Corporate money

Kevin Lewis

April 11, 2018

How Misconduct Spreads: Auditors’ Role in the Diffusion of Stock-option Backdating
Aharon Mohliver
Administrative Science Quarterly, forthcoming


I study the role of external auditors in the diffusion of stock-option backdating in the U.S. to explore the role of professional experts in the diffusion of innovative practices that subvert stakeholders’ interests. Practices that are eventually accepted as misconduct may emerge as liminal practices - ethically and legally questionable but not clearly illegitimate or outlawed - and not be categorized as misconduct until social control agents notice, scrutinize, and react to them. I examine how the role of external auditors in the diffusion of stock-option backdating changed as the practice shifted from liminality to being illegal and illegitimate. The findings suggest that professional experts’ involvement in the diffusion of liminal practices is highly responsive to the institutional environment. Initially, professional experts diffuse these practices via local networks, but when the legal environment becomes more stringent, implying that the practice will become illegitimate, experts reverse their role and extinguish the practice. The larger network remains largely uninvolved in both diffusing and extinguishing the liminal practice until the practice is publicly exposed and labeled as illegal and illegitimate. The findings further show that the diffusion and then extinguishing of backdating before it was outlawed depended on the adopter’s geographic proximity to a local office of a complacent expert and on the absence of traceable communication about backdating between these offices. This combination set the stage for each office to develop independent views about backdating, leading some offices to view backdating favorably and diffuse it, and others to view it unfavorably and curtail it - even at the same time and within the same audit firm. This study contributes to research on the diffusion of misconduct by providing insight into the role of professional experts and the mechanisms and boundary conditions governing that role.

The unintended consequences of divestment
Shaun William Davies & Edward Dickersin Van Wesep
Journal of Financial Economics, forthcoming


A divestment campaign aims to depress share prices to induce managers to change firm behavior. Assuming that managers make profit-maximizing decisions in the absence of a campaign, firms that accede to divestors’ demands raise short-run share prices but depress long-run profits. Managers who are more interested in short-run prices are therefore more motivated by divestment than managers who care about long-run profits. We show that, as most managerial compensation contracts reward long-run profitability and stock returns, divestment can be ineffective at best, and perhaps counterproductive, rewarding managers who attract divestment campaigns. In a quantification exercise, we show that the wealth of most executives running likely divestment targets in 2015 would be unaffected by even large movements in share prices. Of those affected, a substantial majority would benefit from divestment.

Bragging Rights: Does Corporate Boasting Imply Value Creation?
Pratik Kothari, Don Chance & Stephen Ferris
University of Missouri Working Paper, March 2018


We examine all S&P 500 firms over 1999-2014 that publicly characterize their annual performance with extreme positive language. We find that only 18% of such firms increase shareholder value, while nearly 75% have insignificant performance, and the remaining 7% actually destroy shareholder value. Our evidence suggests that firms often base their positive claims on high raw returns or strong relative accounting performance. In comparison to firms that generate positive abnormal returns without boasting, our sample firms tend to have superior accounting performance. These results show that boasting about performance is rarely associated with value creation and is consistent with executive narcissism.

Learning Not to Diversify: The Transformation of Graduate Business Education and the Decline of Diversifying Acquisitions
Jiwook Jung & Taekjin Shin
Administrative Science Quarterly, forthcoming


Once a preferred strategy, corporate diversification into disparate lines of business has gradually declined in the U.S. over the past several decades. We argue that changes that occurred in a closely related domain - graduate business education - are important in understanding variation in de-diversification across firms. Building on a historical account of the transformation of business education, we explain how the rise of financial economics and agency-theoretic logic in business education changed students’ views about diversification. Nearly 20 years later, these MBA graduates rose to top decision-making positions and put the brakes on diversification. Using data on CEOs who ran 640 large U.S. corporations from 1985 to 2015, we show that CEOs who earned an MBA before the 1970s actively pursued diversification, whereas the next cohort of CEOs, who had been exposed to agency-theoretic logic in financial economics, refrained from it. We also demonstrate that the degree of managerial discretion moderated the effect of the CEO’s MBA education. Our study shows that institutional change in one domain (i.e., business education) contributed to change in another domain (i.e., corporate diversification), albeit with a considerable time lag.

