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

Abstract

The literature shows that a lender reduces its monitoring of client activities and decreases the accommodation it offers to a distressed client after the lender receives insurance on its outstanding client debt via a credit default swap (CDS). These changes in lender behavior can exacerbate downside risk but can also create upside potential for the reference firm’s shareholders. We predict that the firm’s shareholders, being the residual claimholders, would then increase their interest in firm affairs, by demanding improved corporate governance and the quality of financial reports. We find an increase in independence of the board of directors and a decline in the dual position of chief executive officer 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 suggest that shareholders demand and obtain higher quality of, or pay greater attention to, financial reports in the years following the onset of CDS trading.