1 / 59

Trust and Reputation Market forces and business misconduct

Trust and Reputation Market forces and business misconduct. Jonathan M. Karpoff Metcalfe Professor of Finance Foster School of Business University of Washington Amsterdam Center for Law and Economics Conference To Enforce and  Comply: Incentives inside Corporations and Agencies

rhys
Download Presentation

Trust and Reputation Market forces and business misconduct

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Trust and ReputationMarket forces and business misconduct Jonathan M. Karpoff Metcalfe Professor of Finance Foster School of Business University of Washington Amsterdam Center for Law and Economics Conference To Enforce and  Comply: Incentives inside Corporations and Agencies 5 March 2009

  2. Adam Smith’s invisible hand “[Each person] generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it … he intends only his own gain, and he is in this … led by an invisible hand to promote an end which was no part of his intention… By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.” – Adam Smith (IV.ii.6-9, page 456 of the 1776 Glasgow Edition of Smith’s works; vol. IV, ch. 2, p. 477 of 1776 U. of Chicago Edition.) Not always? When does the pursuit of self-interest not promote society’s interest? • Monopoly • Externality • Distributional issues • What else? ACLE Conference 05Mar09

  3. What about liars, cheats, and thieves? Dennis Kozlowski, CEO of Tyco International, Ltd. – “One of theTop 25 Managers of the Year” (Business Week magazine in 2001) – Now Prisoner 05A4820, in jail ACLE Conference 05Mar09

  4. What to do? • “A more activist SEC is what’s needed.” – The Christian Science Monitor • “It’s time to stop coddling white-collar crooks. Send them to jail ... Enough is enough: They lie, they cheat, they steal and they’ve been getting away with it for too long.” – Fortune magazine ACLE Conference 05Mar09

  5. What else can we do? “The first thing we do, let's kill all the lawyers.” – William Shakespeare, in Henry VI “…[L]et's kill all the accountants.” – New York Daily News ACLE Conference 05Mar09

  6. The economic problem • Fraudulent, deceptive, and opportunistic behaviors are difficult to control • Information and contracts are costly • Contracts are incomplete • Contracts are costly to enforce • Buyers demand discounts, and sellers demand premiums, for the expected amount of cheating by their counterparties ACLE Conference 05Mar09

  7. … Leading to the Marxist problem… • That’s Groucho Marx: “I don’t want to trade with anyone who is willing to trade with me…” ACLE Conference 05Mar09

  8. … This is the “lemons problem” • At average terms, only lower quality sellers stay in the market. • Buyers know this, and demand a higher discount. • But at the higher discount, only much lower quality sellers remain… • … Markets break down, as no one trusts their counterparties ACLE Conference 05Mar09

  9. What keeps it all together? Why isn’t fraud the norm in most transactions? ACLE Conference 05Mar09

  10. Small capital base(Losses and leverage) Current crisis Broken financial sector Breakdown in trust Will my counterparty perform? Are they solvent? Poor asset quality (Bad loans, uncertain value) ACLE Conference 05Mar09

  11. The breakdown in trust – TED spread What large lenders charge each other minus short-term Treasury rates ACLE Conference 05Mar09

  12. The breakdown in trust hits the real economy –commercial paper rates What nonfinancial firms have to pay for short term loans (e.g., to meet payroll) ACLE Conference 05Mar09

  13. …Creating tremendous uncertainty(The “fear index” (VIX)) Still extremely high today ACLE Conference 05Mar09

  14. What keeps it all together? Why isn’t fraud the norm in most transactions? ACLE Conference 05Mar09

  15. What keeps it all together? • Regulations? • Sarbanes-Oxley (2002) • Private Securities Litigation Reform Act (1995) • U.S. Sentencing Commission guidelines for organizations (1991) • Securities Enforcement and Penny Stock Reform Act (1990) • Foreign Corrupt Practices Act (which imposed penalties for financial misrepresentation) (1977) ACLE Conference 05Mar09

  16. What keeps it all together? • Regulators? • AFM, SEC, DOJ, CFTC… • “European Commission proposes bodies to oversee banking risk and financial regulators” – Telegraph.co.uk, 26 February 2009 • European Systemic Risk Council • Chaired by the European Central Bank • Pool and analyse all information for financial stability across the continent. • European System of Financial Supervisors • Coordinate the work of national regulators. ACLE Conference 05Mar09

  17. What keeps it all together? • Personal ethics? • Teaching ethics is big business • AACSB accreditation requires ethics courses • Economists have little influence in these areas • Have abandoned the topic – and the corresponding budgets – to non-economics based disciplines ACLE Conference 05Mar09

