Sarbanes-Oxley Act and Corporate Credit Spreads

Abstract

Motivated by failures of iconic corporate hallmarks like Enron and WorldCom, in July of 2002 the Sarbanes-Oxley Act was passed to prevent managerial misconduct and deceptive accounting in an effort to ensure incentives alignment between managers and shareholders. Whether the Act has been effective in mitigating the problems that it set out to resolve is the subject of a lively debate, discussion and research. Most current analyses of the Act focus on stock market evidence because it assumes that underpinning agency conflicts that gave rise to high-profile corporate failures of 2001 - 2002 were exclusively limited to incentive misalignments between managers and investors. If the managerial misconducts and accounting deceptions were a reflection of a different agency conflict, per se that of managers and bondholders, then the evidence from corporate bond markets would be much more telling simply because the brunt of such an agency cost would be borne by creditors (Myers, 1977). These iconic debacles trace back to managerial engagement in extremely risky projects and overexpansion in an attempt to meet unreasonable expectations. Equipped with complex accounting practices which made disclosure effectively a voluntary managerial decision, as Shin (2003) predicts, managers 'rolled the dice' with shareholders' fortunes, hoped for unlikely favorable results that could meet unreasonably high expectations, and hide their failures. This of course is the classical Myers' (1977) asset substitution. Since bondholders bear the cost of wealth transfer due to asset substitution, a priori, they will charge a premium. In fact Leland (1998) shows that while agency cost as a percentage of firm value increases moderately with firm's riskiness, the bonds' credit spreads exponentially rise. Examining the impact of the Sarbanes-Oxley on credit spreads then provides us with an excellent setting to determine to what extent manger/bondholder agency problems affects corporate bonds and the firm value. Using a panel regression analysis of credit spreads and controlling for a host of determining variables, we investigate how the Sarbanes-Oxley Act has changed the credit spreads. We show that the Act indeed has caused one third of the 150 basis points increase in credit spreads preceding the passage of the Act to dissipate, implying that the Act succeeded in partially resolving underlying problems.