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Corporate Boards and SEOs: The Effect of Certification and Monitoring:
Abstract
In a sample of underwritten seasoned equity offerings (SEOs), issuers with boards dominated by independent directors experience higher abnormal announcement returns than issuers with boards dominated by insiders. Firm size, transparency, and other governance characteristics do not explain the effect of board independence. The positive relation between board independence and SEO returns is more pronounced for firms with lower monitoring costs and more severe financial constraints. The evidence suggests that independent directors have a positive effect because of their role in controlling both shareholder–manager conflicts (monitoring the use of funds) and current–new shareholder conflicts (certification of the issue’s value).
... firms; (2) offerings of closed-end funds, American Depositary Receipts (ADRs), real estate investment trusts (REITs), and unit offerings; (3) offerings that occur less than one year since the issuer' previous equity issuance; and (4) issues by firms that have less than 220 trading days prior to the SEO available in the CRSP database. Following Akhigbe and Whyte (2015) and Ferreira and Laux (2016), we treat the original filing date from the SDC database as the announcement date. 2 We extract stock trading data from the CSRP files and obtain accounting data from the Compustat Annual Industrial dataset over the 1990-2017 period. We use Compustat Segments dataset for information on firms' business segments and the industry designation of each segment. ...
... Kim and Purnanandam (2014) andFerreira and Laux (2016) compare the SEO announcement dates in the Factiva database and the filing dates in the SDC database and find that in the majority of cases the announcement day is the filing day (usually after the market close) or the day following the filing day. 3 After the Statement of Financial Accounting Standards (SFAS) No. 131 was issued in 1997 as a new standard for the reporting of segment information, the Standard Industrial Classification (SIC) system was replaced by the NAICS.Hoechle et al. (2012) show that segment data using the SIC code as identification before and after 1997 are not directly comparable due to such a change.4 ...
We document that diversified firms experience less negative seasoned equity offering (SEO) announcement returns than focused firms. The relatively better SEO announcement stock performance of diversified firms is more pronounced among issuers with operations across unrelated industries. Furthermore, following the SEO announcement, diversified firms’ stock returns exhibit post-announcement drift, suggesting a delay in information assimilation. Our findings support the information complexity hypothesis that a more sophisticated organizational form leads to a higher degree of complexity in information processing by investors, which in turn causes a delay in the impounding of information into stock prices.
... CEO duality It is widely agreed in both theory and practice that the independence of the boards of directors help to reduce agency costs, especially in the absence of monitoring by shareholders. Ideally, a strong and independent board is better positioned to protect the interests of shareholders (Ferreira and Laux 2016). ...
This paper investigates how economic policy uncertainty affects firms’ frequency and their choice of financial instruments to raise capital. By applying a three-step sequential framework over a sample of 6834 publicly listed US non-financial firms, we find that during periods of high economic uncertainty, firms raise capital more frequently with a preference toward debt financing. The empirical findings suggest that firms prefer debt financing over equity financing to avoid ownership dilution and high equity premia. The rise in leverage during periods of high economic uncertainty highlights the importance of scrutinizing policy tools used to stabilize the economy during such times.
... A final sample of 1,713 offerings from 1,126 firms from 26 countries remains. We use the SEO filing date as the benchmark to define forecasts issued before and after SEO following the literature (Ferreira & Laux, 2016). 12 The SEO filing date hence proxies the SEO announcement date accurately. ...
This PhD dissertation comprises of a detailed theoretical study and two empirical studies on financial analysts’ earnings forecasts when firms manage earnings. The first study explains the gap in the literature – what do analysts forecast when earnings are managed – which the subsequent studies aim to fulfill. The second study finds that analysts generally tend to be informative around seasoned equity offerings (SEO), especially after the adoption of the Market Abuse Directive. The third study confirms that in the long-term informative analyst forecasts are more value relevant than accurate analyst forecasts as well as reported earnings around SEOs. These findings contribute to the literature on analyst forecasts by showing that some analysts may deliberately forego accuracy for informativeness.
... Table 1 shows that 39% of the offers are made by firms with CEO-chairman duality. It is relatively low as compared to a proportion of 75.2% of underwritten SEOs issued by US public industrial firms with CEO-chairman duality, as reported by Ferreira and Laux (2016). More than two-thirds of the firms in East Asian countries are controlled by a single shareholder and the largest shareholder or his relatives usually are the managers of family-controlled firms (Claessens et al., 2000;La Porta et al., 1999). ...
This study investigates the shareholder participation and wealth transfers associated with Hong Kong (HK) open offers. Compared with the results in the US where rights offerings are unpopular, open offers as one of the common rights offerings in HK also have high wealth transfers from nonparticipating to participating shareholders and low shareholder participation. High wealth transfers and low shareholder participation are thus not the main causes of the infrequent use of rights offerings in the US. High expected wealth transfers will lead to more negative announcement returns, but this adverse effect is weaker when there is a large shareholder take-up. This study for the first time finds that three main protective instruments could reduce the wealth transfers: (i) the better underwriter certification provided by the largest shareholders, (ii) the adoption of oversubscription privilege, and (iii) the avoidance of the CEO-chairman position simultaneously held by the largest shareholders.
... Other studies examine monitoring effectiveness by focusing on the conflicts of interest between managers and independent directors. Ferreira and Laux (2016) find that board independence facilitates monitoring. Shivdasani and Yermack (1999) document that investors react less positively to the appointment of independent directors selected by the CEO, and Hwang and Kim (2009) find that directors who have social connections to the CEO grant higher levels of CEO pay that is unrelated to performance. ...
