Mandatory Disclosure by Credit Rating Agencies and Investment Sensitivity to Stock Price: A Managerial Learning Perspective

Abstract

We study the effect of mandatory disclosure by credit rating agencies (CRAs) on investment-price sensitivity. We use the Credit Rating Agency Reform Act (CRARA) in 2006 as a mandatory disclosure setting for CRAs and find an increase in investment-price sensitivity for firms affected by the CRARA. In line with the CRARA alleviating investors’ concern about firm-specific accounting fraud risk, the increase is more pronounced among firms suspected to engage in more earnings management. The sensitivity of investment to stock prices is also more marked among firms with multiple dimensions of uncertainty, firms with higher growth options, firms facing steeper competition, or firms in which managers are less privately informed. Our findings are consistent with managers’ reliance on stock prices increasing when stock prices become more informative to managers’ investment decisions after the CRARA. Corroborating improved investment efficiency, we further find an increase in future profitability for firms affected by the CRARA.