Inside of the boards

Kevin Lewis

July 31, 2017

Do managers overreact to salient risks? Evidence from hurricane strikes
Olivier Dessaint & Adrien Matray
Journal of Financial Economics, forthcoming

We study how managers respond to hurricane events when their firms are located in the neighborhood of the disaster area. We find that the sudden shock to the perceived liquidity risk leads managers to increase corporate cash holdings and to express more concerns about hurricane risk in 10-Ks/10-Qs, even though the actual risk remains unchanged. Both effects are temporary. Over time, the perceived risk decreases, and the bias disappears. The distortion between perceived and actual risk is large, and the increase in cash is suboptimal. Overall, managerial reaction to hurricanes is consistent with salience theories of choice.

Locked-In: The Effect of CEOs' Capital Gains Taxes on Corporate Risk-Taking
Benjamin Yost
MIT Working Paper, April 2017

I study the effects of CEOs' unrealized capital gains tax liabilities (tax burdens) on corporate risk-taking. Recent work suggests that high tax burdens discourage CEOs from selling stock. I hypothesize that this causes the executives to become overexposed to firm-specific risk thereby reducing their willingness to make risky corporate decisions. In a series of tests, I find that corporate risk-taking decreases as CEOs' personal tax burdens increase. Further, firms with CEOs who are more locked-in to their stock positions (i.e., CEOs with higher tax burdens) experience larger increases in risk-taking following federal and state tax cuts. When I investigate the mechanism behind this relation, I find that tax cuts trigger stock sales by the locked-in executives, allowing for improved diversification. Overall, my findings indicate that the personal tax burdens of CEOs affect the firm by reducing executives' preferences for risk at the corporate level.

Board Structure Mandates: Consequences for Director Location and Financial Reporting
Zinat Alam et al.
Management Science, forthcoming

We examine how the director independence mandates of the Sarbanes-Oxley Act (SOX) and related reforms affected board geography and the quality of financial reporting. Using 1998-2006 data on the residential addresses of individual directors, we document that the geographic proximity to headquarters of audit committees and other monitoring committees declined upon implementation of the mandates. The decrease in proximity was especially large for those firms that were both SOX noncompliant and supply constrained in local director labor markets at the time the reforms were enacted. Moreover, firms with larger SOX-related losses of director proximity experienced significantly greater post-SOX declines in earnings quality. Our findings therefore suggest that, for some firms, the director independence mandates had unintended consequences for financial reporting quality.

The Leverage Ratchet Effect
Anat Admati et al.
Journal of Finance, forthcoming

Firms' inability to commit to future funding choices has profound consequences for capital structure dynamics. With debt in place, shareholders pervasively resist leverage reductions no matter how much such reductions may enhance firm value. Shareholders would instead choose to increase leverage even if debt levels are already high and new debt must be junior to existing debt. These asymmetric forces in leverage adjustments, which we call the leverage ratchet effect, cause equilibrium leverage outcomes to be history-dependent. When forced to reduce leverage, shareholders are biased toward selling assets relative to potentially more efficient alternatives such as pure recapitalizations.

The Dark Side of Hedge Fund Activism: Evidence from Employee Pension Plans
Anup Agrawal & Yuree Lim
University of Alabama Working Paper, July 2017

This study examines whether shareholder wealth gains from hedge fund activism are partly wealth transfers from employees and taxpayers. We find that defined benefit employee pension plans of target firms experience underfunding after activism events. Our identification strategy is to use a difference-in-differences approach using control firms identified using a coarsened exact matching method; firm fixed effects; tests of the underlying mechanism; and tests of alternative hypotheses. We find that employee pension plans suffer from underfunding due to reduced employer contributions to the plans. Our tests reject several alternative hypotheses such as activists' stock-picking skills, voluntary reforms by management, mean-reversion, attrition bias, and financial distress. Our results point to a dark side of hedge fund activism in that the shareholder gains from activism appear to partly come from (1) raiding deferred compensation explicitly promised to rank-and-file employees, and (2) taxpayers via the guarantee provided by PBGC.

