We examine how shareholder financial difficulties affect firms’ risk-shifting behavior. Using the 2003 mutual fund scandal as a financial shock to institutions’ risk-shifting incentives, we find that lenders charge higher loan spreads after the scandal. The results are more evident when the scandal is more severe, when tainted institutions have poorer performance and stronger abilities to influence firms, and when firms have higher shareholder-debtholder conflict and greater information asymmetry. Lenders also impose more covenants after the scandal. We further find that bond and stock returns around scandal announcements are negatively correlated and that firms’ post-scandal investments and riskiness increase significantly. 

Keywords: Risk shifting, Shareholder-debtholder conflict, 2003 mutual fund scandal, Cost of debt, Covenant, Tainted institution, Information asymmetry JEL Classification: G21, G23, G32, M41