  18. What keeps it all together? • Regulations and regulators • Personal ethics • Market forces • Repeat contracting, trust, and reputation The focus of this talk ACLE Conference 05Mar09

  19. Xerox’s cumulated market-adjusted returnsJanuary 1997 – December 2006 10/8/99: Xerox warns 3rd qtr 1999 earnings will be short of projections 1/1/97: Violation period begins 6/16/00: Xerox announces 2nd qtr 2000 earnings will not meet expectations 7/3/00: SEC starts formal investigation 3/26/07: SEC enforcement action concluded 4/10-12/02: Wells Notice; SEC files civil complaint ACLE Conference 05Mar09

  20. SEC enforcement actions for financial misrepresentation, 1978-2009 Total # actions = 945 ACLE Conference 05Mar09

  21. Trigger Event The SEC’s enforcement process Regulatory proceedings Resolution Trigger Event Examples: Self disclosure Earnings restatement Management change Auditor change Delay in filings Shareholder lawsuits Unusual trading Whistle blower Periodic SEC review Investigation Period over which books and records are found to be in error Settlement Trial outcome Punishment Last SEC release • - Informal inquiry • Formal investigation • If warranted: • Wells Notice • Frequently, a class action lawsuit is filed SEC releases: -Administrative release -Litigation release -Accounting and Auditing Enforcement Release (AAER)-secondary designation Enforcement Period (avg 57 months) Violation Period (avg 27 months) ACLE Conference 05Mar09

  22. Trigger Event When firms are caught cooking the books:Stock prices get hammered… Regulatory proceedings Investigation Trigger event Resolution Violation Period Down 4% more Down 10% more Down 14% more Down 25% ACLE Conference 05Mar09

  23. The cumulated losses are very large Large losses ACLE Conference 05Mar09

  24. Legal penalties (from regulations, regulators, and private lawsuits) ACLE Conference 05Mar09

  25. The 10 largest fines 1. SEC fine of $2.25B satisfied by $500MM cash + $250MM stock in bankruptcy. ACLE Conference 05Mar09

  26. But firms’ losses are much largerthan the legal penalties* $25 million Average loss in market cap = = Average SEC fine + class action settlement $397 million *Numbers based on 384 firms with complete data available. Comparisons are similar for larger samples with less complete data. ACLE Conference 05Mar09

  27. Do prices simply revert to their pre-inflation levels? (Since inflated earnings eventually must pop) ACLE Conference 05Mar09

  28. Illustration of the readjustment effect:Acme Company, an all-equity firm Before cooking the books: Book value of assets $100 Market-to-book ratio (assumed constant) 1.5 Market value $150 Firm inflates asset values by $10: Book value of assets $110 Market value $165 *When the misrepresentation is discovered, the value will fall back to $150. This is the readjustment effect. ACLE Conference 05Mar09

  29. But firms’ losses are much larger than the readjustment effect, too $97 million Average loss in market cap = $397 million = Average readjustment effect ACLE Conference 05Mar09

  30. Firms’ losses are more than 3X the legal penalties plus readjustment effect $122 million Average loss in market cap = $397 million = Average readjustment + class action + SEC fines What accounts for the discrepancy? ACLE Conference 05Mar09

  31. Reputation losses … the big hammer ACLE Conference 05Mar09

  32. Reputation: The missing link • Reputation is the present value of the cash flows (quasi-rents) earned when you continue to hold up your end of the deal, i.e., you perform as promised. • E.g., see Klein-Leffler JPE 1981. ACLE Conference 05Mar09

  33. Lost reputation… • … Is the present value of the higher costs and/or lower revenues when firms are discovered to have cheated their investors, suppliers, employees, or customers. • It occurs because counterparties stop doing business with the firm, or change the terms with which they are willing to continue to do business with the firm. ACLE Conference 05Mar09

  34. How a reputation loss shows up: • A higher cost of capital • Graham, Li, and Qiu (Journal of Financial Economics 2008) • Murphy, Shrieves, and Tibbs (Journal of Financial and Quantitative Analysis 2009) • Lower future sales • Barber and Darrough (Journal of Political Economy 1996) • Karpoff, Lee, and Vendrzyk (Journal of Political Economy 1999) • Murphy, Shrieves, and Tibbs (Journal of Financial and Quantitative Analysis 2009) • Executive turnover and leadership disruption • Desai, Hogan, and Wilkins (Accounting Review 2006) • Karpoff, Lee, and Martin (Journal of Financial Economics 2008) • Agrawal and Cooper (working paper 2008) ACLE Conference 05Mar09