We examine a specific channel through which director connectedness may improve monitoring: financial reporting quality. We find that the connectedness of independent, non-co-opted audit committee members has a positive effect on financial reporting quality and accounting conservatism. The effect is not significant for non-audit committee or co-opted audit committee members. Our results are robust to tests designed to mitigate self-selection. Consistent with connected directors being valuable, the market reacts more negatively to the death of highly connected directors than less connected directors. Better connected directors also have better career prospects, suggesting that they have greater incentives to monitor.
... See Dann and Mikkelson (1984),Asquith and Mullins (1986),Eckbo (1986),Masulis and Korwar (1986),Mikkelson and Partch (1986),Bayless and Chaplinsky (1991), Pinotte (1992),and Manuel, Brooks, and Schadler (1993). More recently,Ferreira and Laux (2016) report negative announcement returns for both debt and equity offerings, with more negative returns for equity offerings than for debt offerings as predicted by my model. See also surveys by e.g.Eckbo and Masulis (1995) andEckbo, Masulis, and Norli (2007). ...
Purpose
This paper examines the presence of stock market timing in Thailand. We explore the potential impact that equity overpricing, stock ownership and corporate board structure have on equity market timing.
Design/methodology/approach
We use a comprehensive dataset of 1,747 seasoned equity offerings (SEOs) in Thailand obtained from hand-picked data from 2000 to 2020. The empirical methods adopted are generalized least squares (GLS), probit regressions, probit models with continuous endogenous covariates (IV-probit) and instrumental variable (IV) with a two-stage least squares (2SLS) regression approach. To determine the presence of equity overpricing, the intrinsic value of a stock is estimated using the discounted cash flow (DCF) method, the residual income (RIM) method, Tobin’s q ratio and abnormal stock returns.
Findings
We find that firms prefer to time the equity market by issuing SEOs when the stock market is hot. Moreover, hot market timers tend to keep the SEO proceeds as cash and short-term investments, which confirms that one of the reasons for conducting the equity offering is taking advantage of windows of opportunity. We find results consistent with insiders seeking to exploit information asymmetries and/or the lack of rationality of outsiders. However, the effect of the factors we consider, including equity overpricing, ownership and board structures, differs depending on the timing strategy and the method of stock valuation selected by the firms.
Research limitations/implications
We find that a number of complex relationships determine the presence of stock market timing, and it would be interesting to investigate these further in future research.
Practical implications
Our results have policy implications for regulators, managers and investors.
Originality/value
We provide the most comprehensive results to date about SEOs in Thailand. We introduce many explanatory variables and methodological innovations to the literature on SEOs.
We investigate the effect of founder control on firms’ financing costs for seasoned equity offerings (SEOs). Firms issuing SEOs are subject to increased information asymmetry and associated agency conflicts. We hypothesize that founder control has a certification effect that mitigates such problems, and consequently, reduces the cost of issuing SEOs. Consistent with our prediction, firms with founder control enjoy higher abnormal announcement returns and lower SEO gross spreads. We also show that founder firms have better post‐SEO operating performance than non‐founder firms. Additionally, we document that the founder certification effect is more salient among firms with poorer pre‐SEO operating performance and those that do not disclose specific use of the SEO proceeds. Finally, we show that founder firms do not increase the frequency of management earnings forecasts as much as non‐founder firms prior to the SEO. Our results are robust to a battery of sensitivity analyses, and our conclusions are consistent with the founder certification effect.
According to the pecking order theory, firms with potential investment projects should raise external capital if and only if sufficient internal funds are not available. The theory can be violated if equity issuers are motivated by market timing and increasing funds for insiders’ benefits, indicating that firms may already have internal funds surplus without including external funds, but still issue equity. By controlling for future funds needs, the analyses show that issuers that engage in market timing and spend the SEO proceeds on value‐destroying projects are strongly associated with their internal funds surplus. Moreover, SEO announcement returns are lower for issuers with internal funds surplus. This pattern strongly supports the predictive ability of internal funds surplus to detect the need for external capital and ultimately to determine timing incentives and agency spending of SEO proceeds.
We investigate the wealth effects of the Takeover Bids Directive, enacted by the European Union, on mergers and acquisitions. The directive aims at protecting target minority shareholders by restricting anti‐takeovers provisions and preventing managerial entrenchment. We test the regulation impact using a treatment sample of EU public acquisitions and a control sample from outside the EU. Our results suggest diverse effects of the regulation across treatment countries: acquirers from countries with better shareholder protection engage in more value‐enhancing acquisitions post‐regulation that could otherwise be too costly. The regulation also increases the likelihood of firms becoming targets and raises market value. This article is protected by copyright. All rights reserved.
We examine the announcement returns of 3483 seasoned equity offerings (SEOs) during the 1996–2018 period. Although there is a significant decline in SEO announcement returns, we show that cash shortfall in the year before SEO has a positive impact on SEO announcement returns. By matching SEO offers sizes and cash shortfalls, we also find that negative announcement-period returns become positive when SEO offer size is determined in concert with cash shortfall. Patterns of long-run abnormal firm performance after SEO announcements are consistent with those we document for the announcement-period returns. Our results suggest that cash shortfall in the year before SEO as indication of funds needs mitigates agency spending of SEO proceeds, and thus, the market welcomes the SEO announcement with positive stock price reactions.
