Executive power

Kevin Lewis

June 26, 2017

Gambling Attitudes and Financial Misreporting
Dane Christensen, Keith Jones & David Kenchington
Contemporary Accounting Research, forthcoming


We investigate whether attitudes toward gambling help explain the occurrence of intentional misreporting. Similar to gambling, some financial reporting choices involve taking deliberate, speculative risks. We predict that in places where gambling is more socially acceptable, managers will be more likely to take financial reporting risks that increase the likelihood the financial statements will need to be restated. To test this prediction, we exploit geographic variation in local gambling attitudes and find that restatements due to intentional misreporting are more common in areas where gambling is more socially acceptable. This association is even stronger in situations where management is under greater pressure to misreport, including when the firm is: close to meeting a performance benchmark, experiencing poor financial performance, or under investment-related pressure. Furthermore, these results are robust to numerous tests to address omitted variables and endogeneity. Collectively, these findings suggest gambling attitudes help explain the incidence of intentional misreporting.

Do Heads Roll? An Empirical Analysis of CEO Turnover and Pay When the Corporation is Federally Prosecuted
Brandon Garrett, Nan Li & Shivaram Rajgopal
University of Virginia Working Paper, May 2017


Does the criminal prosecution of a corporation affect the CEO? Or do criminal actions directed at the organization itself pose few consequences for the individuals at the top, and the CEO in particular? While CEO’s are rarely themselves prosecuted, organizations could discipline CEO’s through paycuts or outright replacing the CEO in response to a criminal prosecution. We sought to examine whether and how that occurs. We focus our analysis on a dataset of public companies that settled criminal cases brought by federal prosecutors from 2001-2015. We compared those companies to the larger set of companies in the Execucomp database of S&P 1500 firms, focusing on CEO compensation and turnover during the same time period. We examined the time period before and after prosecution, and the year that the company resolved the criminal charges against the company. We found that in the year that the company settled its prosecution, through a guilty plea or a deferred or non-prosecution agreement, there was a significantly higher level of CEO turnover. However, there was little evidence of any CEO pay cut. Second, for the prosecuted firms that did not have CEO turnover after prosecution, there is little evidence of a reduction in compensation. Indeed, we observed a spike in CEO bonuses in the year of prosecution — confirming concerns expressed by judges, prosecutors, lawmakers, and academics that corporate prosecutions do not sufficiently impact high-level decision-makers like CEOs. For the prosecuted firms that did have CEO turnover after prosecution, there is some evidence of a pay cut, both to salary and bonus, prior to the replacement of the CEO. These results raise larger questions whether federal prosecutors targeting the most serious corporate crimes sufficiently incentivize accountability at the top.

The Relationship Between CEO Media Appearances and Compensation
Jingoo Kang & Andy Han Kim
Organization Science, May-June 2017, Pages 379-394


Why do chief executive officers (CEOs) seek media appearances and what benefit do they gain from it? Using a sample of 2,666 U.S. firms from 1997 to 2009, we found that a CEO’s appearance in CNBC interviews and major news articles has a positive relationship with his or her compensation in the following year, after controlling for firm performance and other confounding factors. We further found that the positive relationship is weaker when the CEO is with a large company and is stronger when the CEO is with a company demonstrating strong stock market performance. Finally, we found that when the CEO has a high equity ownership or is a founder CEO, the positive relationship disappears.

Dancing with Activists
Lucian Bebchuk et al.
Harvard Working Paper, May 2017


An important milestone often reached in the life of an activist engagement is the entering into a “settlement” agreement between the activist and the target’s board. Using a comprehensive hand-collected data set, we provide the first systematic analysis of the drivers, nature, and consequences of such settlement agreements. We identify the determinants of settlements, showing that settlements are more likely when the activist has a credible threat to win board seats in a proxy fight. We argue that, due to incomplete contracting, settlements can be expected to contract not directly on the operational or leadership changes that activists seek but rather on board composition changes that can facilitate operational and leadership changes down the road. Consistent with the incomplete contracting hypothesis, we document that settlements focus on boardroom changes and that such changes are subsequently followed by increases in CEO turnover, increased payout to shareholders, and higher likelihood of a sale or a going-private transaction. We find no evidence to support concerns that settlements enable activists to extract significant rents at the expense of other investors by introducing directors not supported by other investors or by facilitating “greenmail.” Finally, we document that stock price reactions to settlement agreements are positive and that the positive reaction is higher for “high-impact” settlements. Our analysis provides a look into the “black box” of activist engagements and contributes to understanding how activism brings about changes in its targets.

