers (with performance pricing) that banks suspect of higher level of information problem, their responses to lenient courts are more sensitive than those without such a concern Analysis of loan types In this section, we examine whether banks facing higher financial reporting disincentive of borrowers tend to arrange different types of loans. Table 9 reports three difference comparisons: (1) institutional term loans versus revolvers; (2) traditional term loans versus revolvers; (3) traditional versus institutional term loans. We do not include lines of credit with maturities less than one year because the comparisons should be between loans with a reasonable level of substitutions. Revolvers, which is loan commitments, are the most common types of loans. A borrowing firm can withdraw funds and payback loans multiple times throughout the life of a loan. In contrast, the funds of a term loan are drawn upon loan origination. In general, traditional term loans are amortized and kept on the balance sheets of banks. Institutional term loans, on the other hand, are not amortized and initiated with the intention to be securitized or sold in the secondary markets. Although banks can also participate, the participants of institutional term loans are often non-bank lenders who tend to have a higher risk appetite for risk than banks (see, for example, Ivashina, and Sun (2011)). Therefore, among all these long-term loans, institutional 17

20 term loans offer the lowest risk exposure for banks followed by revolvers, which allow banks to cancel loan commitments if borrowers financial conditions deteriorate. We find that, in Table 9, none of the estimates on court dismissal rate are significant. However, the estimates on lawsuit filing rate are significant for the comparisons between institutional term loans versus revolvers and traditional versus institutional term loans. The estimates of marginal effects indicate that for one standard deviation increase in lawsuit filing rate, banks increase the probability of arranging institutional term loans versus revolvers by 2.85% and versus traditional loans by 6.46%. Banks appear to react more towards litigation risk than lax litigation environments. Among control variables, the estimates on Tobin s q and capital expenditures indicate that banks have a significantly higher probability of arranging traditional loans versus other two types if borrowers have higher Tobin s q and capital expenditures. In Table 10, we further analyze the interest spreads of these loans by type. In the first three columns of Table 10, the regressions include court fixed effects, the last three do not. It appears that our main results are driven by revolvers, which are the most common type to loans in our sample. Revolvers are loan commitments, so firms may or may not draw down the balance throughout the lives of loans and lenders can cancel the loans easier if firms do not maintain certain requirements depicted in the loan contracts. Although the estimates on court dismissal rate are all positive for traditional loans and institutional loans, none of them are significantly positive. In general, the estimates on lawsuit filing rate are not significant except for the one for traditional term loans without the control for court fixed effects. Because the estimate changes too much when we include court fixed effects, therefore, we do not consider this evidence. 5. Conclusions 18

21 This paper provides the rare, firm level evidence that local legal environments affect financial contracting in private debt. Novelty to this study is our exploitation of the variation of pleading standards of USDC on securities lawsuits as proxy of legal environment, which bypasses drawbacks associated with omitted country-level idiosyncrasies in cross-country studies. By linking firms headquarters to their USDC jurisdictions with time varying pleading standards, we can ensure that court leniency is an exogenous factor from lenders perspective. Using a large sample of syndicated bank loans, we find firms headquartered in more lenient district court jurisdictions pay significantly higher interest rates and borrow with significantly shorter maturities. Furthermore, for firms headquartered in high lawsuit filing districts banks are more likely to arrange institutional term loans which are sold in the secondary market or securitized. This evidence is consistent with a reporting disincentive hypothesis that when other type of monitoring on firms financial reporting incentive is weaker, banks use pricing terms and risk-shifting strategies to overcome information problems. Of particular interest is our finding that USDC litigation environments has little effect on the usage of non-pricing terms such as covenants. This is precisely because covenants rely much on high quality accounting items of which banks are heavy users. Higher misreporting incentives make these accounting items subject to manipulation thus less useful for contracting purpose. We do, however, show that the pricing sensitivity to court leniency is highly significant among borrowers with high information uncertainty (i.e., with performance pricing provision) and insignificant for borrowers with low information uncertainty (without performance pricing provision). We show mechanisms designed for shareholders to seek compensation from defrauding firms have preemptive effect on firms financial reporting, which in turn affects lenders ex ante lending 19