Shareholder Protection and Agency Costs: An Experimental Analysis
Jacob LaRiviere, Matthew McMahon & William Neilson
Management Science, forthcoming

Two competing principal-agent models explain why firms pay dividends. The substitute model proposes that corporate insiders pay dividends to signal and build trust with outside shareholders who lack legal protection. The outcome model, in contrast, surmises that when shareholders have legal protection, they demand dividends from insiders to prevent them from expropriating corporate funds. Either way, dividends represent an agency cost paid to align the interests of shareholders and insiders. Expropriations by insiders and reduced investment by shareholders are also agency costs, but they are difficult to identify with archival data. Using a laboratory experiment, we identify the impact of strengthened shareholder protection on all three types of agency costs. Dividend payout ratios are five times larger with stronger investor protection, insider expropriation ratios are twice as high, and outsider investment falls by 45%. Thus, we find evidence that strengthening shareholder protection introduces previously unidentified agency costs into the insider-investor relationship.

Share buybacks and gender diversity
Theodoros Evgeniou & Theo Vermaelen
Journal of Corporate Finance, August 2017, Pages 669-686

We find that board gender diversity increases the likelihood that firms announce a buyback but long-term excess returns are significantly smaller when there is larger female representation on the board. This is consistent with the governance hypothesis: gender diversity makes it more likely that firms buy back stock to reduce agency costs of free cash flow. But because gender diversity improves the quality of public information disclosure repurchases are less driven by market timing. Moreover, when the quality of monitoring is lower because board members sit on many other boards, long-term excess returns are larger.

Acquiring growth
Oliver Levine
Journal of Financial Economics, forthcoming

I develop a model of mergers in which M&A deals are used to reallocate investment opportunities. In equilibrium, acquirers lack internal growth options and seek out projects from targets in the M&A market. The model is able to reconcile many features of the merger data that I document, including the high productivity, investment, and valuation of target firms. Furthermore, in my model, profitability is highly predictive of acquisition, and merger transactions naturally lead to a substantial drop in profitability despite creating value for the acquirer.

Offshore Expertise for Onshore Companies: Director Connections to Island Tax Havens and Corporate Tax Policy
Chao Jiang et al.
Management Science
, forthcoming

Theory and recent empirical literature suggest that social and professional connections may influence corporate policy. However, inference may be biased by the possibility that firms who share peers also share unobserved characteristics that are correlated with observed policy. Using a novel identification strategy, we predict and find that director connections through well-known island tax havens have a significant effect on corporate tax policy. Specifically, we find that U.S. firms with directors who are connected to firms domiciled on the islands of the Bahamas, Bermuda, or the Caymans exhibit significantly greater tax avoidance than other U.S. firms. The presence or arrival of an island director is associated with a reduction of between one and three percentage points in the firm's effective tax rate. We also observe a significant increase in the use of tax haven subsidiaries following the arrival of the island director.

The Determinants of Buyout Returns: Does Transaction Strategy Matter?
Brian Ayash, Robert Bartlett & Annette Poulsen
Journal of Corporate Finance
, forthcoming

Using an original dataset of fully monetized LBOs initiated from 1990-2006, we examine the emergence of an entrepreneurial transaction strategy focused on revenue growth and its incidence relative to more "classic" strategies focused on operating efficiencies. We additionally show how the conventional focus on returns measured at an IPO or acquisition frequently overstates actual realized returns to sponsors. Using this return data, we evaluate how "classic" and "entrepreneurial" strategies are associated with sponsors' equity returns. Among successful LBOs, LBOs that enhance operating efficiencies produce the highest "exit" returns; however, LBO sponsors commonly fail to monetize these returns due to delays associated with liquidating portfolio positions. In contrast, LBOs that focus on growing revenues are associated with higher fully realized equity returns, suggesting more sustainable value-creation for sponsors and their investors.

Activism mergers
Nicole Boyson, Nickolay Gantchev & Anil Shivdasani
Journal of Financial Economics, forthcoming

Shareholder value creation from hedge fund activism occurs primarily by influencing takeover outcomes for targeted firms. Controlling for selection decisions, activist interventions substantially increase the probability of a takeover offer. Third-party bids for targets have higher returns, premia, and completion rates, but these patterns reverse when the activist is the bidder. Failed bids for activism targets lead to improvements in operating performance, financial policy, and positive long-term abnormal returns, suggesting that activism enhances value. The positive long-term performance from hedge fund activism arises from monitoring target management during merger and acquisition contests and not from target undervaluation or bidder overpayment.

