Do Banks Price Litigation Risk in Debt Contracting? Evidence from Class Action Lawsuits

• Published date: 01 November 2015
• Date: 01 November 2015
• DOI: http://doi.org/10.1111/jbfa.12164

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 42(9) & (10), 1310–1340, November/December 2015, 0306-686X

doi: 10.1111/jbfa.12164

Do Banks Price Litigation Risk in Debt

Contracting? Evidence from Class Action

Lawsuits

QINGBO YUAN AND YUNYAN ZHANG∗

Abstract: Class action lawsuits can be detrimental to debtholders because they deteriorate

defendant firms’ financial position and lower these firms’ value. This study examines whether

banks price their borrowers’ litigation risk in debt contracting. We find that banks charge

19% higher interest spreads on loans to lawsuit firms after litigation. In addition, banks

monitor lawsuit firms more closely by using tighter non-price terms. The results are robust

after correcting for possible endogeneity issues using the propensity score matching approach.

We further find that the effects of lawsuit filing are more pronounced for firms with weaker

corporate governance. Following a lawsuit in the industry, banks also perceive an increased

likelihood of litigation for industry peer firms and adjust price and non-price terms accordingly.

Finally, we find that the magnitude of the lawsuit filing effect is greater for firms with lower

ex-ante litigation risk. Taken as a whole, our findings suggest that banks, as informed stakehold-

ers, perceive litigation risk to be detrimental and price this risk in debt contracting.

Keywords: debt contracting, litigation risk, bank loans, cost of debt, non-price terms

1. INTRODUCTION

Banks, as creditors, own fixed claims that are more senior than the residual and limited

liability claims of shareholders. Nevertheless, their pay-off structure has a limited

upside potential that exposes them mainly to downside risks. There is broad agreement

that shareholder class action lawsuits result in significant losses in defendant firms’

value, which result from not only lawsuits settlements but also the damage to these

firms’ reputation (Fich and Shivdasani, 2007; and Gande and Lewis, 2009). However,

little is known about whether banks react to litigation risk in their debt contracting,

given their superior information processing abilities and direct access to private

∗Both authors are with the Department of Accounting, University of Melbourne, Australia. The authors

would like to thank an anonymous referee, Gary Biddle, Jim Frederickson, Bin Ke, Kevin Li, Brian

Rountree (Editor), Wan Wongsunwai (discussant), Anne Wyatt (discussant), Haifeng You(discussant), and

participants in the Melbourne Early Career Researcher Symposium 2012, American Accounting Association

2013 Annual Conference, and UTS Australian Summer Accounting Conference 2014 for their helpful

comments. Qingbo Yuan acknowledges the Faculty of Business and Economics at University of Melbourne

for financial support. (Paper received March 2015, revised version accepted August 2015).

Address for correspondence: Qingbo Yuan, Department of Accounting, University of Melbourne, Mel-

bourne, VIC 3010, Australia.

e-mail: yuanq@unimelb.edu.au

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LITIGATION RISK IN DEBT CONTRACTING 1311

information. In this paper, we directly investigate this question using a sample of

lawsuit firms.

To protect the interests of shareholders, the Securities Act of 1934 grants share-

holders the right to file a private lawsuit in federal court to recover damages caused

by securities fraud. Firms facing lawsuits often experience a significant drop in market

value on the filing date (Bhagat et al., 1998; and Gande and Lewis, 2009). A drop in

the firm’s value and reduction of its future cash flow due to actual lawsuits increase its

downside risk. Furthermore, a large drop in equity value translates to a substantial

increase in leverage, which exacerbates conflicts of interest between shareholders

and debtholders. Managers acting in the interest of shareholders may have strong

incentives to expropriate debtholder wealth via activities such as asset substitution and

dividend overpayment. These actions not only increase firm default probability, but

also impair the value of collateral, which in turn reduces the recovery rate in the

event of default (Lin et al., 2011). Taken as a whole, shareholder litigation has an

unintended detrimental impact on banks.

In addition to the adverse impacts on banks, a syndicate’s lead banks also suffer

from reputational loss in the syndicated loan market if their clients are discovered to

be involved in fraud (Lin and Paravisini, 2011). In a loan syndicate, although lead

banks retain only a portion of the loan, they hold the primary responsibility for ex-ante

due diligence and ex-post monitoring of the borrower. Fraud revelation signals that

lead banks’ monitoring technology is flawed and that they withhold bad information

in the syndication process. This will in turn have a negative impact on the banks’ future

monitoring pay-offs on the syndicated loan market.

Overall, given the aforementioned detrimental effects on banks from actual law-

suits, banks have strong incentives to take action to protect themselves from these

effects arising from potential future lawsuits. We therefore predict that banks will

price in their borrowers’ litigation risk by charging a higher interest spread to

compensate for possible adverse impacts and more actively monitoring their borrowers

by requiring more restrictive non-price terms.

To test our prediction, we begin by examining the effects of lawsuit filings on bank

loan contracting for a sample of lawsuit firms. We also consider the possibility that

their industry peer firms are susceptible to similar lawsuits signalled by these lawsuits.

Thus we also investigate the spillover effect from industry peer firm lawsuits on the

costs of bank loans.

First, we examine the effects of an actual lawsuit on the cost of a bank loan by

focusing on a sample of firms sued by investors. In particular, we examine the changes

in the costs of bank loans around lawsuit filings for a sample of lawsuit firms. Consistent

with our prediction, we find that banks charge around 19% higher interest spreads on

loans to sued firms after lawsuit filings than the pre-lawsuit filing interest spread level

of 151 basis points. This translates to an increase of 29 basis points in the interest

spread or an increase of a half million dollars in interest expense for each facility,

which is economically significant. To mitigate the concerns of the confounding factors

and market-wide changes of debt financing, we also perform difference-in-differences

analysis by constructing a group of non-sued control firms using the propensity score

matching (PSM) approach. The propensity score is a firm’s probability of incurring

a lawsuit conditional on a vector of its observable characteristics. Our difference-in-

differences analysis yields qualitatively similar results.

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