The Role of Reputable Auditors and Underwriters in the Design of Bond Contracts

Abstract

The authors empirically test the certification hypothesis by studying the roles of reputable auditors and bank underwriters in the design of bond contracts. The certification hypothesis suggests that reputable capital market intermediaries can credibly communicate inside information to outside investors, thereby helping improve financing terms for firms that raise external funding. Consistent with this hypothesis, the authors provide evidence that reputable auditors and underwriters help corporate bond issuers obtain lower bond yields. The effect of reputable auditors on the yields is greater than that of reputable underwriters in terms of economic magnitude and significance, consistent with auditors’ multiple roles as information intermediaries, monitors, and insurance providers. The authors also find that the presence of reputable auditors and underwriters affects bonds’ nonpricing terms. Firms that hire reputable auditors obtain longer term bonds, whereas those that engage reputable underwriters can issue larger bonds. Taken together, the results suggest that reputable auditors and underwriters have integral, but different, roles in the bond-issuing process.