The Effect of Changes in Legal Liability on Credit Rating Agencies’ Reliance on Financial Statement Information and Rating Quality

55 Pages Posted: 11 Jul 2022 Last revised: 6 Feb 2023

See all articles by Petrus (Petri) Ferreira

Petrus (Petri) Ferreira

Rice University

Wayne R. Landsman

University of North Carolina Kenan-Flagler Business School

Tim Liu

University of Utah - David Eccles School of Business

Jianxin (Donny) Zhao

Emory University

Date Written: February 3, 2023

Abstract

This study uses passage of the Dodd-Frank Act as a setting to examine whether changes in legal liability exposure faced by credit rating agencies affect the number of financial statement information signals required before rating changes. For upgrades, we predict and find that the greater legal exposure after the Act incentivized rating agencies to require more information signals, i.e., a greater number of prior quarters in which upgrades were implied by financial statement information. This effect is concentrated among firms in industries with high litigation risk, which is consistent with the Act incentivizing rating agencies to require more signals because of increased litigation risk. The greater required number of information signals after the Act resulted in improved upgrades quality as reflected by a lower likelihood of a ratings reversal or default, and increased informativeness for stock prices for firms in industries in which the rating agency has a relatively high reputation. In contrast, the Act had little influence on the downgrade decision.

Keywords: Dodd-Frank Act, Financial statement information, Credit rating quality

JEL Classification: G3, G24

Suggested Citation

Ferreira, Petrus H. and Landsman, Wayne R. and Liu, Tim and Zhao, Jianxin (Donny), The Effect of Changes in Legal Liability on Credit Rating Agencies’ Reliance on Financial Statement Information and Rating Quality (February 3, 2023). Kenan Institute of Private Enterprise Research Paper No. 4146006, Available at SSRN: https://ssrn.com/abstract=4146006 or http://dx.doi.org/10.2139/ssrn.4146006

Petrus H. Ferreira

Rice University ( email )

6100 South Main Street
Houston, TX 77005-1892
United States

Wayne R. Landsman (Contact Author)

University of North Carolina Kenan-Flagler Business School ( email )

McColl Building
Chapel Hill, NC 27599-3490
United States
919-962-3221 (Phone)
919-962-4727 (Fax)

Tim Liu

University of Utah - David Eccles School of Business ( email )

1645 E Campus Center Dr
Salt Lake City, UT 84112-9303
United States

Jianxin (Donny) Zhao

Emory University ( email )

464 Goizueta Business School
Atlanta, GA 30322
United States

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