Corporate Governance and Credit Access in Brazil: The Sarbanes‐Oxley Act as a Natural Experiment

• Date: 01 September 2016
• DOI: http://doi.org/10.1111/corg.12151
• Author: Bruno Funchal,Danilo Soares Monte‐Mor
• Published date: 01 September 2016

Corporate Governance and Credit Access in Brazil:

The Sarbanes-Oxley Act as a Natural Experiment

Bruno Funchal*and Danilo Soares Monte-Mor

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This study seeks to examine the effect of changes in corporate governance levels on the choice of

firms’debt financing in a relevant emerging economy, taking advantage of the Sarbanes-Oxley Act as a natural experiment.

Research Findings/Insights: Our empirical method uses an experimental design in which we control for observed and unob-

served firm heterogeneity via a difference-in-differences estimator. We show that firms subjected to this new regulation, which

raised governance requirements, observed a positive effect on their access to the credit market, increasing their total debt signifi-

cantly, via long-term and private debt, and reducing the costof debt, indicating that SOX produced economic gains in this aspect.

Theoretical/Academic Implications: The main contributionof the present paper is to measurethe corporate governance effects

on firms’debt financing policies, isolated from other contemporaneous events. Furthermore, we develop a simple theoretical

model to help in the understanding of the main sources of SOX’seffects. Finally, the natural experimental approach deals with

the endogenous relation between corporate governance and firms’choices on debt financing, and presents an alternative to

instrumental variables techniques.

Practitioner/Pol icy Implications: This paper offers insights to policymakers of emerging economies interested in the

development of the credit market. Using laws and regulations like the Sarbanes-Oxley Act, we show that it is possible to

improve firms’governance, with a positive impact on firms’ability to access credit.

Keywords: Corporate Governance, Credit, Experiment

INTRODUCTION

Frictions in credit markets hinder companies from raising

funds to finance investment projects with positive net

present value. On the micro level, these financial constraints

reduce the chance of firms’growth and survival (Aghion,

Angeletos, Banerjee, & Manova, 2005; Musso & Schiavo,

2008). On the macro level, the economic development

literature has established a connection between credit market

development and economic growth (e.g., King & Levine,

1993; Levine, Loyaza, & Beck, 2000). The empirical evidence

suggests that institutions help the development of financial

markets (e.g., Araujo, Ferreira, & Funchal, 2012; Coelho, De

Mello, & Funchal, 2012; Djankov, McLiesh, & Shleifer, 2007;

La Porta, Lopez-de Silanes, Shleifer, & Vishny, 1997 La Porta,

Lopez-de Silanes, Shleifer, & Vishny, 1997 and 1998).

After the failures of Enron, WorldCom, Adelphia and others,

there was a great deal of discussion among academics, politi-

cians and the press re garding a special type of institu tion: corpo-

rate governance.

1

In the United States these huge bankruptcies

spurred legislative reform, chiefly the Sarbanes-Oxley Act

(henceforth SOX), to improve governance schemes. In addition,

the debate in the media pointed to increasing attention of corpo-

rations on governance issues.

2

In this paper, we focus on the ef-

fect of corporate governance on firms’access to debt financing.

Unlike most studies that focus on other types of agency prob-

lems, like the manager compensation literature (Berle & Means,

1932; Fama, 1980; Jensen & Meckling, 1976; among others) or

the ownership concentration literature (e.g., Demsetz, 1983;

Demsetz & Lehn, 1985; Zingales, 1994), we shed some light on

the benefits that improvements in corporate governance have

on the reduction of information asymmetry between companies

and lenders.

The problem of accessing credit markets is more severe in

developing countries (e.g., Araujo et al., 2012; La Porta et al.,

1997). Poorly designed institutions that deepen the asymmet-

ric information problems explain their current situation.

Therefore,from a policy perspectiveit is crucial to understand,

theoretically and empirically, how improvements in gover-

nance schemesaffect firms’debt financing, especially for com-

panies located in developing countries.

To conduct our study we use the Sarbanes-Oxley Act as a

natural experiment as it imposed an exogenous shock at the

corporate governance level. Also, we focus on the effect on

*Address for correspondence: Bruno Funchal, FUCAPE Business School, Fernando

Ferrari Av. 1358, Boa Vista, Vitória,ES, Vitoria, 29075-010, Espirito Santo, Brazil;55 27

40094402;E-mail: bfunchal@fucape.br

© 2016 JohnWiley & Sons Ltd

doi:10.1111/corg.12151

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Corporate Governance: An International Review, 2016, 24(5): 528–547

Brazilian companies. We do this for two reasons: first, we

want to shed some lighton the effect of changes in governance

on a relevant emerging economy; second, Brazil is the devel-

oping economy with the most cross-listed companies in US

equity markets (therefore, subject to SOX regulation) and the

use of Brazilian companies provides us better tools for our

identification strategy.

Leuz (2007) points out that the main problem in assessing

the effects of SOX is the difficulty of finding a control group

of firms not affected and comparable to firms affected by

SOX. This shortcoming makes it difficult to remove market-

wide effects that are unrelated to SOX. In addition, Coates

(2007) states that existing studies of SOX are confounded by

the presence of contemporaneous economic and legal events,

as the legislation was enacted amidst sharp financial and eco-

nomic changes.