The role of underwriters is altered in new seasoned equity offering deal types in which the offering follows quickly after its announcement. Controlling for the endogenous matching between issuing firms and underwriters, we find increased underwriter reputation mitigates the immediate price impact of announcing an accelerated bookbuilt offering, exacerbates the price impact of announcing a bought offering, and has no immediate price impact for fully marketed deals. In contrast, underwriter reputation positively affects price outcomes for fully marketed deals around the offer date. Reputation effects are not apparent in the absence of controlling for the endogenous matching.
Confidentially marketed public offers (CMPOs) represent a popular innovation in the market for seasoned equity offers (SEO) despite large negative announcement reactions. We find that CMPOs are often used by small firms with negative operating cash flows to raise a relatively substantial amount of capital, which is used largely for R&D intensive investments. We argue that the confidential marketing associated with CMPOs has made them a popular way for small firms to make fast-paced public offers, which are known to have reduced price pressure, while sidestepping the problem of inelastic demand. These firms are willing to trade off more negative announcement reactions for the chance to privately assess their prospects for raising capital.
We use meta‐analysis to review studies on announcement effects associated with seasoned equity offerings. Our sample includes 199 studies from 38 leading finance journals and Social Sciences Research Network working papers. The studies cover different countries, but the US is particularly well‐represented with 131 studies. We find a statistically significant mean cumulative abnormal return of −0.98%. Abnormal returns are more negative for equity issues by US companies and for non‐US rights issues and are less negative for private placements. In addition, wealth effects are more negative when the proceeds are used for debt reduction, when the SEO is issued shortly after IPO, and for issues by nondividend‐paying companies and industrial companies. We identify important avenues for future research.
Using a unique investor bid price database of a uniform-price auction pricing mechanism of SEOs in China, we seek answers to two research questions: how does value uncertainty relate to investor bid prices (weighted average and standard deviation) and to the subsequent SEO pricing in an auction price mechanism? What is the underlying transmission mechanism between value uncertainty and SEO discounts? Our findings suggest that: (1) the weighted average of investor bid prices is negatively correlated with value uncertainty, indicating an information cost effect; (2) the dispersion of bids (proxied by standard deviation of bid prices) is positively correlated with value uncertainty, indicating the presence of a heterogeneous investor beliefs effect; and (3) SEO discounts are negatively correlated with the weighted average bid price and with the bid price standard deviation. The magnitude of this impact on the SEO discounts, however, is larger for the weighted average bid price than the standard deviation, suggesting that the information cost effect outweighs the heterogeneous investor beliefs effect. Moreover, we find that investor bid prices (weighted average and standard deviation) form part of the transmission mechanism shaping the relationship between value uncertainty and SEO discounts. Our findings are robust to a battery of robustness checks.
This study examines whether auditors' industry expertise is negatively associated with underpricing of seasoned equity offerings (SEO) and whether the association between auditors' industry expertise and SEO underpricing changes around the global financial crisis (GFC). Using a sample of 2,028 SEO observations from 2001 to 2013, we document that in the pre-GFC period, auditors' industry expertise is negatively associated with SEO underpricing, but not during the post-GFC period. Industry-specialist auditors are also associated with higher earnings response coefficients in the pre-GFC period, but not in the post-GFC period. These results suggest that the GFC affected investor confidence in industry-specialist auditors in the capital markets.
JEL Classifications: G01; G14; M42.
We examine the impact of the enactment of the Market Abuse Directive (MAD) and the Prospectus Directive (PD) across 18 EU countries on seasoned equity offerings (SEOs). Using a difference-in-differences methodology, we document a significant reduction in earnings management, improved post-SEO stock return performance, and a decline in the adverse reaction to SEO announcements following the enactment of MAD. We find similar, albeit weaker, results post-PD. The impact is stronger in countries with high ex-ante institutional quality. Our results suggest that the enactment of these directives leads to improvements in information quality, which reduces information asymmetry around SEOs.
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offerrngs The under\rrltmg Industry, finance textbooks. and corporate proxy statements offer
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alternate explanations of the observed choice of financing method.
When commercial banks make loans to firms and also underwrite securities, does this hamper or enhance their role as certifiers of firm value? This paper examines empirically the pricing of bank-underwritten securities as compared to investment-house-underwritten securities over a unique period in the U.S. (pre-Glass-Steagall) when both banks and investment houses were allowed to underwrite securities. The evidence shows that investors were willing to pay higher prices for securities underwritten by banks rather than investment houses. The results support a certification role for banks, which is more valuable for junior and information sensitive securities.
The Modigliani and Miller propositions on the irrelevancy of capital structure and dividends are shown to be valid in a large
class of models with asymmetric information. The main assumption is that managerial compensation is chosen optimally. This
differs from most of the recent articles on this topic, which impose by fiat a suboptimal contract. Even when imperfections
internal to the firm preclude optimal investment, there is a separation between incentives and financing. We conclude that
corporations should move toward contracts with better incentives, and that new models should be built that recognize the limitations
to optimal contracting.
This paper analyzes the survival of organizations in which decision agents do not bear a major share of the wealth effects of their decisions. This is what the literature on large corporations calls separation of 'ownership' and 'control.' Such separation of decision and risk bearing functions is also common to organizations like large professional partnerships, financial mutuals and nonprofits. We contend that separation of decision and risk bearing functions survives in these organizations in part because of the benefits of specialization of management and risk bearing but also because of an effective common approach to controlling the implied agency problems. In particular, the contract structures of all these organizations separate the ratification and monitoring of decisions from the initiation and implementation of the decisions.