CEO ability and corporate opacity
Ozge Uygur
Global Finance Journal, forthcoming


This paper examines the effect of CEO ability on corporate opacity. High-ability CEOs may seek to create greater transparency to convey their ability to the market, while low-ability CEOs may signal-jam the market's inferences about their talent by limiting the available information. An analysis of S&P 500 firms indicates that firms with high-ability CEOs are significantly less opaque than firms with low-ability CEOs, and that corporate opacity decreases value more for firms managed by low-ability CEOs. Low-ability CEOs hiding behind opacity get away with it owing to lack of strong corporate governance, suggesting that corporate governance is critical for hiring and retaining talented CEOs, and also for preventing low-ability CEOs from exploiting corporate opacity. These findings are robust to the use of samples that are propensity score matched on firm complexity and past firm performance, and also to the use of alternative ability proxies and alternative measures of CEOs' choice of transparency.

Is board compensation excessive?
Mustafa Dah & Melissa Frye
Journal of Corporate Finance, August 2017, Pages 566–585


We develop a model to predict expected or normal director compensation. Based on this, we then calculate whether directors of corporate boards are over- or undercompensated. On average, we find greater evidence of over- rather than undercompensation. For companies that overpay, the average excess compensation is greater than $60,000 per director, while directors that are underpaid receive about $33,000 less than predicted. Excess compensation declines over our sample period, which may be consistent with increased director workloads as well as increased scrutiny. We also find that overcompensated directors exacerbate agency problems and lead to reduced CEO turnover sensitivity to performance and a decrease in CEO pay-for-performance sensitivity. Thus, director excess compensation may be a sign of board entrenchment where overcompensated directors are not necessarily focused on protecting shareholder interests.

Reorganization or Liquidation: Bankruptcy Choice and Firm Dynamics
Dean Corbae & Pablo D'Erasmo
NBER Working Paper, June 2017


In this paper, we ask how bankruptcy law affects the financial decisions of corporations and its implications for firm dynamics. According to current U.S. law, firms have two bankruptcy options: Chapter 7 liquidation and Chapter 11 reorganization. Using Compustat data, we first document capital structure and investment decisions of non-bankrupt, Chapter 11, and Chapter 7 firms. Using those data moments, we then estimate parameters of a firm dynamics model with endogenous entry and exit to include both bankruptcy options in a general equilibrium environment. Finally, we evaluate a bankruptcy policy change recommended by the American Bankruptcy Institute that amounts to a “fresh start” for bankrupt firms. We find that changes to the law can have sizable consequences for borrowing costs and capital structure which via selection affects productivity (allocative efficiency rises by 2.58%) and welfare (rises by 0.54%).

The Acquisitive Nature of Extraverted CEOs
Shavin Malhotra et al.
Administrative Science Quarterly, forthcoming


This study examines how extraversion, a personality trait that signifies more or less positive affect, assertive behavior, decisive thinking, and desires for social engagement, influences chief executive officers’ (CEOs’) decisions and the ensuing strategic behavior of firms. Using a novel linguistic technique to assess personality from unscripted text spoken by 2,381 CEOs of S&P 1500 firms over ten years, we show that CEOs’ extraversion influences the merger and acquisition (M&A) behavior of firms above and beyond other well-established personality traits. We find that extraverted CEOs are more likely to engage in acquisitions, and to conduct larger ones, than other CEOs and that these effects are partially explained by their higher representation on boards of other firms. Moreover, we find that the acquisitive nature of extraverted CEOs reveals itself particularly in so-called “weaker” situations, in which CEOs enjoy considerable discretion to behave in ways akin to their personality traits. Subsequent analyses show that extraverted CEOs are also more likely than other CEOs to succeed in M&As, as reflected by stronger abnormal returns following acquisition announcements.