To deal with this problem, several authors use cross-listed

companies to shed some light on the effects of SOX (e.g.,

Berger, Feng, & Wong, 2005; Li, Pincus, & Rego, 2008; Litvak,

2007; Smith, 2007). Berger et al. (2005 compare returns of

cross-listed foreign companies to returns of US issuers.

According to Litvak (2007), this allows evaluation of cross-

sectional variation in reactions based on home-country char-

acteristics, but does not allow assessment of overall investor

reaction to SOX, because of the lack of a control group of

companies to which SOX doesnot apply. Smith (2007) adopts

an event study approach to test the impactsof SOX and Litvak

(2007) applies a natural experiment approach, controlling for

contemporaneous events using a control group.

To isolate the effect of SOX on debt financing policy from

other shocks, we have to find treatment and control groups

that are subjectto the same shocks, except for SOX implemen-

tation. To do this, we use the difference-in-differences ap-

proach, which accounts for unobservable time effects. Under

this approach, the Sarbanes-Oxley Act (SOX) is our natural

experiment used to test the effect of changes in the level of

corporate governance on the terms of debt, as the law causes

an exogenous shock to governance requirements to all US

public companies andto non-US firms with American depos-

itary receipts (ADRs) listed at levels 2 and 3, and does not

apply to foreign companies not listed or listed with ADR

levels 1 or 144A. Brazil is a good choice in this respect. Large

Brazilian firms extensively use American depositary share

(ADS) programs,

3

implying that part of our sample is subject

to SOX regulation.

Our main results suggest that the average interest rate of

companies subject to the Sarbanes-Oxley Act dropped after

the law came into force,consistent with an expectedreduction

in moral hazard costs due to gains in corporate governance.

We estimate a reduction in the cost of newly issued debt

varying from 7 percent to 11 percent relative to matched firms

not subject to SOXregulation, most of which comesfrom debt

contracts issued in Brazil. As a consequence, we find an

increase in the totalamount of debt around 15 percent, consis-

tent with a positive shift in the supply curve of credit. This

increase in the amount of debt is driven mainly by long-term

debt and private loans. Analyzing debt according to matu-

rities, we find an increase of 23.9 percent in long-term credit,

while on the other hand, we find a decrease of 9 percent in

short-term credit. This indicates an increase in the average

debt maturities. Concerning the source of credit, public and

private loans,we found an increase between 12 and 20percent

for private debt and a reduction between 2 and 4 percent for

public debt.

Together, these results suggest that the Sarbanes-Oxley

Acthadapositiveimpactonthetermsofcredit,lowering

the cost and increasing the amount, consistent with a posi-

tive shift in the credit supply curve. Since SOX brought

better informat ion, manager punishmen t and monitoring,

creditors could ex pect better corporate governance due to

areductioninmanagers’moral hazard acti on. This reduc-

tion of asymmetric information cost increased the probabil-

ity of success of investment projects. This effect reduced the

risk of lending, motivating creditors to supply more credit

with better terms.

In addition to theseaverage effects on the treatedgroup, we

investigate the heterogeneous effect from the gains on gover-

nance. Theonly heterogeneity comes fromthe source of credit.

Companies with lower levels of cash holdings (our proxy for

probability of solvency) and monitoring benefitmorefrom

public and private loans respectively.

Our results also show an increase in long-term private debt

contracts, such as term loans, in the post-SOX year, which

corroborates the findings that SOX led to debt with longer

maturity. Since borrowers’financial health could change

significantly over a long period, this result suggests that im-

proved governance allowed private lenders to take on riskier

debt contracts. With improvements in firms’governance

schemes, the risk of default declined, which explains both

the shift in the supplycurve of debt and the shift of debt from

short term to l ong term.

Our paper belongs to a group of studies that examine the

effect of asymmetric information related to corporate gover-

nance on firms’financing policy and the terms of credit. In a

broad way, Barath, Pasquariello, and Wu (2009) evaluate if

information asymmetry drives decisions on capital structure.

Concerningasymmetric information in corporategovernance,

Anderson, Mansi,and Reeb (2004) analyze the effect of board

size and independence on the cost of debt. Concerning

accounting system and accounting quality, Armstrong, Guay,

and Weber(2010) show that the accounting system plays two

important roles in reducing the agency costs that arise in the

debt contractingprocess. Biddle and Hilary (2006)provide ev-

idence of the relation between accounting quality and access

to debt markets. Finally, Cremers, Nair, and Wei (2007) and

Qiu and Yiu (2009) study the relationship between corporate

control and the cost of debt.

Further, our results bring new evidence of a specific benefit

of SOX, as we are exploring the gains of firms in the terms of

credit. Much research has been carried out regarding the net

effects of SOX (e.g., Engel, Hayes, & Wang, 2007; Kamar,

Karaca-Mandic, & Talley, 2005; Leuz, Triantis, & Wang, 2008;

Piotroski & Srinivasan, 2008; Sneller & Langendijk, 2007;

among others).

Relating SOX and debt, Andrade, Bernille, and Hood (2014)

point to a potential relationship between reliability of

corporate reporting and cost of debt. The authors found a

decrease in the cost of debt, provided by increased corporate

transparency perceived by investors. Carter (2013) argues that

an increase in firms’financial reporting transparency induced

by SOX promoted a reduction in the information asymmetry be-

tween managers and investors, increasing firms’debt financing.

529CORPORATE GOVERNANCE AND CREDIT ACCESS

© 2016 JohnWiley & Sons Ltd Volume 24 Number 5 September 2016