This paper is a survey of the literature on boards of directors, with an emphasis on research done subsequent to the Benjamin E. Hermalin and Michael S. Weisbach (2003) survey. The two questions most asked about boards are what determines their makeup and what determines their actions? These questions are fundamentally intertwined, which complicates the study of boards because makeup and actions are jointly endogenous. A focus of this survey is how the literature, theoretical as well as empirical, deals-or on occasions fails to deal-with this complication. We suggest that many studies of boards can best be interpreted as joint statements about both the director-selection process and the effect of board composition on board actions and firm performance.
This essay surveys the extant literature and adds to the empirical evidence on issuance activity, flotation costs, and valuation effects of security offerings. We focus primarily on public offerings of equity for cash, although we also review and present new evidence on debt offerings and private placements. The essay has four major parts: (1) We review aggregate issue activity in exchange listed securities from 1980 through 2004. Following the IPO, only about one-half of the publicly traded firms undertake a public security offering of any type, and only about one-quarter undertake a SEO. Thus, SEOs are relatively rare, which is consistent with adverse selection costs being an important consideration when raising cash externally. (2) We review the evidence on direct issue costs across security types and flotation methods, including the more recent SEO underpricing phenomenon. A large number of studies provide evidence on the determinants of underwriter compensation, and confirm the importance of variables capturing information asymmetries and underwriter competition. (3) We survey and interpret the valuation effects of security issue announcements. In the period since the Eckbo and Masulis (1995) survey, many studies examining announcement-period stock returns have focused on the effects of flotation method choice and foreign offerings. The well-known negative average announcement effect observed for U.S. SEOs appears to be a somewhat U.S.-specific phenomenon. (4) We review and extend evidence on the performance of issuing firms in the five year post-issue period. The literature proposes either a risk based-explanation or a behavioral explanation for the phenomenon of low average realized returns following IPOs and SEOs. Standard factor model regressions fail to reject the null that the low average returns are commensurate with issuers’ risk exposures. Recent theoretical developments suggest that lower risk levels following equity issues may be linked to issuers’ investment activity, a promising direction for future research.
This paper suggests a new measure of one aspect of the quality of working capital accruals and earnings. One role of accruals is to shift or adjust the recognition of cash flows over time so that the adjusted numbers (earnings) better measure firm performance. However, accruals require assumptions and estimates of future cash flows. We argue that the quality of accruals and earnings is decreasing in the magnitude of estimation error in accruals. We derive an empirical measure of accrual quality as the residuals from firm-specific regressions of changes in working capital on past, present, and future operating cash flows. We document that observable firm characteristics can be used as instruments for accrual quality (e.g., volatility of accruals and volatility of earnings). Finally, we show that our measure of accrual quality is positively related to earnings persistence.
This paper examines how firm credit rating affects SEO underpricing and announcement-period abnormal stock returns. We find that firms with credit ratings have less SEO underpricing than firms without credit ratings. We also find that firms with high credit ratings have less SEO underpricing and smaller announcement-period abnormal stock returns than firms with low credit ratings. These results suggest that the existence of credit ratings reduces information asymmetry and the level of credit ratings indicates the degree of wealth transfer from shareholders to bondholders in SEOs.
We investigate how governance affects investor confidence in seasoned equity offerings (SEOs) and the cost of raising external equity. Using a differences-in-differences approach with business combination statutes as an external shock, we find investors become worried about non-productive use of SEO proceeds when the law change weakens external pressure for good governance. We buttress this finding by identifying a channel through which governance causes heterogeneous investor reaction to SEO announcements--increases in capital expenditures following SEOs. Also consistent with the governance based explanation, market reaction is more negative when issuers have prior records of value-reducing acquisitions and weaker alignment of managerial incentives to shareholder value. The magnitudes of these impacts are surprisingly large, explaining most of negative market reactions to primary offerings. Secondary offerings are met with strong negative reactions due to signaling effects; however, our data show no evidence in support of the adverse selection hypothesis.
Dechow and Dichev (2002) model earnings quality as the magnitude of estimation errors in accruals, and provide empirical estimates of this construct based on the relation between accruals and cash flows. I characterize the innovation and limitations in this approach, and provide empirical evidence of measurement error in their empirical specification. I also adapt their model to assess the specification of the Jones' (1991) model and document that this model provides estimates of discretionary accruals that are significantly associated with cash flows, which are likely to be substantially nondiscretionary. I conclude with suggestions for future research on earnings quality and earnings management.
This essay is a response to Lucian Bebchuk's recent article The Case for Increasing Shareholder Power, 118 Harvard Law Review 833 (2005). In that article, Bebchuk put forward a set of proposals designed to allow shareholders to initiate and vote to adopt changes in the company's basic corporate governance arrangements. In response, I make three principal claims. First, if shareholder empowerment were as value-enhancing as Bebchuk claims, we should observe entrepreneurs taking a company public offering such rights either through appropriate provisions in the firm's organic documents or by lobbying state legislatures to provide such rights off the rack in the corporation code. Since we observe neither, we may reasonably conclude investors do not value these rights. Second, invoking my director primacy model of corporate governance, I present a first principles alternative to Bebchuk's account of the place of shareholder voting in corporate governance. Specifically, I argue that the present regime of limited shareholder voting rights is the majoritarian default and therefore should be preserved as the statutory off-the-rack rule. Finally, I suggest a number of reasons to be skeptical of Bebchuk's claim that shareholders would make effective use of his proposed regime. In particular, I argue that even institutional investors have strong incentives to remain passive.
