Does Bad News Travel across Firms through Board Social Network? Evidence from Financial Misreporting and Bank Loan Contracting

Abstract

This paper examines the information sharing effect of the social network between respective directors of borrowing firm and lending banks. In specific, I choose financial misreporting, when a company involves in ongoing financial misstatements before the public restatement announcement to proxy for private borrower-specific bad news likely to be disseminated through board social connections. Directors are defined as socially connected if either education connections exist when two directors graduate from the same educational institution within two years of one another or working connections exist when two directors overlap through a common past job or board membership.
Using a sample of 426 bank loan observations during 2000 to 2010, borrowed by 85 misreporting firms, I compare the temporal change in bank loan terms, both price and non-price terms, from the pre-misreporting period to misreporting period, to test the possibility that ongoing misreporting is shared through the board social network to banks. Consistent with the prediction, compared with loans issued during the pre-misreporting period, for loans issued during the misreporting period, the existence of board tie leads to 55 basis points (bps) higher loan spread. I then replace the board tie indicator with the natural logarithm of the number of director-pairs from borrower and lender(s) who are socially connected to measure the strength, rather than the existence, of board tie. The loan spread (restrictive non-price term index) increases by 37.8 bps (0.369) with one more director-pair socially connected in the misreporting period. Additional analysis firstly shows that the board tie effect on information sharing, which leads to unfavourable bank loan terms in the misreporting period, is mainly driven by board tie with lead arranger in the syndicate.
Secondly I then add 223 loans issued after the restatement announcement by the 85 misreporting firms. Compared with terms of loans in the pre-misreporting period, terms of loans by board connected lenders are only tightened in the misreporting period, indicating that banks could fully detect the risks associated with financial during the misreporting period through board tie and that the eventual restatement announcement would not add additional information.
Lastly, I use the evolution of each misreporting borrower's credit rating and the performance of stock return 12 or 24 months subsequent to the initiation of a bank loan deal (before the public restatement announcement) to capture the reactions by credit rating agency and equity investors on the same misreporting firm at the time of loan initiation. The results indicate that credit rating agencies and equity investors could not respond to misreporting in a similar manner to those lenders with board tie do. However, credit rating agencies and investors potentially incorporate loan term information in the misreporting period into their evaluations.
Overall, this study provides evidence that the information sharing effect of the social network applies to individuals from different firms. Banks utilize the director social network for information gathering purpose, rather than be influenced by the social connections, and charge unfavourable bank loan terms to borrowers with inferior creditworthiness.

Date of Award	16 Mar 2016
Original language	English
Awarding Institution	City University of Hong Kong
Supervisor	Hao ZHANG (Supervisor)