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
5 March 2009
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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?
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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
What about liars, cheats, and thieves?
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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
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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
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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
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… Leading to the Marxist problem…
That’s Groucho Marx:
“I don’t want to trade with anyone who is willing to trade with me…”
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… 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
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What keeps it all together?
Why isn’t fraud the norm in most transactions?
Small capital base(Losses and leverage)
Breakdown in trust
Poor asset quality(Bad loans, uncertain value)
Will my counterparty perform?Will my counterparty perform? Are they solvent?Are they solvent?
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The breakdown in trust – TED spread
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What large lenders charge each other minus short-term Treasury rates
What large lenders charge each other minus short-term Treasury rates
The breakdown in trust hits the real economy –commercial paper rates
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What nonfinancial firms have to pay for short term loans (e.g., to meet payroll)
What nonfinancial firms have to pay for short term loans (e.g., to meet payroll)
…Creating tremendous uncertainty(The “fear index” (VIX))
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Still extremely high todayStill extremely high today
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What keeps it all together?
Why isn’t fraud the norm in most transactions?
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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)
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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.
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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
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What keeps it all together?
1. Regulations and regulators
2. Personal ethics
3. Market forces
Repeat contracting, trust, and reputation
The focus of this talk
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Xerox’s cumulated market-adjusted returnsJanuary 1997 – December 2006
6/16/00: Xerox announces 2nd qtr 2000 earnings will not meet expectations
10/8/99: Xerox warns 3rd qtr 1999 earnings will be short of projections
7/3/00: SEC starts formal investigation
4/10-12/02: Wells Notice; SEC files civil complaint
3/26/07: SEC enforcement action concluded
1/1/97: Violation period begins
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SEC enforcement actions for financial misrepresentation, 1978-2009
Total # actions = 945
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The SEC’s enforcement process
Investigation Regulatory proceedings
ResolutionTrigger Event
Examples: Self disclosure Earnings restatement Management change Auditor change Delay in filings Shareholder lawsuits Unusual trading Whistle blower Periodic SEC review
SEC releases:-Administrative release-Litigation release-Accounting and Auditing Enforcement Release (AAER)-secondary designation
SettlementTrial outcomePunishmentLast SEC release
- Informal inquiry-Formal investigation
If warranted:-Wells Notice
Frequently, a class action lawsuit is filed
Period over which books and records are found to be in error
Enforcement Period(avg 57 months)
Violation Period(avg 27 months)
Trigger Event
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When firms are caught cooking the books:
Stock prices get hammered…
Investigation Regulatory proceedings Resolution
Down 25%
Violation Period
Trigger Event
Down 10%more
Down 14%more
Down 4%
more
Trigger event
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The cumulated losses are very large
Based on 384 firms with complete data available
Mean Median Aggregate
Cumulative Abnormal Return
‑38.06% ‑29.16%
Total Dollar Loss ($ millions) 397.24 21.49 152,539.0
Large losses
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Legal penalties (from regulations, regulators, and private lawsuits)
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The 10 largest finesFirm First Action Last Action Fine ($Mill.)
WorldCom 1 06/26/02 10/03/06 2,277.7
AIG 09/12/03 02/25/08 1,755.5
Enron 12/24/01 01/21/08 1,522.4
Tenet Healthcare 04/15/94 07/19/96 705.2
Reliant Resources 05/12/03 12/22/05 605.8
HealthSouth 03/19/03 06/28/07 548.0
Time Warner 12/15/04 07/17/06 510.0
Bristol Myers Squibb 08/04/04 08/22/05 450.0
Fannie Mae 05/23/06 04/09/07 400.0
Salomon 08/26/96 08/26/96 290.0
1. SEC fine of $2.25B satisfied by $500MM cash + $250MM stock in bankruptcy.
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But firms’ losses are much largerthan the legal penalties*
$397 million
$25 million
= Average SEC fine + class action settlement
Average loss in market
cap =
*Numbers based on 384 firms with complete data available. Comparisons are similar for larger samples with less complete data.
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Do prices simply revert to their pre-inflation levels?
(Since inflated earnings eventually must pop)
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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.
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But firms’ losses are much larger than the readjustment effect, too
$97 million
= Average readjustment
effect
Average loss in market cap = $397 million
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Firms’ losses are more than 3X the legal penalties plus readjustment effect
Average loss in market cap = $397 million
$122 million
What accounts for the discrepancy?What accounts for the discrepancy?
