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Monday, January 9, 2017

Principals and agents

 

Who Killed the Inner Circle? The Decline of the American Corporate Interlock Network

Johan Chu & Gerald Davis

American Journal of Sociology, November 2016, Pages 714-754

Abstract:
U.S. corporations have shared members of their boards of directors since the early 1900s, creating a dense interlock network in which nearly every major corporation was connected through short paths and elevating a handful of well-connected directors to an influential "inner circle." This network remained highly connected throughout the 20th century, serving as a mechanism for the rapid diffusion of information and practices and promoting elite cohesion. Some of the most well-established findings in the sociology of networks sprang from this milieu. In the 2000s, however, board recruiting practices changed: the authors find that well-connected directors became less preferred. As a result, the inner circle disappeared and companies became less connected to each other. Revisiting three classic studies, on the diffusion of corporate policies, on corporate executives' political unity, and on elite socialization, shows that established understandings of the effects of board interlocks on U.S. corporations, directors, and social elites no longer hold.

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Short-Termism and Shareholder Payouts: Getting Corporate Capital Flows Right

Jesse Fried & Charles Wang

Harvard Working Paper, January 2017

Abstract:
During the period 2005-2014, S&P 500 firms distributed to shareholders more than $3.95 trillion via stock buybacks and $2.45 trillion via dividends―$6.4 trillion in total. These shareholder payouts amounted to over 93% of the firms' net income. Academics, corporate lawyers, asset managers, and politicians point to such shareholder-payout figures as compelling evidence that "short-termism" and "quarterly capitalism" are impairing firms' ability to invest, innovate, and provide good wages. We explain why S&P 500 shareholder-payout figures provide a misleadingly incomplete picture of corporate capital flows and the financial capacity of U.S. public firms. Most importantly, they fail to account for offsetting equity issuances by firms. We show that, taking into account issuances, net shareholder payouts by all U.S. public firms during the period 2005-2014 were in fact only about $2.50 trillion, or 33% of their net income. Moreover, much of these net shareholder payouts were offset by net debt issuances, and thus effectively recapitalizations rather than firm-shrinking distributions. After excluding marginal debt capital inflows, net shareholder payouts by public firms during the period 2005-2014 were only about 22% of their net income. In short, S&P 500 shareholder-payout figures are not indicative of actual capital flows in public firms, and thus cannot provide much basis for the claim that short-termism is starving public firms of needed capital. We also offer three other reasons why corporate capital flows are unlikely to pose a problem for the economy.

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The Role of Facial Appearance on CEO Selection After Firm Misconduct

David Gomulya et al.

Journal of Applied Psychology, forthcoming

Abstract:
We investigate a particular aspect of CEO successor trustworthiness that may be critically important after a firm has engaged in financial misconduct. Specifically, drawing on prior research that suggests that facial appearance is one critical way in which trustworthiness is signaled, we argue that leaders who convey integrity, a component of trustworthiness, will be more likely to be selected as successors after financial restatement. We predict that such appointments garner more positive reactions by external observers such as investment analysts and the media because these CEOs are perceived as having greater integrity. In an archival study of firms that have announced financial restatements, we find support for our predictions. These findings have implications for research on CEO succession, leadership selection, facial appearance, and firm misconduct.

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Into the Dark: Shifts in Corporate Political Activity after Social Movement Challenges

Mary-Hunter McDonnell & Timothy Werner

University of Pennsylvania Working Paper, December 2016

Abstract:
Using a unique database on social movement boycotts of corporations, we examine how firms alter their political activities in the wake of a reputational threat. We show that boycotts lead to significant reductions in the amount of targets' political action committee campaign contributions and simultaneous increases in targets' CEOs' personal campaign contributions, as well as targets' lobbying expenditures. We argue that these patterns represent a shift toward more covert forms of political engagement that present new problems for activists and shareholders seeking to monitor corporate political activity.

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Do Good Times Breed Cheats? Prosperous Times Have Immediate and Lasting Implications for CEO Misconduct

Emily Bianchi & Aharon Mohliver

Organization Science, November-December 2016, Pages 1488-1503

Abstract:
We examine whether prosperous economic times have both immediate and lasting implications for corporate misconduct among chief executive officers (CEOs). Drawing on research suggesting that prosperous times are associated with excessive risk-taking, overconfidence, and more opportunities to cheat, we first propose that CEOs will be more likely to engage in corporate misconduct during good economic times. Next, we propose that CEOs who begin their careers in prosperous times will be more likely to engage in self-serving corporate misconduct later in their careers. We tested these hypotheses by assembling a large data set of American CEOs and following their stock option reporting patterns between 1996 and 2005. We found that in good economic times, CEOs were more likely to backdate their stock options grants. Moreover, CEOs who began their careers in prosperous times were more likely to backdate stock option grants later in their careers. These findings suggest that the state of the economy can influence current ethical behavior and leave a lasting imprint on the moral proclivities of new workforce entrants.