22 decisions. This discovery highlights the value of private securities class action as monitoring mechanism, as well as the complex interactions among the various institutions that shape the financial system. 20

23 References Alexander, Janet C., 1991, Do the Merits Matter? A Study of Settlement in Securities Class Actions. Stanford Law Review 43, Asquith, Paul, Anne Beatty, and Joseph Weber, 2005, Performance Pricing in Bank Debt Contracts. Journal of Accounting and Economics 40, Bae, Kee-Hong, and Vidhan K. Goyal, 2009, Creditor Rights, Enforcement, and Bank Loans. The Journal of Finance 64, Baginski, Stephen P., John M. Hassell, and Michael D. Kimbrough, 2002, The Effect of Legal Environment on Voluntary Disclosure: Evidence from Management Earnings Forecasts Issued in US and Canadian Markets. The Accounting Review 77, Ball, Ray, Xi Li, and Lakshmanan Shivakumar, 2015, Contractability of Financial Statement Information Prepared Under IFRS: Evidence from Debt Contracts around IFRS Adoption. Journal of Accounting Research 53, Barclay, Michael J., and Clifford W. Smith, 1995, The Maturity Structure of Corporate Debt. The Journal of Finance 50, Berger, Allen N., and Gregory F. Udell, 1990, Collateral, Loan Quality, and Bank Risk. Journal of Monetary Economics 25, Bharath, Sreedhar T., Jayanthi Sunder, and Shyam V. Sunder, 2008, Accounting Quality and Debt Contracting. The Accounting Review 83, Chalmers, Keryn, Vic Naiker, and Farshid Navissi, 2012, Earnings Quality and Rule 10b-5 Securities Class Action Lawsuits. Journal of Accounting and Public Policy 31, Chava, Sudheer, Dmitry Livdan, and Amiyatosh Purnanandam, 2009, Do Shareholder Rights Affect the Cost of Bank Loans? The Review of Financial Studies 22, Choi, Stephen J., Do the Merits Matter Less After the Private Securities Litigation Reform Act? Journal of Law, Economics & Organization 23, Choi, Stephen J., Karen K. Nelson, and Adam C. Pritchard, 2009, The Screening Effect of the Private Securities Litigation Reform Act. Journal of Empirical Legal Studies 6, Cox, James D., Randall S. Thomas, and Lynn Bai, 2009, Do Differences in Pleading Standards Cause Forum Shopping in Securities Class Action Lawsuits?: Doctrinal and Empirical Analysis. Wisconsin Law Review 32, Demerjian, Peter R., John Donovan, and Chad R. Larson, 2016, Fair Value Accounting and Debt Contracting: Evidence from Adoption of SFAS 159. Journal of Accounting Research 54,