= Average readjustment + class action + SEC fines
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Reputation losses
… the big hammer
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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.
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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.
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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)
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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
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Price inflation during the violation period
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24Ac tua l 150 150 150 150 150 150 151 152 153 154 155 156 157 158 159 160 161 162 163 164 165 105 105 105 105Withou t inflatio n 150 150 150 150 150 150 150 150 150 150 150 150 150 150 150 150 150 150 150 150 150 150 150 150 150
Readjustment (back to $15.725b) = 23% of loss
Actual price path
}Losses due to legal penalties = 10% of loss
}
Reputation loss = 67% of loss}
Xerox’s reputation loss…
Hypothetical value without the short-term inflation from cooking the books
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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.
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Enron’s share price in 2001
16 Oct 2001: $618 million 3rd quarter loss and $1.2 billion reduction in equity
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
8 Nov 2001: restates 1997-2001 earnings from $2.7 billion to $2.1 billion
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Satyam Computer Services, Ltd. (SAY)
7 Jan 2009: Chairman B. Ramalinga Raju confesses to falsified accounting and inflated earnings
7 Jan 2009: Chairman B. Ramalinga Raju confesses to falsified accounting and inflated earnings
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Ahold’s 2003 misrepresentation
23 Feb 2003: Announced that U.S. subsidiary overstated profits by $0.5 billion
23 Feb 2003: Announced that U.S. subsidiary overstated profits by $0.5 billion
Product recalls
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Sources: Jarrell and Peltzman (JPE 1985), Rubin, Murphy, and Jarrell (Regulation 1988), Barber and Darrough (JPE 1996)
Direct cost = 23%
Frauds of private parties
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Sources: Karpoff and Lott (JLE 1993), Alexander (JLE 1999), Murphy, Shrieves, and Tibbs (JFQA 2009)
Direct cost = 7%
Airplane crashes(when airline bears some blame)
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Sources: Chalk (Econ Inq. 1986), Mitchell and Maloney (JLE 1989), Borenstein and Zimmerman (AER 1988)
Direct cost = 38%
Reputation loss = 62%
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Reputation losses also are large for:
Product tamperingMitchell (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)
Environmental violations
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Sources: Klassen and McLaughlin (Mgmt. Sci. 1996), Karpoff, Lott, and Wehrly (JLE 2005)
Reputation loss = 0%
“Third-party” violations (e.g., check-kiting, currency reporting violations)
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Sources: Alexander (JLE 1999), Murphy, Shrieves, and Tibbs (JFQA 2009)
Reputation loss = 0%
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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
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Do managers and directors pay?
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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
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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
What affects the speed of ouster?
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Do directors suffer long-term consequences?
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For outside directors of firms sued for misconduct:
Tainted directors lose ~50% of their board seats in other
firms
Particularly true for directors on the audit committee
Lost reputation is greatest when the misconduct is particularly
egregious
Well-governed firms are especially likely to kick out fraud-
affiliated directors
Source: E.M. Fich and A. Shivdasani, 2007, Financial fraud, director reputation, and
shareholder wealth, J. Fin. Econ. 86, 306-336.
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Takeaways…
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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
Exceptions:
• Monopoly
• Externality
• Distributional issues
• Cheating, opportunism
Market forces – “Reputation” – limit and control such opportunism
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Think about the total costs of misconduct
*Numbers based on 384 firms with complete data available. Comparisons are similar for larger samples with less complete data.
Legal headaches are relatively small
This is the larger part of the story
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For regulators:
Coordinate with market-based penalties
Focus energy, fines, and sanctions where reputation effects are small
E.g., environmental violations
Rely on market-based discipline where reputation effects are large E.g., financial misrepresentation
Consider interaction effects Legal penalties advertise the misconduct and boost reputation effects
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For managers: Avoid the Pinto (myopia) problem
Trust and reputation are valuable assets
… affecting all aspects of your business model
The Ford Pinto memo calculated the cost of reinforcing the rear end ($121 million) versus the potential payout to victims ($50 million).
The Ford Pinto memo calculated the cost of reinforcing the rear end ($121 million) versus the potential payout to victims ($50 million).
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