Internal Control Weakness and Bank Loan Contracting: Evidence from SOX Section 404 Disclosures

Abstract

Using a sample of borrowing firms who filed SOX Section 404 disclosures first-time with the SEC, this study compares various features of loan contracts between firms with internal control weakness (ICW) problems and those without such problems. Our results show the following. First, the loan spread is higher for ICW firms than for non-ICW firms by about 37 basis points in the full-model regression, after controlling for all other factors that are known to influence loan contract terms. Second, firms with more severe, company-level ICW problems pay significantly higher loan rates, compared with those with less severe, account-level ICW problems. Third, lenders impose tighter nonprice terms on firms with ICW problems than they do on those without such problems. Fourth, fewer (more) lenders are attracted to loan contracts involving firms with (without) ICW problems. Finally, we also provide evidence that lenders charge a higher loan rate, are more likely to require collateral, and structure their loans with fewer participant lenders in a loan syndicate for borrowers who failed to remediate previously disclosed ICW problems, but there is no indication that lenders penalize those who remediated the problem. Our results shed light on the empirical validity of the alleged benefits associated with Section 404 disclosures from the debt market perspective.

Keywords: Internal control weakness, Loan contracting, Loan ownership structure, Sarbanes-Oxley Act (SOX)

JEL Classification: G21, G32, K22, M41