Job market paper
Financial covenants, which use financial information to determine control rights in corporate loan contracts, are frequently amended (Roberts, 2015). Despite the strong evidence, prior literature has not found an explanation for the high frequency. In this paper, I offer a model of debt covenant amendments and structurally estimate it using novel data on amendments of financial covenants in U.S. companies' loan contracts. The model offers three explanations for why financial covenants get amended: (1) the degree of contractual incompleteness is high, (2) non-contractible information is highly predictive of the future, and (3) the costs of amendments are small, while the costs of misallocating control rights are high. The estimation results mostly support the first and the third explanations. Financial covenants are amended because contracting parties indeed face a high degree of contractual incompleteness, because the costs of amendments are indeed low compared to the costs of misallocating control rights, but not necessarily because non-contractible information is highly predictive of the future.
Revise & resubmit - Journal of Accounting Research
Investors’ information about different aspects of financial reporting – firm fundamentals and managers’ reporting objectives – affect earnings quality and price efficiency unambiguously (Fischer and Stocken, 2004), making proper measurement of investors’ information important for researchers and policymakers. I develop a structural approach that uses firms' prices and analyst forecasts to measure how much fundamental and misreporting incentives information investors know. The new technique is used to estimate the amount of information an average U.S. investor has, and the magnitude of the trade-off between reporting quality and price efficiency faced by policymakers. Next, I apply the technique in two settings to obtain potentially policy-relevant insights. First, I measure how much misreporting incentives investors learned after the introduction of the Compensation Disclosure & Analysis (CD&A) section in 2007 and whether the regulation hurt the precision of reported earnings. Second, I measure the information spillover during an earnings cycle – the extent to which fundamental and incentives information disclosed by early reporters informs traders of later reporters’ stocks.
(with Mirko S. Heinle and Christopher S. Armstrong)
Accepted at the Review of Accounting Studies 2023 Conference
Standard Bayesians' beliefs converge when they receive the same piece of new information. However, when agents have uncertainty about the precision of a signal, their beliefs might instead diverge more despite receiving the same information. We demonstrate that this divergence leads to a unimodal effect of the absolute surprise in the signal on trading volume. We show that this prediction is consistent with the empirical evidence using trading volume around earnings announcements of US firms. We find evidence of elevated volume following moderate surprises and depressed volume following more extreme surprises, a pattern that is more pronounced when investors are more uncertain about earnings' precision. Because investors can disagree even further after receiving the same piece of news, the relationship between news and trading volume is not necessarily linear, suggesting that trading volume may not be an appropriate proxy for market liquidity.
(with Henry L. Friedman and Mirko S. Heinle)
Firms and jurisdictions worldwide are adopting ESG reporting in various forms. To better understand potential implications of ESG reporting, we develop a model in which a firm provides ESG and financial reports to investors. Investors price the firm's stock, and stock prices provide both real and reporting incentives to management. We characterize how the introduction of ESG reporting affects ESG performance, expected cash flows, and misreporting. ESG reporting tends to encourage corporate ESG, but can discourage ESG when it has significantly negative cash flow implications. For ESG with moderately negative cash flow implications, the firm's price can suffer from the introduction of ESG reporting. Finally, we use comparative statics to show how changes in investor preferences (e.g., concern for ESG) and ESG efforts' cash flow implications (e.g., penalties, subsidies, or physical and transition risk) affect market responses to financial and ESG reports, corporate misreporting, and ESG and cash flow outcomes.
(with Henry L. Friedman and Mirko S. Heinle)
We provide a theoretical framework for reporting of firms' environmental, social, and governance (ESG) activities to investors. In our model, investors receive an ESG report and use it to price the firm. Because the manager is interested in the firm's price, disclosing an ESG report provides effort and greenwashing incentives. We analyze the impact of different reporting characteristics on the firm's price, cash flows, and ESG performance. In particular, we investigate the consequences of whether the report captures ESG inputs or outcomes, how the report aggregates different ESG dimensions, and the manager's tradeoffs regarding ESG efforts and reporting bias. We find that, for example, an ESG report that weights efforts by their impact on the firm's cash flows tends to have a stronger price reaction than an ESG report that focuses on the ESG impact per se. ESG reports aligned with investors' aggregate preferences provide stronger incentives and lead to higher cash flows and ESG than reports that focus on either ESG or cash flow effects individually. Additionally, in the presence of informative financial reporting, ESG reports that focus on ESG impacts lead to the same cash flow and better ESG results than reports focusing on cash flow impacts alone.
(with S. Sarkisyan)
We study cost and sources of debt for companies with poor ESG performance. We find that, while both loan and bond financing are costlier for borrowers with poor ESG performance, "brown" firms face a lower extra premium for borrowing from banks than "green" firms. In addition, companies with poorer ESG performance obtain larger bank loans and borrow smaller amounts from the public bond market, gradually shifting their debt structure towards more bank-loan-heavy. We discuss multiple explanations for our findings: brown borrowers' financial risk, banks' superior information about their borrowers, public debt holders' inherent preference for high ESG performance firms, and public debt holders being subject to stricter ESG regulation than banks.