  35. Xerox’s reputation loss Market cap before the misrepresentation was discovered $16.864b Less: Readjustment to uninflated value $1.139b Fines and class action amounts 0.523b Lost reputation 3.338b Total loss when the misrepresentation was discovered 5.000b Value after the misrepresentation was discovered $11.864b ACLE Conference 05Mar09

  36. Xerox’s reputation loss… Readjustment (back to $15.725b) = 23% of loss Price inflation during the violation period } } } Losses due to legal penalties = 10% of loss Hypothetical value without the short-term inflation from cooking the books Reputation loss = 67% of loss Actual price path ACLE Conference 05Mar09

  37. Xerox’s experience is close to the norm: *Numbers based on 384 firms with complete data available. Comparisons are similar for larger samples with less complete data. ACLE Conference 05Mar09

  38. Enron’s share price in 2001 16 Oct 2001: $618 million 3rd quarter loss and $1.2 billion reduction in equity 8 Nov 2001: restates 1997-2001 earnings from $2.7 billion to $2.1 billion ACLE Conference 05Mar09

  39. Satyam Computer Services, Ltd. (SAY) 7 Jan 2009: Chairman B. Ramalinga Raju confesses to falsified accounting and inflated earnings ACLE Conference 05Mar09

  40. Ahold’s 2003 misrepresentation 23 Feb 2003: Announced that U.S. subsidiary overstated profits by $0.5 billion ACLE Conference 05Mar09

  41. Product recalls Direct cost = 23% • Sources: Jarrell and Peltzman (JPE 1985), Rubin, Murphy, and Jarrell (Regulation 1988), Barber and Darrough (JPE 1996) ACLE Conference 05Mar09

  42. Frauds of private parties Direct cost = 7% • Sources: Karpoff and Lott (JLE 1993), Alexander (JLE 1999), Murphy, Shrieves, and Tibbs (JFQA 2009) ACLE Conference 05Mar09

  43. Airplane crashes(when airline bears some blame) Direct cost = 38% Reputation loss = 62% • Sources: Chalk (Econ Inq. 1986), Mitchell and Maloney (JLE 1989), Borenstein and Zimmerman (AER 1988) ACLE Conference 05Mar09

  44. Reputation losses also are large for: • Product tampering Mitchell (Econ Inq. 1989), Dowdell, Govindaraj, and Jain (JFQA 1992) • Deceptive advertising Peltzman (JLE 1985), Leffler and Sauer (AER 1990) • Corporate crime Strachan, Smith, Beedles (Fin. Rev. 1983) • Salomon’s misleading Treasury-bidding practices Smith (J. Applied Corp. Finance 1992) • IPO underwriters who perform poorly Beatty, Bunsis, and Hand (JFE 1998) ACLE Conference 05Mar09

  45. Environmental violations Reputation loss = 0% • Sources: Klassen and McLaughlin (Mgmt. Sci. 1996), Karpoff, Lott, and Wehrly (JLE 2005) ACLE Conference 05Mar09

  46. “Third-party” violations (e.g., check-kiting, currency reporting violations) Reputation loss = 0% • Sources: Alexander (JLE 1999), Murphy, Shrieves, and Tibbs (JFQA 2009) ACLE Conference 05Mar09

  47. Why is reputation important for some types of misconduct and not for others? • Product recalls, frauds • Firm has repeat business with harmed parties, or potentially harmed parties • Customers, suppliers, employees change the terms of contract to reflect the higher probability that they will be harmed • Environmental violations • Harmed parties do not in general do business with the firm • Parties with whom the firm does business suffer little or no direct harm • Customers, suppliers, employees have no incentive to change the terms of contract ACLE Conference 05Mar09

  48. Do managers and directors pay? ACLE Conference 05Mar09

  49. For culpable managers…The total picture is not pretty • 92% are ousted by the final proceeding • 60% are explicitly fired • 39% debarred from serving as an officer or director • $8.3 million in regulatory fines and disgorgement • $2–$23 million in dissipated shareholdings • 27% indicted (4% acquittal rate among the indicted) • 5.1 year jail sentences • 3.1 year probationary sentences

  50. What affects the speed of ouster? • The quality of firm governance: • Board independence • Outside blockholders • Shareholdings of non-respondent insiders • Other factors: • The severity of the harm to shareholders • Firms in development stage • Firms in financial distress

More Related