Do Banks Care About Litigation Against Auditors of Borrower Firms? Evidence from Bank Loan Pricing

Abstract

This study examines how auditors’ reputational damage caused by litigation affects audit clients’ borrowing costs. Focusing on a sample of syndicated loans made to non-litigated borrowers, we find that borrowing costs are higher when the firms’ auditors are sued for alleged audit failures. However, this positive association is significantly attenuated when syndicate participant banks have a prior lending relationship with the borrower, when they repeatedly interact with the lead bank through other loan transactions, or when they are more willing to join the syndicate. Furthermore, loans to the clients of litigated auditors include more general covenants and fewer accounting-based performance pricing provisions. Collectively, our findings suggest that private lenders such as banks, on average, incorporate auditors’ reputation damage in assessing the credit risk of their borrowers. This study provides important insights into the externalities of litigation against auditors in the context of private debt contracting and lending relationships.