Cornered office
Large Market Declines and Securities Litigation: Implications for Disclosing Adverse Earnings News
Dain Donelson & Justin Hopkins
Management Science, forthcoming
Abstract:
This study finds that large marketwide declines in stock prices are associated with higher litigation incidence and settlements even though marketwide events are legally irrelevant. The probability of litigation nearly doubles (from 0.29% to 0.55%) and the amount of settlements also doubles (from $5.0 million to $10.1 million) when earnings disclosures occur during a large market decline, even after controlling for the firm’s market-adjusted return. Furthermore, judges with (without) specialized experience in securities litigation are more (less) likely to dismiss cases triggered by disclosures during large market declines. This pattern is consistent with experienced judges recognizing and dismissing weaker cases. Finally, managers are less likely to disclose adverse news at the end of trading days with large market declines. Although we cannot definitively identify the motive behind this pattern, it is consistent with managers recognizing increased litigation risk during large market declines.
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SEC Investigations and Securities Class Actions: An Empirical Comparison
Stephen Choi & A.C. Pritchard
Journal of Empirical Legal Studies, March 2016, Pages 27–49
Abstract:
Using actions with both an SEC investigation and a class action as our baseline, we compare the targeting of SEC-only investigations with class-action-only lawsuits. Looking at measures of information asymmetry, we find that investors in the market perceive greater information asymmetry following the public announcement of the underlying violation for class-action-only lawsuits compared with SEC-only investigations. Turning to sanctions, we find that the incidence of top officer resignation is greater for class-action-only lawsuits relative to SEC-only investigations. Our findings are consistent with the private enforcement targeting disclosure violations at least as precisely as (if not more so than) SEC enforcement.
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Executive Compensation and Misconduct: Environmental Harm
Dylan Minor
Harvard Working Paper, January 2016
Abstract:
We explore the relationship between managerial incentives and misconduct using the setting of environmental harm. We find that high powered executive compensation can increase the odds of environmental law-breaking by 40-60% and the magnitude of environmental harm by over 100%. We document similar results for the setting of executive compensation and illegal financial accounting. Finally, we outline some managerial and policy implications to blunt these adverse incentive effects.
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How Do Accounting Practices Spread? An Examination of Law Firm Networks and Stock Option Backdating
Patricia Dechow & Samuel Tan
University of California Working Paper, February 2016
Abstract:
We hypothesize that one way accounting practices spread is through law firm connections. We investigate this prediction by examining companies that avoided reporting compensation expense by engaging in stock option backdating. We hypothesize that executives engaged in backdating because they were desensitized to its inappropriateness when they learned through their legal counsel that other companies were engaging in this practice. Using network analysis we find that backdating companies are highly connected to one another via shared law firms. In addition, we find that backdating spread first to the more highly connected companies and then to less well connected companies. Further, the likelihood that a company backdates is 1.4 to 3.3 times higher when its law firm has had another backdating company as a client. We find that sharing a law firm is incremental to and more economically significant than the impact of board interlocks and geographical location for explaining backdating. Our evidence is consistent with law firms acting as “observers” or “system supporters” in enabling executives to engage in backdating.
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Timothy Quigley, Craig Crossland & Robert Campbell
Strategic Management Journal, forthcoming
Abstract:
Despite a number of studies highlighting the important impact CEOs have on firms, several theoretical and methodological questions cloud existing findings. This study takes an alternative approach by examining how shareholders’ perceptions of CEO significance have changed over time. Using an event study methodology and a sample of 240 sudden and unexpected CEO deaths, we show that absolute (unsigned) market reactions to these events in U.S. public firms have increased markedly between 1950 and 2009. Our results indicate that shareholders act in ways consistent with the belief that CEOs have become increasingly more influential in recent decades.
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Executive Overconfidence and Compensation Structure
Mark Humphery-Jenner et al.
Journal of Financial Economics, forthcoming
Abstract:
We examine the impact of overconfidence on compensation structure. Our findings support the exploitation hypothesis: firms offer incentive-heavy compensation contracts to overconfident Chief Executive Officers (CEOs) to exploit their positively biased views of firm prospects. Overconfident CEOs receive more option-intensive compensation and this relation increases with CEO bargaining power. Exogenous shocks (Sarbanes-Oxley Act of 2002 (SOX) and Financial Accounting Standard (FAS) 123R) provide additional support for the findings. Overconfident non-CEO executives also receive more incentive-based pay, independent of CEO overconfidence, buttressing the notion that firms tailor compensation contracts to individual behavioral traits such as overconfidence.
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Conglomerate Investment, Skewness, and the CEO Long-Shot Bias
Christoph Schneider & Oliver Spalt
Journal of Finance, forthcoming
Abstract:
Do behavioral biases of executives matter for corporate investment decisions? Using segment-level capital allocation in multi-segment firms (“conglomerates”) as a laboratory, we show that capital expenditure is increasing in the expected skewness of segment returns. Conglomerates invest more in high-skewness segments than matched standalone firms, and trade at a discount, which indicates overinvestment that is detrimental to shareholder wealth. Using geographical variation in gambling norms, we find that the skewness-investment relation is particularly pronounced when CEOs are likely to find long shots attractive. Our findings suggest that CEOs allocate capital with a long-shot bias.
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The causal effect of option pay on corporate risk management
Tor-Erik Bakke et al.