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How Common Are Intentional GAAP Violations? Estimates from a Dynamic Model

Anastasia Zakolyukina

University of Chicago Working Paper, December 2016

Abstract:
This paper estimates the extent of undetected misstatements that violate GAAP using data on detected misstatements - earnings restatements - and a dynamic model. The model features a CEO who can manipulate his firm's stock price by misstating earnings. I find that the CEO's expected cost of misleading investors is low. The probability of detection over a five-year horizon is 13.91%, and the average misstatement, if detected, results in a 8.53% loss in the CEO's wealth. The low expected cost implies a high fraction of CEOs who misstate earnings at least once at 60%, inflation in stock prices across CEOs who misstate earnings at 2.02%, and inflation in stock prices across all CEOs at 0.77%. Wealthier CEOs with higher equity holdings or higher cash wealth manipulate less and the average misstatement is larger in smaller firms.

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Marital Status and Earnings Management

Gilles Hilary, Sterling Huang & Yanping Xu

Georgetown University Working Paper, November 2016

Abstract:
In this note, we examine the effect of CEO marital status on the riskiness of financial reporting. Using multiple proxies, we find that firms headed by a single CEO display a higher degree of earnings management than those headed by a married CEO. The effect is economically significant. Our results persist in an instrumental variable regression, suggesting that our results are not driven by innate heterogeneity in preferences.

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Do Fraudulent Firms Produce Abnormal Disclosure?

Gerard Hoberg & Craig Lewis

Journal of Corporate Finance, April 2017, Pages 58-85

Abstract:
Using text-based analysis of 10-K MD&A disclosures, we find that fraudulent firms produce verbal disclosure that is abnormal relative to strong counterfactuals. This abnormal text predicts fraud out of sample, has a verbal factor structure, and can be interpreted to reveal likely mechanisms that surround fraudulent behavior. Using a conservative difference-based approach, we find evidence that fraudulent managers discuss fewer details explaining the sources of the firm's performance, while disclosing more information about positive aspects of firm performance. They also provide less content relating the disclosure to the managerial team itself. We also find new interpretable verbal support for the well-known hypothesis that managers commit fraud in order to artificially lower their cost of capital.

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The impact of the Sarbanes-Oxley Act on corporate innovation

Yuqi Gu & Ling Zhang

Journal of Economics and Business, March-April 2017, Pages 17-30

Abstract:
We study the effect of the passage of the Sarbanes-Oxley Act (SOX) on corporate innovation. SOX dramatically changed corporate governance landscape of public firms in the U.S, especially in increasing monitoring from outside independent directors, which may have an impact on corporate innovation. The passage of SOX introduced an exogenous shock to the corporate governance structure, which enables us to establish causality between SOX and corporate innovation. Using patent and citation data from the NBER patent citation database, board of directors data from Institutional Shareholder Services (ISS) and a difference-in-difference regression technique, we find that SOX increases corporate innovation, as measured by the number of patents and the number of citations per patent. Moreover, we find that the effects are stronger for firms facing more severe agency problems, i.e., firms with more entrenched CEOs as proxied by a longer tenure, and firms with low institutional ownerships. The effect is also found to be stronger for firms operating in innovative industries.

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Do Clawbacks Have Claws? The Value Implications of Mandatory Clawback Provisions

Tor-Erik Bakke, Hamed Mahmudi & Aazam Virani

University of Oklahoma Working Paper, December 2016

Abstract:
Performance-based compensation can give managers an incentive to misreport financial information. This incentive can be mitigated by requiring the recoupment of erroneously awarded performance-based compensation from executives, which is known as a clawback provision. We study the value implications of having a clawback provision by examining the stock market's reaction to the SEC's announcement of proposed Rule 10D-1 that mandates clawback provisions. We find that relative to firms that had voluntarily adopted a clawback provision prior to the SEC's announcement, firms that did not have a clawback provision experienced positive abnormal returns, suggesting that clawback provisions are value-enhancing. Furthermore, the announcement had the greatest positive impact on firms without a clawback with more powerful managers. Our findings suggest that clawbacks create a valuable disincentive to misreport information, but that despite this, powerful managers may resist their adoption, which is why regulation mandating clawbacks may be necessary.