24 Diamond, Douglas W., 1984, Financial Intermediation and Delegated Monitoring. The Review of Economic Studies 51, Djankov, Simeon, Oliver Hart, Caralee McLiesh, and Andrei Shleifer, 2008, Debt Enforcement around the World. Journal of Political Economy 116, Dobbie, Will., Goldsmith-Pinkham, Paul., Yang, Crystal, 2016, Consumer Bankruptcy and Financial Health. Review of Economics and Statistics (forthcoming). Dyck, Alexander, Adair Morse, and Luigi Zingales, 2010, Who Blows the Whistle on Corporate Fraud? The Journal of Finance 65, Field, Laura, Michelle Lowry, and Susan Shu, 2005, Does Disclosure Deter or Trigger Litigation? Journal of Accounting and Economics 39, Galasso, Alberto, and Schankerman Mark, 2015, Patents and Cumulative Innovation: Causal Evidence from the Courts. The Quarterly Journal of Economics 130, Graham, John R., Si Li, and Jiaping Qiu, 2008, Corporate Misreporting and Bank Loan Contracting. Journal of Financial Economics 89, Habib, Ahsan., Jiang, Haiyan, Bhuiyan, Md. Borhan Uddin, Islam Ainul, Litigation risk, financial reporting and auditing: A survey of the literature. Research in Accounting Regulation 26, Ivashina, Victoria, and Zheng Sun, Institutional Demand Pressure and the Cost of Corporate Debt. Journal of Financial Economics 99, Kling, Jeffrey R., Incarceration length, employment, and earnings. The American Economic Review 96, La Porta, Rafael, Florencio Lopez-de Silanes, Andrei Shleifer, and Robert W. Vishny, 1998, Law and Finance. Journal of Political Economy 106, La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert Vishny, 1997, Legal Determinants of External Finance. The Journal of Finance 52, Lerner, Josh, and Antoinette Schoar, 2005, Does Legal Enforcement Affect Financial Transactions? The Contractual Channel in Private Equity. Quarterly Journal of Economics 120, Liberti, Jose M., and Atif R. Mian, 2010, Collateral Spread and Financial Development. The Journal of Finance 65, Qian, Jun, and Philip E. Strahan, 2007, How Laws and Institutions Shape Financial Contracts: The Case of Bank Loans. The Journal of Finance 62,

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26 Figure 1 Dismissal Rate by Federal Court See Appendices A for variable definitions and B for the list of USDC and corresponding dismissal rates. The numbers in the graph are standard deviations of court dismissal rate. 24

27 Appendix A. Variable Definitions Variable names USDC characteristics Court dismissal rate Lawsuit filing rate Variable definitions The number of cases dismissed within 5 years prior to the end of a borrowing firms fiscal year scaled by the number of cases filed during the same period The number of cases filed within 5 years prior to the end of a borrowing firms fiscal year scaled by the number of firms headquartered in the same federal district during the same period Loan Characteristics Interest spread Facility amount/ta Ln(loan maturity in months) The All-In-Drawn item in DealScan database. It includes interest cost in basis points over LIBOR (prime rate) and annual fees Loan amount scaled by total assets Natural log of the loan maturity measured in months =1 if secured A dummy variable that equals one if the loan facility is secured by collateral and zero otherwise =1 if having performance pricing A dummy variable that equals one if the loan facility contains performance pricing provision =1 if having dividend restriction =1 if having net worth covenant Covenant index No of sweeps No of financial covenants Loan type fixed effects Firm Characteristics Firm size A dummy variable that equals one if the loan facility has a restriction on dividend payment and zero otherwise A dummy variable that equals one if the loan facility has net worth covenants The sum of number of sweeps and four covenant indicator: secured, dividend restriction, more than two financial covenants, net worth. Asset sales sweep, debt issuance sweep, equity issuance sweep, and insurance proceeds sweep Number of restrictions to maintain certain financial ratios Loan types include line of credit less than one year maturity, revolvers, traditional term loans, and institutional term loans. Natural log of total assets 25

28 Tobin's q Cash holdings Current ratio ROA Tangible Assets Leverage (Total assets + market value of equity book value of equity)/total assets Cash and equivalent as a percentage of total assets Current assets divided by current liabilities Operating income before depreciation as a percentage of total assets Net property, plant, and equipment plus inventory as a percentage of total assets Total liabilities as a percentage of total assets =1 if pay dividends A dummy variable that equals to one if firm pays dividends and zero otherwise. Inverse of interest coverage Capital expenditure R&D scaled by sales Interest expenses as a percentage of operating income before depreciation Capital expenditure as a percentage of total assets R&D expenses as a percentage of sales; equals to zero if the value is missing. =1 if R&D missing A dummy variable equals to one if R&D expenses are missing and zero otherwise =1 if no credit rating A dummy variable equals to one if firm does not have S&P Domestic Long Term Issuer Credit Rating and zero otherwise =1 if firm has investment grade A dummy variable equals to one if firm s S&P Domestic Long Term Issuer Credit Rating is equal to BBB or better and zero otherwise Credit rating fixed effects S&P Domestic Long Term Issuer Credit Rating 26