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

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