Litigation Contingency Disclosure and Debt Contracting

In this paper, I examine the impact of litigation contingency disclosure in a 10K/Q filing on a defendant firm's choice of debt, and its effect on the design of a public debt contract. Consistent with the theory positing that firms with higher disclosure costs prefer to communicate proprietary information to private lenders, I find that defendant firms that withhold information about litigation contingencies are more likely to access the private debt market, while those disclosing litigation contingencies tend to borrow from the public debt market. When firms access the public debt market, the disclosure of litigation contingency is associated with higher yields and a higher likelihood of including event-of-default clauses that pertain to court judgments in the bond indentures. However, conditional on disclosure, firms with a higher level of disclosure are rewarded with lower yields. Taken together, these results suggest that public debt holders relate the disclosure decision to the materiality of a litigation contingency, while they associate the disclosure level with the reduction of information uncertainty regarding the contingency.