Disclosure of Pending Lawsuits and Bond Terms

I examine the effect of the disclosure of pending lawsuits in 10-K/Q filings on the contractual terms of newly issued bonds. I find that firms’ decisions to disclose pending lawsuits and the amount of disclosed information (i.e., the level of disclosure) have opposite effects. Specifically, firms that disclose a higher proportion of their pending lawsuits face higher yields and are more likely to include default clauses pertaining to court judgments in the bond prospectuses. However, within the subsample of firms that disclose their lawsuits, I find that firms with a higher level of disclosure regarding their pending lawsuits are rewarded with lower yields. This evidence suggests that bond investors interpret the decision to disclose pending lawsuits as a sign that the potential losses due to these lawsuits are material and reasonably possible and thus demand more stringent bond terms. However, bond investors associate a higher level of disclosure with a lower likelihood of withholding bad news and thus accept lower yields. This paper was accepted by Mary Barth, accounting.