One of the most pressing questions facing both corporate scholars and businesspeople today is the question of how corporate directors can be made accountable. Before addressing this issue, however, it seems important to consider two antecedent questions: To whom should directors be accountable? And for what? Contemporary corporate scholarship often starts from a "shareholder primacy" perspective that holds that directors of public corporations ought to be accountable only to the shareholders, and ought to be accountable only for maximizing the value of the shareholders' shares. This perspective rests on the conventional contractarian assumption that the shareholders are the sole residual claimants and risk bearers in a public firm. More recent work in economics suggests, however, that this assumption is false. In particular, options theory and the growing literature on the contracting difficulties associated with firm-specific investment both support the claim that a wide variety of groups are likely to bear significant residual risk and enjoy significant residual claims on firm earnings. These groups include not only shareholders, but also creditors, managers, and employees. Thus economic efficiency may be best served not by requiring corporate directors to focus solely on shareholders' interests, but by requiring them instead to maximize the sum of all the interests held by all the groups that bear residual risks and hold residual claims. In accord with this view, we argue that corporate directors ought to be viewed not as "agents" who serve only the shareholders, but as "mediating hierarchs" who enjoy ultimate control over the firm's assets and outputs and who are charged with the task of balancing the sometimes conflicting claims and interests of the many different groups that bear residual risk and have residual claims on the firm. This mediating model of the board's role offers to explain a variety of important doctrines in U.S. law that preserve director autonomy and insulate the board from the command and control of the shareholders or indeed any other group. At the same time, the mediating model raises the question of why directors who are largely insulated from outside pressures should be expected to do a good job of running the firm. We suggest that answers to this question are available, but only if we are willing to look beyond the homo economicus model of rationally selfish behavior commonly employed in economic analysis and to consider as well the extensive empirical evidence in the social sciences literature on the phenomenon of intrinsically trustworthy, other-regarding behavior. We briefly explore how this literature both supports the claim that directors may behave trustworthily even when they do not have explicit incentive to do so, and suggests some of the circumstances that are likely to promote accountable director behavior.
This paper examines the relation between the market reaction to primary seasoned equity offerings and alternative measures of the profitability of the issuing firm's growth opportunities. While the sample offerings display a positive relation between announcement period prediction errors and several ex ante measures of growth opportunities, this relation is not monotonic and appears to be driven by a small subset of younger, higher growth firms, whose announcement effects are insignificantly different from zero. For the remainder of the sample firms, there is no relation between the estimated profitability of new investment and the market reaction to announced equity offerings. Moreover, announcement effects are nonpositive regardless of how profitable investment opportunities are expected to be. These findings collectively suggest that investment opportunities play, at best, a minor role in explaining the cross-sectional distribution of equity offering announcement effects.
This paper tests whether there is a difference in the stock price reactions to industrial straight debt offerings of different risk. Using bond ratings at the time of announcement as a measure of risk, we find that there is no monotonic relation between stock price impact and rating and no statistically significant difference across risk classes, even though the sample includes low-rated debt issues from recent years. This confirms earlier evidence on straight debt issues, but differs from the evidence on convertible securities. The paper also finds that the results for straight debt are not affected by shelf registrations or by the issuing firms' involvement in merger and acquisition-related activity.
It is well known that historically a larger number of firms issue common stock and the proportion of external financing accounted for by equity is substantially higher in expansionary phases of the business cycle. We show that this phenomenon is consistent with firms selling seasoned equity when they face lower adverse selection costs, which occurs in periods with more promising investment opportunities and with less uncertainty about assets in place. Thus, firm announcements of equity issues are predicted to convey less adverse information about equity values in such periods. Empirically, we find evidence that generally supports these predictions. Consistent with historical patterns, firms in recent times have tended to increase equity more frequently in expansionary periods. While business cycle variables have significant explanatory power, interest rate variables are generally insignificant. The adverse selection effects as measured by the average negative price reaction to seasoned common stock offering announcements is significantly lower in expansionary periods and in periods with a relatively larger volume of equity financing. These offer announcement effects are less negative for smaller stock offerings and for issuers with less uncertainty about assets in place.
Using a comprehensive sample of nearly 7,000 firms from 1990 to 2004, we examine the corporate board structure, trends, and determinants. Guided by recent theoretical work, we find that board structure across firms is consistent with the costs and benefits of the board's monitoring and advising roles. Our models explain as much as 45% of the observed variation in board structure. Further, small and large firms have dramatically different board structures. For example, board size fell in the 1990s for large firms, a trend that reversed at the time of mandated reforms, while board size was relatively flat for small and medium-sized firms.
This study examines whether audit committee and board characteristics are related to earnings management by the firm. A negative relation is found between audit committee independence and abnormal accruals. A negative relation is also found between board independence and abnormal accruals. Reductions in board or audit committee independence are accompanied by large increases in abnormal accruals. The most pronounced effects occur when either the board or the audit committee is comprised of a minority of outside directors. These results suggest that boards structured to be more independent of the CEO are more effective in monitoring the corporate financial accounting process.
This paper investigates the ability of the pecking-order model, the agency model, and the timing model to explain firms' decisions whether to issue debt or equity, the shock price reaction to their decisions and their actions afterward. We find strong support for the agency model. Firms often depart from the pecking order because of agency considerations. We fail to find support for the timing model.