Do Auditors Recognize the Potential Dark Side of Executives' Accounting Competence?
Anne Albrecht, Elaine Mauldin & Nathan Newton
Accounting Review, forthcoming


Practice and research recognize the importance of extensive knowledge of accounting and financial reporting experience for generating reliable financial statements. However, we consider the possibility that such knowledge and experience increase the likelihood of material misstatement when executives have incentives to misreport. We use executives' prior experience as an audit manager or partner as a measure of extensive accounting and financial reporting competence. We find that the interaction of this measure and compensation-based incentives increases the likelihood of misstatements. Further, auditors discount the audit fee premium associated with compensation-based incentives when executives have accounting competence. Together, our results suggest a dark side of accounting competence emerges in the presence of certain incentives, but auditors view accounting competence favorably despite the heightened risk. In further analyses, we demonstrate that executives' aggressive attitude towards reporting exacerbates the effect of accounting competence and compensation-based incentives on misstatements, but not on audit fees.

What is the Impact of Successful Cyberattacks on Target Firms?
Shinichi Kamiya et al.
NBER Working Paper, March 2018


We examine which firms are targets of successful cyberattacks and how they are affected. We find that cyberattacks are more likely to occur at larger and more visible firms, more highly valued firms, firms with more intangible assets, and firms with less board attention to risk management. These attacks affect firms adversely when consumer financial information is appropriated, but seem to have little impact otherwise. Attacks where consumer financial information is appropriated are associated with a significant negative stock market reaction, an increase in leverage following greater debt issuance, a deterioration in credit ratings, and an increase in cash flow volatility. These attacks also affect sales growth adversely for large firms and firms in retail industries, and there is evidence that they decrease investment in the short run. Affected firms respond to such attacks by cutting the CEO’s bonus as a fraction of total compensation, by reducing the risk-taking incentives of management, and by taking actions to strengthen their risk management. The evidence is consistent with cyberattacks increasing boards’ assessment of target firm risk exposures and decreasing their risk appetite.

Why Has the Value of Cash Increased Over Time?
Thomas Bates, Ching-Hung Chang & Jianxin Daniel Chi
Journal of Financial and Quantitative Analysis, forthcoming


The value of corporate cash holdings has increased significantly in recent decades. On average, $1 of cash is valued at $0.61 in the 1980s, $1.04 in the 1990s, and $1.12 in the 2000s. This increase is predominantly driven by the investment opportunity set and cash-flow volatility, as well as secular trends in product market competition, credit market risk, and within-firm diversification. We document a secular decrease in the speed of adjustment (SOA) in cash holdings, particularly for financially constrained firms with cash deficits, suggesting that capital market frictions can account for the trend in the value of cash holdings.

Outside CEOs and Innovation
Trey Cummings & Anne Marie Knott
Strategic Management Journal, forthcoming


Innovation is the principle driver of firm and economic growth. Thus one disturbing trend that may explain stagnant growth is a 65% decline in firms’ R&D Productivity. We propose that the rise of outside CEOs may be partially responsible for the decline, because those CEOs are more likely to lack technological domain expertise necessary to manage R&D effectively. While this proposition was motivated by interviews with CTOs, we test it at large scale. We find that firm R&D productivity decays during the tenure of outside CEOs relative to that of inside CEOs. We further find this effect is more pronounced for firms with high R&D intensity, and for firms employing outside CEOs with more remote experience, lending circumstantial support for the underlying assumption regarding lack of expertise. Note, this is not a call for boards to avoid outside CEOs, rather it is recommendation to consider the implications for innovation.

She is mine: Determinants and value effects of early announcements in takeovers
Nihat Aktas, Guosong Xu & Burcin Yurtoglu
Journal of Corporate Finance, June 2018, Pages 180-202


Some bidders voluntarily announce a merger negotiation before the definitive agreement. We propose an “announce-to-signal” explanation to these early announcements: they allow bidders to signal to target shareholders high synergies so as to overcome negotiation frictions and improve success rates. Consistent with signaling, we show that negotiation frictions predict earlier announcements. Early announced transactions are associated with higher expected synergies, offer premium, completion rates, and public competition. Moreover, bidder announcement returns do not suggest overpayment and the existence of agency issues in these transactions. Taken collectively, our findings rule out alternative explanations such as managerial learning from investors and jump bidding.

Zombie Board: Board Tenure and Firm Performance
Sterling Huang & Gilles Hilary
Journal of Accounting Research, forthcoming


We show that board tenure exhibits an inverted U‐shaped relation with firm value and accounting performance. The quality of corporate decisions, such as M&A, financial reporting quality, and CEO compensation, also has a quadratic relation with board tenure. Our results are consistent with the interpretation that directors’ on‐the‐job learning improves firm value up to a threshold, at which point entrenchment dominates and firm performance suffers. To address endogeneity concerns, we use a sample of firms in which an outside director suffered a sudden death, and find that sudden deaths that move board tenure away from (toward) the empirically observed optimum level in the cross‐section are associated with negative (positive) announcement returns. The quality of corporate decisions also follows an inverted U‐shaped pattern in a sample of firms affected by the death of a director.

