Creditors’ Expected Recovery and Internal Control Quality: Evidence from Credit Default Swaps

Abstract

Prior studies find significant reactions in credit markets, but not in the equity market, to SOX 404 internal control disclosures. Because creditors’ expected recovery, the complement of expected loss given default, affects creditors but not equity-holders, it could provide a unique angle to understand such differential findings. Using credit default swaps (CDS) and expected default frequency (EDF) data, we estimate the expected recovery component in CDS spreads. We find that creditors’ expected recovery is significantly lower for firms reporting internal control material weaknesses. This effect concentrates among firms with high default risk where the concern for recovery is most relevant. Furthermore, creditors’ expected recovery is only sensitive to the more severe type of (company-level) internal control material weaknesses.

Keywords: Internal control weaknesses, credit default swaps, EDF, recovery value

JEL Classification: M41, G00, G32, K22