The Understatement of Large Negative Earnings News in Managers’ Annual Guidance
Helen Hurwitz
Journal of Contemporary Accounting & Economics, August 2017, Pages 119–133


This study examines whether managers understate large negative earnings news in annual forecasts that are generally issued early when limited earnings information of the fiscal year is publicly available. I find that management forecasts of annual earnings conveying relatively large negative earnings news are systematically optimistic, and it is more (less) pronounced for firms with greater litigation risk or financial distress (net insider sale). The results suggest that fear of immediate lawsuits or job loss instead of trading opportunism motivates managers to understate large negative earnings news to mitigate immediate significantly negative consequences. I also provide evidence consistent with the market not identifying the bias in managers’ annual earnings guidance. This study has important implications for market participants relying on annual management forecasts to form earnings expectations early in the fiscal year and for regulators attempting to balance the quality and quantity of management guidance.

Option Repricing, Corporate Governance, and the Effect of Shareholder Empowerment
Huseyin Gulen & William O'Brien
Journal of Financial Economics, forthcoming


We use the practice of employee option repricing to investigate how shareholder involvement in firm compensation policies affects the quality of firm governance. We find that a 2003 reform that empowered shareholders to approve or reject repricing proposals led to value increases in previous repricers. The likelihood of repricing becomes less sensitive to poor manager performance, but remains similarly sensitive to bad luck, after the reform. Average post-repricing changes in firm performance are positive only after the reform. Overall, our results suggest that shareholder empowerment improves the governance of repricing and can transform repricing into a value-creating tool.

U.S. class action lawsuits targeting foreign firms: The country spillover effect
Xuxing Huang et al.
Journal of Corporate Finance, August 2017, Pages 378–400


We find negative price reactions among non-sued U.S.-listed foreign firms to filings of U.S. shareholder lawsuits targeting firms from their home country. This country spillover effect is stronger for lawsuits, especially accounting-related ones, targeting firms from more poorly-governed countries. We also document a stronger country spillover effect for a recent wave of U.S. lawsuits targeting Chinese issuers than for other standalone litigation. Finally, a foreign firm's price reaction to lawsuits targeting its country peers predicts its chance of being sued in the future. Our findings are consistent with investors updating a foreign firm's litigation risk upon lawsuits targeting its country peers.

Governance and Stakeholders
Vikas Mehrotra & Randall Morck
NBER Working Paper, June 2017


Economic models routinely assume firms maximize shareholder wealth; however common law legal systems only require that officers and directors pursue the interests of the corporation, leaving this ill-defined. Economic arguments for shareholder wealth maximization derived from shareholders’ status as residual claimants are vulnerable on several fronts. Share valuations fluctuate as sentiment shifts. Introductory finance casts firms as maximizing expected net present values, which are quasirents, expected earnings beyond expected costs of capital from investors, to which shareholders have no obvious claim. Other stakeholders – entrepreneurial founders or CEOs, employees, employees, customers, suppliers, communities or governments, having made firm-specific investments, may exert stronger claims than atomistic public shareholders have to shares of their firms’ quasirents. Consistent with this, their contractual claims are often augmented by residual claims and liabilities. Still, shareholder value maximization constitutes something of a bright line; whereas stakeholder welfare maximization is an ill-defined charge to assign boards that gives self-interested insiders broader scope for private benefits extraction. The common law concept of “the interests of the corporation” captures this ambiguity.

Through the Eyes of the Founder: CEO Characteristics and Firms' Regulatory Filings
Bradley Hendricks, Mark Lang & Kenneth Merkley
University of North Carolina Working Paper, May 2017


Linguistic features of a firm’s regulatory filings, taken at face value, convey valuable information about the firm. In this paper, we examine whether a manager-specific, non-economic component also exists within these filings and whether investors consider this component when assessing firm value. To do so, we build on prior research that shows founders have unique personality attributes, including excessive optimism. Consistent with a manager-specific component, our results indicate that 10-K text for founder-led firms is characterized by “excess” optimism relative to current and future realized earnings and relative to non-founder-led firms. The effect is reduced for firms with large auditors, greater ex ante litigation risk and those with high analyst coverage, suggesting that more intense oversight mitigates the effect of founder optimism. Based on stock price at the 10-K release, it does not appear that investors appropriately discount the tone disclosed by founder-led firms. Consistent with investor mispricing, we then show that tone for founder-led firms is associated with negative returns during the year subsequent to the 10-K release and is not predictive of future valuation. Finally, to bolster the conclusion that CEOs do, in fact, influence text, we provide broad sample evidence that CEO fixed effects are significantly related to several textual attributes, including disclosure tone.