This paper reexamines the relation between firm value and board structure. We find that complex firms, which have greater advising requirements than simple firms, have larger boards with more outside directors. The relation between Tobin's Q and board size is U-shaped, which, at face value, suggests that either very small or very large boards are optimal. This relation, however, arises from differences between complex and simple firms. Tobin's Q increases (decreases) in board size for complex (simple) firms, and this relation is driven by the number of outside directors. We find some evidence that R&D-intensive firms, for which the firm-specific knowledge of insiders is relatively important, have a higher fraction of insiders on the board and that, for these firms, Q increases with the fraction of insiders on the board. Our findings challenge the notion that restrictions on board size and management representation on the board necessarily enhance firm value.
Flotation costs represent a significant loss of capital to firms and are positively related to information asymmetry between managers and outside investors. We measure a firm's information asymmetry by its accounting information quality based on two extensions of the Dechow and Dichev [2002. The quality of accruals and earnings: the role of accrual estimation errors. Accounting Review 77, 35–59] earnings accruals model, which is a more direct approach to assessing the information available to outside investors than the more commonly used proxies. Our main hypothesis is that poor accounting information quality raises uncertainty about a firm's financial condition for outside investors, though not necessarily for insiders. This accounting effect lowers demand for a firm's new equity, thereby raising underwriting costs and risk. Using a large sample of seasoned equity offerings (SEOs), we show that poor accounting information quality is associated with higher flotation costs in terms of larger underwriting fees, larger negative SEO announcement effects, and a higher probability of SEO withdrawals. These results are robust to joint determination of offer size and flotation cost components and to adjustments for sample selection bias.
This paper generalizes the Myers and Majluf (1984) model by introducing an agency cost structure based on private benefits of control. This new model predicts that many corporate finance variables each have opposing effects on under- and overinvestment. Private benefits exacerbate overinvestment but, interestingly, a small amount of private benefits can enhance firm value by alleviating underinvestment. Likewise, an increase in insider ownership alleviates overinvestment but aggravates underinvestment. When private benefits are small, the adverse effect of insider ownership on underinvestment tends to dominate. When there are considerable private benefits, the incentive-alignment effect of insider ownership is pronounced. Additionally, this model reconciles existing equity financing theories on announcement effects. It helps resolve the puzzle that small-growth firms do not seem to have an asymmetric information disadvantage when they issue new equity.
Using a unique panel dataset that tracks corporate board development from a firm's IPO through 10 years later, we find that: (i) board size and independence increase as firms grow and diversify over time; (ii) board size—but not board independence—reflects a tradeoff between the firm-specific benefits and costs of monitoring; and (iii) board independence is negatively related to the manager's influence and positively related to constraints on that influence. These results indicate that economic considerations—in particular, the specific nature of the firm's competitive environment and managerial team—help explain cross-sectional variation in corporate board size and composition. Nonetheless, much of the variation in board structures remains unexplained, suggesting that idiosyncratic factors affect many individual boards’ characteristics.
Estimates of the cost of equity for industries are imprecise. Standard errors of more than 3.0% per year are typical for both the CAPM and the three-factor model of Fama and French (1993). These large standard errors are the result of(i) uncertainty about true factor risk premiums and (ii) imp ecise estimates of the loadings of industries on the risk factors. Estimates of the cost of equity for firms and projects are surely even less precise.
This paper reviews the theory and evidence on the process by which corporations raise debt and equity capital and the associated effects on security prices. Findings from related transactions are used to test hypotheses about the stock price patterns accompanying announcements of security offerings. Various contractual alternatives employed in security issues are examined; for example, rights or underwritten offers, negotiated or competitive bid, best efforts or firm commitment contracts, and shelf or traditional registration. Finally, incentives for underpricing new issues are analyzed.
Many corporate assets, particularly growth opportunities, can be viewed as call options. The value of such ‘real options’ depends on discretionary future investment by the firm. Issuing risky debt reduces the present market value of a firm holding real options by inducing a suboptimal investment strategy or by forcing the firm and its creditors to bear the costs of avoiding the suboptimal strategy. The paper predicts that corporate borrowing is inversely related to the proportion of market value accounted for by real options. It also rationalizes other aspects of corporate borrowing behavior, for example the practice of matching maturities of assets and debt liabilities.
This paper presents a stock-flow consistent macroeconomic model in which financial fragility in firm and household sectors evolves endogenously through the interaction between real and financial sectors. Changes in firms' and households' financial practices produce long waves. The Hopf bifurcation theorem is applied to clarify the conditions for the existence of limit cycles, and simulations illustrate stable limit cycles. The long waves are characterized by periodic economic crises following long expansions. Short cycles, generated by the interaction between effective demand and labor market dynamics, fluctuate around the long waves.
This paper uses recent regulations that have required some companies to increase the number of outside directors on their boards to generate estimates of the effect of board independence on performance that are largely free from endogeneity problems. Our main finding is that the effectiveness of outside directors depends on the cost of acquiring information about the firm: when the cost of acquiring information is low, performance increases when outsiders are added to the board, and when the cost of information is high, performance worsens when outsiders are added to the board. The estimates provide some of the cleanest estimates to date that board independence matters, and the finding that board effectiveness depends on information cost supports a nascent theoretical literature emphasizing information asymmetry. We also find that firms compose their boards as if they understand that outsider effectiveness varies with information costs.