Does corporate lobbying activity provide useful information to credit markets?
George Brandon Lockhart & Emre Unlu
Journal of Corporate Finance, June 2018, Pages 128-157


Although corporate lobbying can be motivated for numerous reasons, much of corporate lobbying is aimed to secure public subsidies for the firm's high-risk R&D investment, which aggravates the shareholder-creditor conflict. This paper examines how creditors respond to the firm's lobbying that pursues R&D subsidies. Using syndicated bank loan data, we show that R&D-targeted lobbying activity aggravates shareholder-debtholder conflicts and results in debt rationing, shorter debt maturity, and larger loan spreads. We find weak evidence that creditors also impose tighter covenants. We also show that these effects are generally increasing in the firm's R&D intensity. These results are robust to instrumental variable estimations that endogenizes the decision to lobby by instrumenting cost of lobbying with the number of Electoral College representation in the firm's headquarters state. Further analyses show that R&D-targeted lobbying activity is positively related to the value of equity, suggesting that costs of creditor-imposed restrictions do not dominate the benefits of R&D-targeted lobbying. Overall, our findings suggest that the firm's lobbying activity provides useful incremental information to creditors in resolving informational and adverse selection problems in lending transactions.

Social Connections Within Executive Teams and Management Forecasts
Ruihao Ke et al.
Management Science, forthcoming


We examine the role of teamwork within the top executive teams in generating management forecasts. Using social connections within the executive team to capture the team’s interaction, cooperation, and teamwork, we find that social connections among team members are associated with higher management forecast accuracy, consistent with economic theories that information is dispersed within a firm and with sociology insights that social connections facilitate information sharing. Further analyses show that the association between social connections and forecast accuracy is stronger when the teams are just beginning to work together, when their firms face more uncertainty or adversity, and when the CEOs are less powerful. Our results hold for a subsample of executive teams that experience pseudo exogenous shocks to their social connectedness. Taken together, our results underscore the importance of teamwork among executives in the forecast generation process.

Selecting Directors Using Machine Learning
Isil Erel et al.
NBER Working Paper, March 2018


Can an algorithm assist firms in their hiring decisions of corporate directors? This paper proposes a method of selecting boards of directors that relies on machine learning. We develop algorithms with the goal of selecting directors that would be preferred by the shareholders of a particular firm. Using shareholder support for individual directors in subsequent elections and firm profitability as performance measures, we construct algorithms to make out-of-sample predictions of these measures of director performance. We then run tests of the quality of these predictions and show that, when compared with a realistic pool of potential candidates, directors predicted to do poorly by our algorithms indeed rank much lower in performance than directors who were predicted to do well. Deviations from the benchmark provided by the algorithms suggest that firm-selected directors are more likely to be male, have previously held more directorships, have fewer qualifications and larger networks. Machine learning holds promise for understanding the process by which existing governance structures are chosen, and has potential to help real world firms improve their governance.

The value of director reputation: Evidence from outside director appointments
Fabian Gogolin, Mark Cummins & Michael Dowling
Finance Research Letters, forthcoming


This study examines the role of director reputation using a sample of outside director appointments. Relative to existing literature, we focus on outside director appointments involving CEO award winners. Exploiting the award-induced change in a director’s reputation, we are able to show that investors react more positively to the appointment of outside directors they perceive as more reputable. We find that this ’reputation premium’ is approximately 2%, and robust across a range of subtests that control for a wide range of possibly confounding influences.

Obscured Transparency? Compensation Benchmarking and the Biasing of Executive Pay
Mathijs De Vaan, Benjamin Elbers & Thomas DiPrete
Columbia University Working Paper, March 2018


The disclosure of compensation peer groups is argued to provide shareholders with valuable information that can be used to scrutinize CEO compensation. However, research suggests that there are substantial incentives for executives and directors to bias the compensation peer group such that the CEO can extract additional rent. Analyses of eleven years of comprehensive data on compensation peer groups demonstrate that the average firm uses an upwardly biased peer group. The size of the bias is positively associated with poor firm performance and with the amount of structural ambiguity regarding the peer group that best matches the focal firm. Both of these relationships imply that firms select peer groups strategically in order to justify higher pay for the CEO. More importantly, upward bias in compensation peer groups is highly predictive of an increase in CEO compensation suggesting that there is a strong incentive for CEOs to introduce upward bias into the peer group. Finally, while average peer group bias has gone down in recent years, the predictive effect of bias on pay has gone up. These findings call into question the practical impact of recent efforts to introduce greater transparency into the process for determining executive compensation.