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How does governance affect tax avoidance? Evidence from shareholder proposals

Alex Young

Applied Economics Letters, forthcoming

Abstract:
I examine the effect of corporate governance on tax avoidance. Specifically, I use a regression discontinuity design to analyse the effect of governance-related shareholder proposals that pass or fail by a small percentage of votes. The passage of such proposals around the 50% threshold can be viewed as random assignment of improved governance and thus cleanly identifies a causal estimate. I find that the adoption of governance proposals decreases cash effective tax rates (ETR), which suggests that improved governance increases tax avoidance. The result contributes to our understanding of the determinants of firms' ETR.

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Decision Diversion in Diverse Teams: Findings from Inside a Corporate Boardroom

Sarah Harvey, Steven Currall & Tove Helland-Hammer

Academy of Management Discoveries, forthcoming

Abstract:
Using qualitative data from a five-year participant observation study conducted inside the corporate board of a publicly-held company, we discovered what happened when team composition changed to increase the diversity of perspectives and interests represented on the team. Based on board meeting transcripts over the five-year period, we observed that a change in team composition was followed by a process we label decision diversion, a dysfunctional process in which the team replaced its goal of effective task performance with negotiating the interests of sub-group members. A key insight of our study is that this process unfolded as team members attempted to engage in effective task-based information analysis and decision-making. Our study suggests that the traditional assumptions underlying the understanding of team composition may be insufficient. We provide alternative explanations for the origins of the dynamics of decision diversion in teams.

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Explaining CEO Retention in Misreporting Firms

Messod Beneish, Cassandra Marshall & Jun Yang

Journal of Financial Economics, forthcoming

Abstract:
We propose a framework that advances our understanding of Chief Executive Officer (CEO) retention decisions in misreporting firms. Consistent with economic intuition, outside directors are more likely to fire (retain) CEOs when retention (replacement) costs are high relative to replacement (retention) costs. When the decision is ambiguous because neither cost dominates, outside directors are more likely to retain the CEO when they both benefit from selling stock in the misreporting period. We show that joint abnormal selling captures director-CEO alignment incrementally to biographical overlap. This new proxy operationalizes information sharing and trust, making it useful for studying economic decision-making embedded in social relationships.

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Does a Long-Term Orientation Create Value? Evidence from a Regression Discontinuity

Caroline Flammer & Pratima Bansal

Strategic Management Journal, forthcoming

Abstract:
In this paper, we theorize and empirically investigate how a long-term orientation impacts firm value. To study this relationship, we exploit exogenous changes in executives' long-term incentives. Specifically, we examine shareholder proposals on long-term executive compensation that pass or fail by a small margin of votes. The passage of such "close call" proposals is akin to a random assignment of long-term incentives and hence provides a clean causal estimate. We find that the adoption of such proposals leads to i) an increase in firm value and operating performance ― suggesting that a long-term orientation is beneficial to companies ― and ii) an increase in firms' investments in long-term strategies such as innovation and stakeholder relationships. Overall, our results are consistent with a "time-based" agency conflict between shareholders and managers.

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Corporate social responsibility and CEO confidence

Scott McCarthy, Barry Oliver & Sizhe Song

Journal of Banking & Finance, February 2017, Pages 280-291

Abstract:
This study examines the relationship between firm corporate social responsibility (CSR) and CEO confidence. Research shows that CSR has a hedging feature. Research also shows that more confident CEOs underestimate firm risks, which, in turn, leads them to undertake relatively less hedging. Consistent with this, we find that CEO confidence is negatively related to the level of CSR. Closer analysis shows that this effect is stronger in the institutional aspects of CSR, such as community and workforce diversity, rather than in the technical aspects of CSR, such as corporate governance and product quality. Our results are robust to different competing explanations, including narcissism, which refers in this context to CEOs who engage in CSR to attract attention and alternative proxies for CSR and CEO confidence.

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Takeover Defenses: Entrenchment and Efficiency

Sanjeev Bhojraj, Partha Sengupta & Suning Zhang

Journal of Accounting and Economics, February 2017, Pages 142-160

Abstract:
This paper explores the potential role of anti-takeover provisions (ATPs) in long-term value creation. Using a change in the legal environment in Delaware as an exogenous event, we document that a subset of firms with a relatively longer term focus (innovative firms) benefit from ATPs. Particularly, these firms experience an increase in Tobin's Q following a state law change in Delaware that increases the effectiveness of ATPs in defending against hostile takeovers. This increase is greater than that for non-innovative firms in Delaware as well as for innovative firms outside Delaware. Furthermore, the innovative firms in Delaware experience a stronger positive market reaction around the state law change dates, relative to other firms. Finally, in a cross-sectional setting we find that innovative firms with above-average takeover protection outperform other firms and are less likely to engage in harmful real earnings management. Taken together, these results provide empirical evidence of potential benefits of ATPs and help explain why such protection continues to be prevalent in the United States.

