Contracting and Reporting Conservatism around a Change in Fiduciary Duties
47 Pages Posted: 9 Jan 2014 Last revised: 27 Mar 2019
Date Written: March 2019
We exploit an influential 1991 Delaware court ruling to simultaneously examine two types of conservatism that play important roles in resolving creditor-owner agency conflicts: contracting conservatism and reporting conservatism. The ruling expanded managerial fiduciary duties in favor of creditors for Delaware-incorporated firms in the vicinity of insolvency. Using a handcollected sample of debt contracts around the event date, we find that, following the ruling, debt contracts are less likely to include conservative adjustments to accounting numbers used to measure covenant compliance (i.e., contracting conservatism decreases), while borrowing firms’ public financial reporting becomes more conservative (i.e., reporting conservatism increases). The evidence suggests a replacement of contracting conservatism with reporting conservatism as creditors gain more power, and is consistent with the conjecture that reporting conservatism becomes relatively more cost effective than contracting conservatism in resolving the agency conflicts following an increase in fiduciary duties favoring creditors. We directly test for and find that the decrease in contracting conservatism in response to the ruling is concentrated in firms that exhibit a greater increase in reporting conservatism. In addition, the substitution appears more pronounced when there are ex-ante fewer creditor-owner agency conflicts (fewer covenants and lower debt levels) or greater financial reporting credibility (greater past financial reporting conservatism or presence of Big 6 auditors).
Keywords: Contracting Conservatism; Reporting Conservatism; Debt Contracting; Fiduciary Duties; Corporate Governance
JEL Classification: G3, L2, M41
Suggested Citation: Suggested Citation