Accounting and economic consequences of CEO paycuts
Gerald Lobo, Hariom Manchiraju & Sri Sridharan
Journal of Accounting and Public Policy, January-February 2018, Pages 1-20


Boards sometimes cut a CEO’s pay following poor performance. This study examines whether such CEO paycuts really work. We identify 1,496 instances of large CEO paycuts during the period 1994-2013. We then create a propensity-score-matched control group of firms that did not cut their CEOs’ pay and employ a difference-in-differences approach to examine the consequences of paycuts. Our results show that, following a paycut, CEOs are likely to engage in earnings management in an attempt to accelerate improvement in the reported performance and to achieve a speedier restoration of their pay to pre-cut levels. Further, we find that improvement in long-term performance after a paycut occurs only for those firms with lower levels of earnings management after the paycut. Finally, we show that paycuts are more likely to lead to unintended value-destroying consequences in the absence of high institutional ownership or when the CEO is sufficiently entrenched, thereby impairing the effectiveness of internal monitoring by boards.

Managerial Risk-Taking Incentive and Firm Innovation: Evidence from FAS 123R
Connie Mao & Chi Zhang
Journal of Financial and Quantitative Analysis, forthcoming


We investigate how chief executive officers’ (CEOs) risk incentive (VEGA) affects firm innovation. To establish causality, we exploit compensation changes instigated by the FAS 123R accounting regulation in 2005 that mandated stock option expensing at fair values. Our identification tests indicate a positive and causal effect of CEOs’ VEGA on innovation activities. Furthermore, dampened managerial risk-taking incentive after the implementation of FAS 123R leads to a significant reduction in innovation related to firms’ core business and explorative inventions. It implies that managers diversify their innovation portfolios and decrease explorative inventions to curtail business risk when their risk-taking incentive is reduced.

Executive labor market segmentation: How local market density affects incentives and performance
Hong Zhao
Journal of Corporate Finance, June 2018, Pages 1-21


I study how the density of executive labor markets affects managerial incentives and thereby firm performance. I find that U.S. executive markets are locally segmented rather than nationally integrated, and that the density of a local market provides executives with non-compensation incentives. Empirical results show that in denser labor markets, executives face stronger performance-based dismissal threats as well as better outside opportunities. These incentives result in higher firm performance in denser markets, especially when executives have longer career horizons. Using state-level variation in the enforceability of covenants not to compete, I find that the positive effects of market density on incentive alignment and firm performance are stronger in markets where executives are freer to move. This evidence further supports the argument that local labor market density works as an external incentive alignment mechanism.

Are institutional investors with multiple blockholdings effective monitors?
Jun-Koo Kang, Juan Luo & Hyun Seung Na
Journal of Financial Economics, forthcoming


We examine whether institutions’ monitoring effectiveness is related to the number of their blockholdings. We find that the number of blocks that a firm's large institutions hold is positively associated with forced chief executive officer (CEO) turnover-performance sensitivity, abnormal returns around forced CEO turnover announcements and 13D filings, and changes in firm value. These results are particularly evident when institutions have multiple blockholdings in the same industry, when they have activism experience, or when they have long-term blockholdings in their portfolio firms. Our results suggest that information advantages and governance experience obtained from multiple blockholdings are important channels through which institutions perform effective monitoring.

The Market for Non‐Executive Directors: Does Acquisition Performance Influence Future Board Seats?
Svetlana Mira, Marc Goergen & Noel O'Sullivan
British Journal of Management, forthcoming


This paper investigates whether non‐executive directors associated with good (bad) board decisions are subsequently rewarded (penalized) in the market for directors. This question is addressed by assessing whether the post‐acquisition performance of acquiring companies influences the number of non‐executive directorships that non‐executives involved in these acquisitions hold subsequent to the acquisition. We find that non‐executives on the boards of acquirers that increase (omit or cut) their dividend subsequently hold more (fewer) non‐executive directorships in listed companies. Our findings suggest that the non‐executive labour market is efficient and rewards (penalizes) non‐executives for good (bad) acquisitions.

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