Shyam V. Sunder

How Has Regulation FD Affected the Operations of Financial Analysts

In this paper, we analyze how financial analysts generate information, make decisions about firm coverage, and try to maintain their forecasting accuracy after the passage of Regulation Fair Disclosure (“Reg FD”). Using the model developed by Barron, Kim, Lim, and Stevens 1998, we find that analysts are investing more effort in idiosyncratic information discovery. In order to do this, individual analysts appear to be reducing coverage for well-followed firms while increasing coverage of firms that were less followed prior to Reg FD. Analysts who had preferential links with firms that they covered, such as analysts from large brokerage houses, tend to have greater forecast accuracy in the pre-FD period. However, these analysts are unable to sustain their forecasting superiority in the post-FD period, which suggests that there has been a leveling of the information playing field among analysts. Overall, our results reflect a trend toward greater reliance on idiosyncratic information discovery on part of the financial analysts.

Measure for Measure: The Relation between Forecast Accuracy and Recommendation Profitability of Analysts

We examine the contemporaneous relation between earnings forecast accuracy and recommendation profitability to assess the effectiveness with which analysts translate forecasts into profitable recommendations. We find that, after controlling for expertise, more accurate analysts make more profitable recommendations, albeit only for firms with value-relevant earnings. Next, we show that conflicts of interest from investment banking activities affect the relation between accuracy and profitability. In the case of buy recommendations, more accurate forecasts are associated with more profitable recommendations only for the nonconflicted analysts. For hold recommendations, higher levels of accuracy are associated with higher levels of profitability for conflicted analysts, provided these recommendations are treated as sells. Finally, we find that regulatory reforms aimed at mitigating analyst conflicts of interest appear to have improved the relation between accuracy and profitability. Specifically, the integrity of buy and hold recommendations has improved and the change is more pronounced for analysts expected to be most conflicted.

Balance Sheet Conservatism and Debt Contracting

We study the dual role of borrowers’ balance sheet conservatism (i.e., conservatism in asset values) in debt contract design. Conservative asset values reduce lenders’ uncertainty regarding asset valuation and mitigate debtholder-shareholder conflicts. However, as asset valuation approaches its lower-bound estimates, it constrains the borrowers’ future ability to take write-downs in response to bad news. Consistent with these two effects, we find that high balance sheet conservatism is associated with lower interest and less restrictive covenants for bank loans. Further, lenders appear to recognize that future conservatism is constrained when balance sheet conservatism is high. Our results highlight the importance of considering time-series dependencies of accounting policies in contract design.

The Role of Managerial Overconfidence in the Design of Debt Covenants

We examine the influence of behavioral characteristics on the design of debt covenants. We find that firms with overconfident CEOs face tighter restrictions on their ability to make future investments, acquisitions, and raise additional debt financing. These restrictions are partially mitigated when firms with overconfident CEOs have greater information transparency, a better performance record, and investment opportunities. Interestingly, we find only weak evidence for the effects on cost of debt. Overall, our study highlights the role of debt covenants in mitigating the effects of behavioral characteristics incremental to other firm and CEO specific factors documented in the prior literature.