The Impact of the Sarbanes-Oxley Act on Private Debt Contracting

INTRODUCTION The purpose of this paper is to investigate whether an association exists among monitoring, debt covenants, and the cost of debt and whether it has been affected by certain provisions of the Sarbanes-Oxley Act of 2002 (hereafter SOX). I also examine whether the increased monitoring that resulted from SOX differentially affected firms with certain characteristics, such as size or presence of growth options. The agency costs of debt arise because of conflicts between shareholders and debtholders and are mainly due to asset substitution and underinvestment problems which occur after the debt contract is finalized. Jensen and Meckling (1976) posit that shareholders have incentives to invest in high variance projects, i.e., risky and high expected return projects, at the expense of debtholders (asset substitution). Alternatively, Myers (1977) argues that shareholders have incentive to underinvest in positive net present value (NPV) projects because the positive expected NPV fails to cover previously promised debt repayments (underinvestment). To mitigate shareholder-bondholder agency costs, bondholders use three devices--monitoring, debt covenants, and cost of debt--to protect themselves from managerial opportunism. Thus, an exogeneously mandated increase in monitoring should produce less reliance on the other two methods, debt covenants and cost of debt, for reducing agency costs. In this paper, I examine whether the event of increased regulatory monitoring produced less reliance on debt covenants, the cost of debt or both. To accomplish my objective, I compare the number of debt covenants and the cost of debt for private debt contracts during the pre-SOX and post-SOX periods. Using data on private debt issued during the 1999-2005 time period (specifically a sample of 4,610 facilities), I empirically examine the association among monitoring, debt covenants, and the cost of debt. I focus on private debt because, by its nature, private debt is more likely to have restrictive covenants than public debt (Kwan and Carleton, 2004). Due to the large number of bondholders involved in a public debt issue, renegotiating a debt contract following a debt covenant violation can be costly and difficult. Thus, private debt contracts generally contain a greater number of debt covenants than public debt contracts making it easier to examine the association among monitoring, debt covenants, and cost of debt in private debt contracts. In the analysis that follows, I rely on the definition of monitoring in Jensen and Meckling (1976) (Jensen and Meckling define monitoring as more than just measuring or observing the behavior of the agent. It includes efforts on the part of the principal to "control" the behavior of the agent through various activities. I define "monitoring" in terms of broad measure which includes all internal and external monitoring that affects agent's behavior to reduce his or her discretion) and the specific provisions in SOX that increase the monitoring of public companies, especially Title II "Auditor Independence," Title III "Corporate Responsibility," and Title IV "Enhanced Financial Disclosures. " Previous studies on debt contracts document only the association between monitoring and debt covenants (Black et al., 2004) or the association between debt covenants and the cost of debt (Beatty et al., 2002). Black et al. (2004) find a negative relationship between monitoring and the frequency of debt covenants. In particular, they document decreases in the use of debt covenants during the periods of increased monitoring. In addition, Beatty et al. (2002) find a negative relationship between the inclusion of debt covenants and the cost of debt. They argue that managers are willing to bear higher interest rates to retain accounting flexibility. I extend the work in these two studies by evaluating a broader set of variables that are used to mitigate agency costs between shareholders and debtholders. …