Journal of Financial Economics, forthcoming
Abstract:
This study provides strong evidence of a causal effect of risk-taking incentives provided by option compensation on corporate risk management. We utilize the passage of Financial Accounting Standard (FAS) 123R, which required firms to expense options, to investigate how chief executive officer option compensation affects the hedging behavior of oil and gas firms. Firms that did not expense options before FAS 123R significantly reduced option pay, which resulted in a large increase in their hedging intensity compared with firms that did not use options or expensed their options voluntarily prior to FAS 123R.
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The cost of financial flexibility: Evidence from share repurchases
Alice Bonaimé, Kristine Hankins & Bradford Jordan
Journal of Corporate Finance, forthcoming
Abstract:
Over the last two decades, share repurchases have emerged as the dominant payout channel, offering a more flexible means of returning excess cash to investors. However, little is known about the costs associated with payout-related financial flexibility. Using a unique identification strategy, we document a significant cost. We find that actual repurchase investments underperform hypothetical investments that mechanically smooth repurchase dollars through time by approximately two percentage points per year on average. This cost of financial flexibility is correlated with earnings management, managerial entrenchment, and less institutional monitoring.
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Phillip Lamoreaux
Journal of Accounting and Economics, forthcoming
Abstract:
To gain insight into the impact of the Public Company Accounting Oversight Board’s (PCAOB) auditor inspection program, I examine the association between the PCAOB’s access to inspect auditors of foreign SEC registrants and audit quality. Although the PCAOB is mandated to inspect all auditors of SEC registrants, certain foreign governments prohibit PCAOB inspections of their domestic auditors, providing variation in PCAOB inspection access that is not available when studying a sample of US companies. I find that auditors subject to PCAOB inspection access provide higher quality audits as measured by more going concern opinions, more reported material weaknesses, and less earnings management, relative to auditors not subject to PCAOB inspection access. There is no observable difference between the two sets of auditors prior to the PCAOB inspection regime. The positive effect of PCAOB inspection access on audit quality is observed in jurisdictions with, and without, a local audit regulator. Overall, the results are consistent with PCAOB inspection access being positively associated with audit quality.
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The Role of Activist Hedge Funds in Financially Distressed Firms
Jongha Lim
Journal of Financial and Quantitative Analysis, December 2015, Pages 1321-1351
Abstract:
In this paper I investigate the role of activist hedge funds in the restructuring of a sample of 469 firms that attempted to resolve distress either out of court, in conventional Chapter 11, or via prepackaged restructuring. Activist hedge funds strategically gain a position of influence in the restructuring of economically viable firms with contracting problems that prevent efficient restructuring without outside intervention. I find that hedge fund involvement is associated with a higher probability of completing prepackaged restructurings, faster restructurings, and greater debt reduction. Overall, the evidence in this article suggests that activist hedge funds can create value by enabling more efficient contracting.
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Geography and the Market for CEOs
Scott Yonker
Management Science, forthcoming
Abstract:
I examine the role of geography in the market for CEOs and find that firms hire locally five times more often than expected if geography were irrelevant to the matching process. This local matching bias is widespread and exists even among the largest U.S. firms. Tests reveal that both labor supply and demand influence local matching. Compensation and unforced turnover are lower for local than for nonlocal CEOs, and the compensation of local CEOs depends on local labor market factors, unlike that of nonlocal CEOs. These findings suggest the presence of market segmentation and contrast with much of the prior literature, which explicitly or implicitly assumes a single national market.
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Industry Expertise of Independent Directors and Board Monitoring
Cong Wang, Fei Xie & Min Zhu
Journal of Financial and Quantitative Analysis, October 2015, Pages 929-962
Abstract:
We examine whether the industry expertise of independent directors affects board monitoring effectiveness. We find that the presence of independent directors with industry experience on a firm’s audit committee significantly curtails firms’ earnings management. In addition, a greater representation of independent directors with industry expertise on a firm’s compensation committee reduces chief executive officer (CEO) excess compensation, and a greater presence of such directors on the full board increases the CEO turnover-performance sensitivity and improves acquirer returns from diversifying acquisitions. Overall, the evidence is consistent with the hypothesis that having relevant industry expertise enhances independent directors’ ability to perform their monitoring function.
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The effect of internal control weakness on firm valuation: Evidence from SOX Section 404 disclosures
Yingqi Li et al.
Finance Research Letters, forthcoming
Abstract:
We find that firms reporting internal control material weakness (ICW) under Section 404 of Sarbanes–Oxley Act (SOX) have 13% lower valuation than non-ICW firms based on Tobin's q. This valuation difference is mainly driven by stock underperformance of more than 13% during the year before ICW disclosure. The ICW firms that remedy the internal control weakness in the subsequent year have much better stock performance compared to those firms that fail to remedy existing ICW problems. We further show a better stock performance in the year before disclosure if a SOX 404 ICW firm has prior SOX 302 ICW disclosure more than one year earlier. All these results are consistent with the hypothesis that the equity market has incorporated the negative information associated with SOX 404 ICW reports before the actual disclosures are made.
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Managerial Entrenchment and Firm Value: A Dynamic Perspective
Xin Chang & Hong Feng Zhang
Journal of Financial and Quantitative Analysis, October 2015, Pages 1083-1103
Abstract:
We examine the impact of managerial entrenchment on firm value using a dynamic model with firm fixed effects. To estimate the model, we employ the long-difference technique, which is shown by our simulation to deliver the least biased estimates. Based on a large sample of U.S. companies, we document a significantly negative and causal effect of managerial entrenchment on firm value after taking into account omitted variables, reverse causality, and highly persistent endogenous variables. Additional analysis suggests that the causality running from managerial entrenchment to firm value is more pronounced than that for reverse causality.