The impact on shareholder value of top defense counsel in mergers and acquisitions litigation
C.N.V. Krishnan, Steven Davidoff Solomon & Randall Thomas
Journal of Corporate Finance, August 2017, Pages 480–495


Defense litigation counsel are retained by target firm management to defend them in mergers and acquisition (M&A) litigation. We use hand collected data from a ten-year period (2003 − 2012) to examine whether the choice of defense litigation counsel affects the outcome of M&A litigation and shareholder value. We construct league tables for defense litigation firms and identify the top 10 defense litigation firms. Comparing these firms with all other defense litigation firms, we find that top defense litigation counsel are involved in a significantly higher proportion of cash deals, non-same-industry deals (implying a lower possibility of antitrust-related concerns), and friendlier deals, all of which are associated with smaller initial takeover premium proposals. We find evidence that, controlling for endogeneity, top defense litigation counsel negotiate cheaper and faster settlements than other defense litigation counsel thereby protecting low premium deals from more serious challenges. We also show that top defense litigation counsel are more effective in multijurisdictional litigation cases, again obtaining cheaper and faster settlements in low premium deals, which we theorize shows that they are better able to handle the complexity and strategy that accompany these lawsuits.

Lawyer CEOs
Todd Henderson et al.
University of Chicago Working Paper, April 2017


We examine the value of CEOs with specialized professional skills by focusing on CEOs with law degrees and their effect on corporate litigation. We find that lawyer CEOs are associated with both lower litigation frequency and less severe litigation. This relation is observed for most of nine types of common corporate litigation. This reduction in litigation is achieved, in part, through a decrease in activities that can lead to litigation, such as earnings management, and an increase in legal oversight by directors with legal expertise. Moreover, CEOs with legal training are associated with higher value in firms with high litigation risk and growth firms.

Litigation risk and institutional monitoring
Kuntara Pukthuanthong et al.
Journal of Corporate Finance, August 2017, Pages 342–359


According to the existing literature, institutional investors have a significant impact on the litigation risk of publicly traded companies. This should be particularly true after the Private Securities Litigation Reform Act (PSLRA) of 1995 that encourages institutional investors to serve as lead plaintiffs in securities class actions. Using a large sample of securities class action lawsuits, we distinguish between different types of institutional investors based on their investment horizon and ownership structure and find that both factors significantly affect a firm's litigation risk. Short-term institutional investors are more likely to monitor firms through ex-post litigation, whereas long-term institutional investors prefer to monitor firms internally. Further, we document a nonlinear relation between the stock ownership of the largest institutional investor and a firm's litigation risk. In particular, as measures of long-term (short-term) ownership increase, the likelihood of litigation declines (increases). In summary, shareholder litigation may be an effective external monitoring device for short-term investors that serves as a substitute for internal corporate governance mechanisms.

Equity-based incentive contracts and behavior: Experimental evidence
Rudy Santore & Martin Tackie
Managerial and Decision Economics, forthcoming


Equity-based incentive contracts provide managers with dual incentives, motivating both effort and fraud. We report the results from an experiment in which manager subjects make effort and fraud decisions that affect a firm's value. The main treatment variable is the incentive contract, which can be of either the simple equity or stock option type. We find that both effort and fraud are increasing in a manager's share of equity and decreasing in the strike price of an option. Interestingly, the stock option contract induces relatively more fraud than the simple equity contract, even though the two induce the same effort.

The Informational Role of Corporate Hedging
Alberto Manconi, Massimo Massa & Lei Zhang
Management Science, forthcoming


We study the informational role of corporate hedging, comparing two hypotheses. Under the “opacity” hypothesis, corporate hedging makes earnings less informative, renders the firm opaque, and increases informed traders’ profitability. Under the “transparency” hypothesis, hedging reduces uncertainty and erodes the informed traders’ information advantage and profitability. Our tests support the transparency hypothesis. Hedging is associated with lower uncertainty (lower implied volatility and analyst forecast dispersion, and greater breadth of ownership). It is also associated with a lower informed trading intensity, in particular for short selling. Short selling profits are more than twice lower on the stocks of firms engaging in corporate hedging.

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