Corporate Cash Hoarding: The Role of Just-in-Time Adoption
Xiaodan Gao
Management Science
, forthcoming

I explore the role of the just-in-time (JIT) inventory system in the increase in cash holdings by U.S. manufacturing firms. I develop a model to illustrate the mechanism through which JIT affects cash and quantify its impact. In the model, both cash and inventory can serve as working capital. As firms switch from the traditional system to JIT, they shift resources from inventory to cash to facilitate transactions with suppliers. On average, this switchover accounts for a 4.1-percentage-point increase in the cash-to-assets ratio, which is approximately 28% of the change observed in the data.

The Effects of Institutional Investor Objectives on Firm Valuation and Governance
Paul Borochin & Jie Yang
Journal of Financial Economics, forthcoming

We find that ownership by different types of institutional investors has varying implications for future firm misvaluation and governance characteristics. Dedicated institutional investors decrease future firm misvaluation, in both direction and magnitude, relative to fundamentals. In contrast, transient institutional investors have the opposite effect. Using the U.S. Securities and Exchange Commission (SEC) Regulation FD as an exogenous shock to information dissemination, we find evidence consistent with dedicated institutions having an information advantage. Similarly, dedicated investors are associated with better future governance characteristics, while transient investors are not. The valuation effects are primarily driven by institutional portfolio concentration while the governance effects are driven by portfolio turnover. These results imply a more nuanced relationship between institutional ownership and firm value and corporate governance.

Firm Performance in the Face of Fear: How CEO Moods Affect Firm Performance
Ali Akansu et al.
Journal of Behavioral Finance
, forthcoming

The authors use facial emotion recognition software to quantify CEO mood. Anger or disgust motivates a CEO to work harder to improve his or her situation; thus firm profitability improves in the subsequent quarter. Happy CEOs are less likely to work on hard or unpleasant tasks; thus profitability decreases in the subsequent quarter. In the short term, fear explains the firm's announcement period market performance. However, fear is transient and performance improvement is short term.

Saving face: How exit in response to negative press and star analyst downgrades reflects reputation maintenance by directors
Joseph Harrison et al.
Academy of Management Journal, forthcoming

This paper explores the extrinsic and intrinsic motivations driving individual level responses to reputational threats in the context of the director labor market. Integrating work on reputation with self-determination and identity theories, we theorize that negative attention from the media and star equity analysts threatens directors' reputations, motivating proactive behavior to mitigate both the external and internal consequences of reputation damage. Using a sample of directors of S&P 1500 firms between 2003 and 2014, we argue and find that negative media coverage and downgrades by star equity analysts are positively related to director exit, even after controlling for firm performance, overall media visibility, and negative events such as lawsuits and financial restatements. We also find that director status intensifies the effect of negative media coverage on exit, serving as the board chair attenuates the effect of star analyst downgrades on exit, and director tenure intensifies the effects of both negative media coverage and star downgrades on exit. In post-hoc testing, we provide further evidence of director reputation maintenance by demonstrating the counterintuitive finding that negative attention from the media and star analysts also increases directors' likelihood of joining the boards of other S&P 1500 firms.

Are managers paid for better levels of pension funding?
Michael Alderson, Brian Betker & Joseph Halford
Journal of Corporate Finance, October 2017, Pages 25-33

Despite the evidence that full funding of defined benefit pension obligations is value maximizing, managerial price and volatility sensitivities (deltas and vegas) do not appear to influence funded status for all except the CFOs of plan sponsors with weak credit ratings (Anantharaman and Lee, 2014). Whether realized total compensation (as opposed to changes in the value of securities held) encourages full funding is an open question. Here we examine the empirical relation between realized managerial compensation and the extent to which plan liabilities are funded, and find that CEO pay bears a significant relation with funded status.

Impact of Shareholder Proposals on the Functioning of the Market for Corporate Control
Rwan El-Khatib, Kathy Fogel & Tomas Jandik
Financial Review, August 2017, Pages 347-371

Firms receiving shareholder proposals are 16% more likely to become a target of acquisition. Such companies earn approximately 7.2% lower acquisition returns compared to gains for targets with no proposals. Higher acquisition likelihood and lower target returns are primarily associated with proposals drawing a larger proportion of favorable votes, larger voter turnout, as well as with proposals submitted shortly before takeover announcements, and motivated by the removal of antitakeover provisions. Our findings suggest that shareholder proposals can assist bidders in the identification of targets or signal the willingness of target shareholders to accept bids with lower premiums.

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