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The Impact of Corporate Convictions on Syndicated Bank Loan Prices
1. Introduction
Over the past two decades, with the business expansion of corporations and the maturity of global financial market, the market for syndicated loan has experienced rapid growth. As one of the largest sources of worldwide corporate financing, the syndicated loan market helped facilitate the use of capital by lining up with financial institutions under the structure of syndicated loan1. It has also inspired large varieties of studies on the effective contracting tool in response to specific conditions or changing environment. The specific conditions including adjustment of borrower’s credit worthiness have been extensively reviewed in previous literature. Researchers also examine how bank reflect borrower’s risk and cost through loan contracting.
Graham, Li and Qiu (2008) study the effect of financial restatement on bank loan contracting, and they found that delinquency and negligence of firms can imply the inaccuracy in the information previously known to the lending bank; therefore, prior beliefs concerning loan risk often need to be reevaluated. That is, a financial restatement, either as result of fraudulent intentions or incautious action, creates uncertainty about the credibility of financial statements, hence, increases the firm’s perceived informational asymmetry from the bank’s perspective. It is the first paper focusing on the cause and effect between corporate misreporting and bank loan contracting.
1 In a syndicated loan, two or more lenders jointly offer funds to a borrower where the roles of lenders can be further divided into two groups: lead arrangers and participants. The lead arrangers retain part of the loan while, at the same time, act as the agents for the lending syndicate. Lead arrangers are responsible for both ex-ante due diligence and screening and the ex-post monitoring against borrowers. On the other hand, the participant lenders rely on the information provided by lead arrangers, including their assessment of the borrower’s credibility.
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However, as financial restatement gains more attention in the research of syndicated loan, loan-contracting issues concerning other corporate misconducts or delinquencies has rarely been explored.
In recent years, a number of well-known corporations had been prosecuted as a result of violating US domestic regulations or International Standards. Among those convicted, many have borrowed from syndicated loan markets. For instance, during 2008, the German multinational industrial firm, Siemens AG, was prosecuted for its violation of Foreign Corrupt Practices Act (FCPA) involving payments of $1.4 billion in bribes to government officials in sixty-five countries. Siemens was not alone in the list of those accused, during year 2008 to 2010, other prominent multinational corporations, such as Japanese electronics giant, Panasonic Co., Sweden polymer-engineering whale, Trelleborg Industries, and the world's largest LCD panel maker, LG
Display Co.(Korea based) were also prosecuted for violating U.S. Antitrust Act.
Similar to the consequences resulted from financial restatement, being prosecuted can be costly to firms under investigation. Negative effects resulted from being prosecuted can observed in many forms, ranging from potential obligation to pay substantial fines, shaking investors’ confidence in the credibility of corporate disclosure, dampening the demand for a firm’s securities and leading to a substantial loss in the market value of the firm. Moreover, the records of being prosecuted, like financial misreporting, may potentially induce a change in loan contracting for the following reasons. First, the fact that a firm is convicted may indicate its incapability of abiding by the law, which may signal its deficiency in corporate governance and internal control. This can make the firm a comparatively undesirable borrower to the banks; therefore, in order to control the risks borne, banks may raise the spread charged, reduce debt maturity, and demand more collaterals. Second, if the firm in concern is deemed as capable of abiding the rules, then the fact that it’s convicted would be interpreted as a record of rebel
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behavior or disobedience on purpose, which would discount the firm’s integrity in the eyes of lenders and make it an even worse borrower. Either way, with the record of being prosecuted, it’s expected that there’d be differences in bank contracting before and after corporate litigation. Among the research related to the effect in the level of prosecution and corporate misconduct, most existing literature focuses on the release of related news of the company and how it may influence the firm’s market value in terms of equity market; However, we know very little about how the events of being prosecuted affect specific contract terms in syndicated loan market. This paper attempts to fill this gap by analyzing the impact of corporate convictions on the price of bank debt.
The reason why we explore the impact of convictions using syndicated loan data is that they provide multi-dimensional information about corporate loans, and that the reactions of lead arrangers and participant banks to the violation record of common laws can be observed explicitly through various features of loan contracts. These terms of contract allow us to explore the effects of corporate being prosecuted on the direct (interest rate) and indirect (loan maturity, covenant restriction, choice of loan origin) costs of debt. Moreover, loan contracts allow us to look into how the structure of bank loans such as the number and shares of lenders in a syndicate loan and loan transaction fees may be affected by the indictment record of the borrower.
Even though similar to the issue of financial restatement, the effect of corporate convictions can be quite different from that of a financial restatement. The issue of how potential consequences from convictions affect firms has been raised in the field of Law.
Professor Brandon Garrett of University of Virginia School of Law has pointed out in his book Too Big to Jail that when prosecutors target the Goliaths of the corporate world, they usually find themselves at a huge disadvantage in terms of capital and human resource. To avoid time consuming trial and possible economic clash, American courts
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routinely hand down harsh sentences to individual convicts, but consider a very different standard of justice applies to corporations. He reveals a pattern of negotiation and settlement in which prosecutors tends to compromise with the company accused.
When some corporations are considered too economically important to fail, they even receive government bailout by agreeing to, structural reforms so that they can avoid negative consequences of criminal convictions. He shows that convicted corporations are not exactly at disadvantage in negotiations. Therefore we examine whether banks respond in the same courtesy like prosecutors?
Even though banks may be different from government and prosecutors, there are incentives for banks to compromise on loan deals as well. For example, banks may have the incentives to settle with less defensive terms in order to attract new clients and compete with its opponents; or they may toned to settle with the terms just to hold on to its existing clients.
To answer these questions, we begin by examining the effect of corporate convictions on loan spreads. We measure loan spread as the amount the borrower pays in basis points over LIBOR (London Interbank Offered Rate). In addition, corporate convictions vary in severity. When studying the impact of corporate convictions on bank loan contract, we should bear in mind that different types of violations may result in different degree of impact on contract terms. Since some of violations are minor misdemeanors than others, taking lenders’ concern into consideration, we expect that the syndicate loan market will take more precautions against firms that are involved in fraud-related or other significant violations of laws in terms of a larger increase in loan spread.
To summarize, this paper makes three contributions. First, it contributes to the loan contracting literature by studying how corporate litigation may or may not affect the loan spread of bank debt. Second, this paper is the first to connect Loan Pricing
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Corporation’s Dealscan database and the database of Corporate Convictions, hand-collected by Professor Brandon Garrett of University of Virginia School of Law.
Through the collaboration of these two distinctive yet potentially relevant database, we expect this paper may provide results that are relevant for many studies in the future.
The remainder of the paper is organized as follows. The next chapter presents related literature covering how different corporate misconduct affect the value of the firm and how banks cope with risk and information asymmetry through the use of contracting mechanism, and potential challenges when collaborating corporate misconduct database. Chapter 3 describes the data, summary statistics and methodology.
Results and implication are summarized in Chapter 4, while Chapter 5 examines possible time lag of the conviction database. Chapter 6 concludes.
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