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Outsourcing Corporate Governance: Conflicts of Interest Within the Proxy Advisory Industry

Tao Li

Management Science, forthcoming

Abstract:
Proxy advisory firms wield large influence with voting shareholders. However, conflicts of interest may arise when an advisor sells services to both investors and issuers. Using a unique data set on voting recommendations, I find that for most types of proposals, competition from a new entrant reduces favoritism toward management by an incumbent advisor that serves both corporations and investors. The results are not driven by factors that influence the entrant's coverage decision, such as the marginal cost of new coverage or previously biased recommendations by the incumbent. Similar to other information intermediaries, biased advice by proxy advisors is shown to have real, negative consequences that allow management to enjoy greater private benefits. These results suggest conflicts of interest are a real concern in the proxy advisory industry, and increasing competition could help alleviate them.

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Inside Directors, Risk Aversion, and Firm Performance

Arun Upadhyay et al.

Review of Financial Economics, forthcoming

Abstract:
Prior literature provides mixed evidence on managerial risk aversion. Using a sample of 1737 large US firms from 1996 to 2005, we find a negative association between the insider ratio and firm risk. Upon further analysis, we show that firms with a greater insider ratio are also likely to have more conservative CEO compensation and investment policies. Analysis of CEO compensation policies indicates that firms with a greater insider ratio offer lower equity based compensation, lower vega and lower total compensation to their CEOs. Also, firms with a greater insider ratio tend to invest more in tangible assets such as plant and equipment and have lower intangible investments. Consistent with these boards instituting conservative policies, we find that firms with a greater insider ratio perform better when they operate in highly volatile environments. Overall, this study suggests that high-insider boards are more conservative in policy initiation and that such boards are valuable in firms with greater operating uncertainties.

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Independent Boards and Innovation

Benjamin Balsmeier, Lee Fleming & Gustavo Manso

Journal of Financial Economics, forthcoming

Abstract:
Much research has suggested that independent boards of directors are more effective in reducing agency costs and improving firm governance. How they influence innovation is less clear. Relying on regulatory changes, we show that firms that transition to independent boards focus on more crowded and familiar areas of technology. They patent and claim more and receive more total future citations to their patents. However, the citation increase comes mainly from incremental patents in the middle of the citation distribution; the numbers of uncited and highly cited patents - arguably associated with riskier innovation strategies - do not change significantly.

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The Power of the Pen Reconsidered: The Media, CEO Human Capital, and Corporate Governance

Baixiao Liu, John McConnell & Wei Xu

Journal of Banking & Finance, March 2017, Pages 175-188

Abstract:
By examining the post-retirement outside board seats held by former CEOs of S&P 1500 firms, we find that CEOs' post-retirement outside board memberships are influenced by the level and the tone of media coverage given to the CEOs' firms while the CEOs were "on the job." These results provide evidence of a direct economic link between media coverage of CEOs' performance today and CEOs' future opportunity sets. These results lend support to the proposition that the media can play a role in corporate governance by influencing the value of CEOs' human capital.

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Corporate Governance and Nested Authority: Cohesive Network Structure, Actor-Driven Mechanisms, and the Balance of Power in American Corporations

Richard Benton

American Journal of Sociology, November 2016, Pages 661-713

Abstract:
Corporate governance describes practices that allocate power and control within public corporations, especially between shareholders, the board of directors, and managers. Shareholder value norms have replaced earlier managerialist governance models. Concurrently, cohesion among the managerial corporate elite has declined, further contributing to a declining managerialist governance consensus. This study considers how governance orientations in publicly held corporations are nested within interfirm networks. Drawing on prior theory, the author argues that cohesive substructures among the corporate elite help account for the surprising resilience of managerial control. He finds that more cohesive subgroups in the board interlock network have greater managerial control and shows how cohesive substructures emerge out of local actor-driven mechanisms: (1) directors affiliated with managerialist firms select into dense groups, (2) firms appoint directors from similarly governed firms, and (3) interlocks help spread governance orientations. These findings have implications for theory and research on collective action in corporate governance.

By KEVIN LEWIS | 09:00:00 AM