Heightened Shareholder Interest in Firm Affairs Following the Inception of Credit Default Swap Trade

Abstract

The literature shows that a lender becomes reluctant to aid a distressed client after it receives insurance on its outstanding debt via a credit default swap (CDS). The onset of CDS trade thus accelerates client bankruptcy. We predict that the client firm’s shareholders would respond by demanding improved corporate governance and financial reporting quality to protect their interests. We find an increase in independence of the board of directors and a decline in the dual position of chief executive office and board chairman following the onset of CDS trading. We also find higher earnings response coefficient and trading volumes around the earnings announcement dates and lower post–earnings announcement drift. Overall, our results are consistent with the idea that shareholders demand higher quality of, or pay greater attention to, financial reports following the onset of CDS trading.

Keywords: credit default swap, agency conflict, corporate governance, financial reporting quality, bankruptcy

JEL Classification: G32, G33, M41, M48