Economists have long been concerned with the incentive problems that arise when decision making in a firm is the province of managers who are not the firm's security holders. One outcome has been the development of “behavioral” and “managerial” theories of the firm which reject the classical model of an entrepreneur, or owner-manager, who single-mindedly operates the firm to maximize profits, in favor of theories that focus more on the motivations of a manager who controls but does not own and who has little resemblance to the classical “economic man.” Examples of this approach are Baumol (1959), Simon (1959), Cyert and March (1963), and Williamson (1964b). More recently the literature has moved toward theories that reject the classical model of the firm but assume classical forms of economic behavior on the part of agents within the firm. The firm is viewed as a set of contracts among factors of production, with each factor motivated by its self-interest. Because of its emphasis on the importance of rights in the organization established by contracts, this literature is characterized under the rubric “property rights.” Alchian and Demsetz (1972) and Jensen and Meckling (1976b) are the best examples. The antecedents of their work are in Coase (1937, 1960). The striking insight of Alchian and Demsetz (1972) and Jensen and Meckling (1976b) is in viewing the firm as a set of contracts among factors of production.
This article addresses the following basic capital budgeting problem: suppose that cross-sectional differences in stock returns can be predicted based on variables other than beta (e.g., book-to-market) and that this predictability reflects market irrationality rather than compensation for fundamental risk. In this setting, how should companies determine hurdle rates? The author shows how factors such as managerial time horizons and financial constraints affect the optimal hurdle rate. Under some circumstances, beta can be useful as a capital budgeting tool, even if it is of no use in predicting stock returns. Copyright 1996 by University of Chicago Press.
This paper develops a model of inefficient managerial behavior in the face of a rational stock market In an effort to mislead
the market about their firms' worth, managers forsake good investments so as to boost current earnings. In equilibrium the
market is efficient and is not fooled: it correctly conjectures that there will be earnings inflation, and adjusts for this
in making inferences. Nonetheless, managers, who take the market's conjectures as fixed, continue to behave myopically. The
model is useful in assessing evidence that has been presented in che “myopia” debate. It also yields some novel implications
regarding firm structure and the limits of intergation.
We identify factors that lead to changes among corporate directors. We hypothesize that the CEO succession process and firm performance will affect board composition. Our findings are consistent with both hypotheses. When their CEO nears retirement, firms tend to add inside directors (who may be possible candidates to be the next CEO) Just after a CEO change, inside directors with short tenures appear more likely to leave the board (they, perhaps, being the losing candidates). We also find that inside directors are more likely to leave the board and outside directors more likely to join after a firm performs poorly and when a firm leaves a product market.
This article presents a model of optimal control of corporate boards of directors. We determine when one would expect inside
versus outside directors to control the board, when the controlling party will delegate decision-making to the other party, the
extent of communication between the parties, and the number of outside directors. We show that shareholders can sometimes
be better off with an insider-controlled board. We derive endogenous relationships among profits, board control, and the number
of outside directors that call into question the usual interpretation of some documented empirical regularities. (JEL G34)
This paper investigates the sources of the correlation between corporate cash flow and investment by undertaking an in-depth analysis of the 49 low-dividend firms identified by Fazzari, Hubbard, and Petersen (1988) as having an unusually high investment-cash flow sensitivity. We find that in only 15% of firm-years is there some question as to a firm's ability to access internal or external funds to increase investment. Strikingly, those firms that appear less financially constrained exhibit a significantly greater investment- cash flow sensitivity than firms that appear more financially constrained. We find this pattern for the entire sample period, for sub-periods, and for individual years. The results indicate that a higher sensitivity cannot be interpreted as evidence that a firm is more financially constrained. We discuss reasons and provide evidence why the opposite may be true. These findings challenge much of the existing evidence on the effects of financial constraints.
We argue that the root cause behind the recent corporate scandals associated with CEO pay is the technology bubble of the latter half of the 1990s. Far from rejecting the optimal incentive contracting theory of executive compensation, the recent evidence on executive pay can be reconciled with classical agency theory once one expands the framework to allow for speculative stock markets.
In the 1980s, the average first-day return on initial public offerings (IPOs) was 7%. The average first-day return doubled to almost 15% during 1990-1998, before jumping to 65% during the internet bubble years of 1999-2000 and then reverting to 12% during 2001-2003. We attribute much of the higher underpricing during the bubble period to a changing issuer objective function. We argue that in the later periods there was less focus on maximizing IPO proceeds due to an increased emphasis on research coverage. Furthermore, allocations of hot IPOs to the personal brokerage accounts of issuing firm executives created an incentive to seek rather than avoid underwriters with a reputation for severe underpricing.
Myers and Majluf (1984) argue that informational asymmetry between managers and investors can explain the negative stock returns around the announcement of new equity. Using analyst following and consensus as proxies for information asymmetry, we observe that announcement period returns are significantly more negative for firms followed by fewer analysts and whose forecasts exhibit less consensus. Our findings hold after controlling for firm size and growth opportunities. Finally, we find evidence suggesting that analyst activity also influences firms’ long-term performance. We conclude that the information role of security analysts partially explains the negative stock returns surrounding the announcement of new equity.
We analyze tests for long-run abnormal returns and document that two approaches yield well-specified test statistics in random samples. The first uses a traditional event study framework and buy-and-hold abnormal returns calculated using carefully constructed reference portfolios. Inference is based on either a skewness-adjusted "t"-statistic or the empirically generated distribution of long-run abnormal returns. The second approach is based on calculation of mean monthly abnormal returns using calendar-time portfolios and a time-series "t"-statistic. Though both approaches perform well in random samples, misspecification in nonrandom samples is pervasive. Thus, analysis of long-run abnormal returns is treacherous. Copyright The American Finance Association 1999.
This paper analyzes the effect of corporate debt offerings on stock prices. Straight debt offerings have non-positive price effects, while convertible debt offerings have significantly negative effects. Public utility mortgage (non-convertible) bond offerings have marginally negative effects, and the effect is significantly negative when the proceeds are used to finance the utility's investment program. Cross-sectional regressions reveal no relation between offer-induced price effects and offering size, rating, post-offer changes in abnormal earnings or debt-related tax shields. The evidence is inconsistent with theories predicting that the price effects of capital structure changes go in the direction of the leverage change.
Previous work shows that average returns on common stocks are related to firm characteristics like size, earnings/price, cash flow/price, book-to-market equity, past sales growth, long-term past return, and short-term past return. Because these patterns in average returns apparently are not explained by the capital asset pricing model, (CAPM), they are called anomalies. The authors find that, except for the continuation of short-term returns, the anomalies largely disappear in a three-factor model. Their results are consistent with rational intertemporal CAPM or arbitrage pricing theory asset pricing but the authors also consider irrational pricing and data problems as possible explanations. Copyright 1996 by American Finance Association.
This paper examines the returns earned by subscribing to initial public offerings of equity. K. Rock (1986) suggests that initial public offerings of equity returns are required by uninformed investors as compensation for the risk of trading against superior information. The authors show that initial public offerings of equity with more informed investor capital require higher returns. The marketing underwriter's reputation reveals the expected level of "informed" activity. Prestigious underwriters are associated with lower risk offerings. With less risk there is less incentive to acquire information and fewer informed investors. Consequently, prestigious underwriters are associated with initial public offerings of equity that have lower returns. Copyright 1990 by American Finance Association.
This paper provides a review of the empirical earnings management literature. In particular, it presents a review of the factors that induce and constrain earnings management through accounting decisions. The consequences of actual or assumed earnings management are also discussed. The far majority of the literature focuses on the Anglo-Saxon context. However, major differences exist between Anglo-Saxon and continental European countries. This may result in differences in the importance of various incentives of and constraints on earnings management. In particular, we argue that explicit contracts and a firm's relations with capital markets may be less important sources of earnings management in continental Europe. Implicit contracts and the political and regulatory process may however be of major importance. We question further whether a firm's ownership and internal governance structure and the quality of the external auditor can constrain the ability to manage earnings in continental European countries.
We investigate the robustness of the long-term underperformance of initial public offering (IPO) and seasoned equity offering (SEO) firms from 1975-1992. The conclusion that issuer underperformance is unique is questioned by our results. We find that underperformance is largely concentrated in the smallest issuing firms. IPO firms perform similarly to nonissuing firms matched on the basis of firm size and book-to-market ratios. SEO firm returns can be priced by four factor regression models indicating common covariation in SEO returns with nonissuing firms. Furthermore, SEO underperformance disappears for issuances beyond the first SEO. We find that the results are robust to purging benchmarks and factor returns of IPO and SEO firms.
Recent studies argue that the spread-adjusted Taylor rule (STR), which includes a response to the credit spread, replicates monetary policy in the United State. We show (1) STR is a theoretically optimal monetary policy under heterogeneous loan interest rate contracts in both discretionay and commitment monetary policies, (2) however, the optimal response to the credit spread is ambiguous given the financial market structure in theoretically derived STR, and (3) there, a commitment policy is effective in narrowing the credit spread when the central bank hits the zero lower bound constraint of the policy rate.
This paper considers a firm that must issue common stock to raise cash to undertake a valuable investment opportunity. Management is assumed to know more about the firm's value than potential investors. Investors interpret the firm's actions rationally. An equilibrium model of the issue-invest decision is developed under these assumptions. The model shows that firms may refuse to issue stock, and therefore may pass up valuable investment opportunities. The model suggests explanations for several aspects of corporate financing behavior, including the tendency to rely on internal sources of funds, and to prefer debt to equity if external financing is required. Extensions and applications of the model are discussed.
We present a multiperiod agency model of stock-based executive compensation in a speculative stock market, where investors
have heterogeneous beliefs and stock prices may deviate from underlying fundamentals and include a speculative option component.
This component arises from the option to sell the stock in the future to potentially overoptimistic investors. We show that
optimal compensation contracts may emphasize short-term stock performance, at the expense of long-run fundamental value, as
an incentive to induce managers to pursue actions which increase the speculative component in the stock price. Our model provides
a different perspective on the recent corporate crisis than the “rent extraction view” of executive compensation.
Using a sample free of survivor bias, the author demonstrates that common factors in stock returns and investment expenses almost completely explain persistence in equity mutual funds' mean and risk-adjusted returns. Darryll Hendricks, Jayendu Patel, and Richard Zeckhauser's (1993) 'hot hands' result is mostly driven by the one-year momentum effect of Narasimham Jegadeesh and Sheridan Titman (1993), but individual funds do not earn higher returns from following the momentum strategy in stocks. The only significant persistence not explained is concentrated in strong underperformance by the worst-return mutual funds. The results do not support the existence of skilled or informed mutual fund portfolio managers. Copyright 1997 by American Finance Association.
This paper presents an information-theoretic, infinite-horizon model of the equity issue decision. The model predicts that equity issues on average are preceded by an abnormal positive return on the stock, although for some firms the issue is preceded by a loss; equity issues on average are preceded by an abnormal rise in the market; and the stock price drops at the announcement of an issue. The model provides a measure of the welfare cost of asymmetric information; the welfare loss may be small even if the price drop at issue announcement is large. Copyright 1990 by American Finance Association.
I modify the uniform-price auction rules in allowing the seller to ration bidders. This allows me to provide a strategic foundation for underpricing when the seller has an interest in ownership dispersion. Moreover, many of the so-called "collusive-seeming" equilibria disappear.