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The Financial Implications of Corporate Fraud

The Financial Implications of Corporate Fraud. Chen Lin Chinese University of Hong Kong Frank M. Song University of Hong Kong Zengyuan Sun University of Hong Kong. Motivation. Corporate fraud is a problematic issue around the world Prevalence Seriousness

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The Financial Implications of Corporate Fraud

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  1. The Financial Implications of Corporate Fraud Chen Lin Chinese University of Hong Kong Frank M. Song University of Hong Kong Zengyuan Sun University of Hong Kong

  2. Motivation • Corporate fraud is a problematic issue around the world • Prevalence • Seriousness • Corporate fraud: misconduct behavior of firms or managers, which results in material value loss to shareholders, or relevant stakeholders (like creditors, customers, suppliers, and so on), and therefore leads to legal enforcement in shareholder class action lawsuit (Dyck, Morse, and Zingales, 2010)

  3. Motivation • Value Implications • Firms and managers’ suffering (Feroz, Park, and Pastena, 1991; DuCharme, Malatesta, and Sefcik, 2004; Karpoff, Lee, and Martin, 2008a; Karpoff, Lee, and Martin, 2008b) • Much less clear on whether and how corporate fraud affects firm’s financing costs, decisions and polices. • Fill the gap by investigating the effect of corporate fraud on cost of debt financing and corporate cash holding policies. • the most important external and internal financing

  4. Motivation • Fraud damages the ability to raise additional fund • Reputation damage: Klein and Leffler (1981) and Jarrel and Peltzman (1985) • Information asymmetry: Kreps and Wilson (1982) and Milgrom and Roberts (1982) • Might force the firms to pass up future valuable positive NPV projects • To keep the liquidity and avoid the underinvestment issues, fraudulent firms might rely more on internal sources of fund in terms of cash holdings accumulation to finance future valuable investments

  5. Motivation • Fraudulent firms will accumulate more cash and the value of cash increases • If the external finance does become more costly after corporate fraud, fraudulent firms are expected to become financially more constrained and as a consequence, accumulate more cash out of cash flow (Almeida, Campello, and Weisbach, 2004) • Corporate fraud results in a higher degree of cash flow sensitivity of cash. • Despite the theoretical appeal, to our knowledge, we are among the first to directly investigate the interactions between costly external finance and corporate cash holdings in the framework of corporate fraud.

  6. Literature & Hypothesis • Possible channels: Adjustment and Reputation (Karpoff, Lee, and Martin, 2008a; Graham, Li, and Qiu, 2008) • Adjustment: Readjust upward fraudulent firms’ credit risk (transitory) • Reputation: two meanings (the main channel) • Increases information asymmetry perceived by outsiders • damages firms’ reputation in terms of changes of terms of trade • Hypothesis: Corporate fraud results in increase of cost of debt

  7. Literature & Hypothesis • Interaction with governance • Since corporate fraud results in information asymmetry issue, the outsiders may impose more agency cost if the shareholder right is weak and therefore can not provide sufficient monitoring for fraud issue • Agrawal, Jaffe, and Karpoff (1999); Farber (2005) • Hypothesis: the costly external finance resulted by corporate fraud is more severe in weak governance firms

  8. Literature & Hypothesis • Precautionary motive argument • Firms retain cash holdings to better cope with adverse shocks when getting access to capital market is costly (Bates, Kahle, and Stulz, 2009) • Firms with greater information asymmetry with outsiders tend to hold more cash (Opler, Pinkowitz, Stulz, and Williamson, 1999) • Marginal value of cash increases for firms facing financing frictions because the internal funds enable firms to invest in valuable investments projects which might forgo due to costly external finance (Faulkender and Wang, 2006) • Almeida, Campello, and Weisbach (2004) model the precautionary demand of cash and empirically show that financial constrained firms tend to save cash out of cash flow, while unstrained firms do not • Hypothesis: Fraudulent firms accumulate more cash and value of cash increases associated with corporate fraud based on the precautionary motive argument • Hypothesis: Fraudulent firms display positive cash flow sensitivity of cash after corporate fraud

  9. Literature & Hypothesis • Interaction effects: • further check the causal effect of costly external finance on cash holdings • Costly external finance increases more shock for firms in great need for capital • Cash concerns should be more pronounced in industries more dependent on external finance (Rajan and Zingales, 1998) • Cash concerns should be more pronounced for firms in weak governance • Hypothesis: Based on the precautionary hypothesis, the effect of corporate fraud on cash, value of cash, and cash flow sensitivity of cash should be more pronounced in weak governance firms and in industries in great need of capital

  10. Findings • Corporate fraud significantly increases the external financing cost (costly and restrictive external financing) • The effect of corporate fraud on cost of debt is more pronounced in weak governance firms • Consistent with the precautionary motive argument, fraudulent firms retain more cash and value of cash significantly increases after corporate fraud • Corporate fraud contribute to financial constrains as finding that fraudulent firms save more cash out of cash flow • The effect on cash, value of cash, and cash flow sensitivity of cash is more pronounced in weak governance firms and firms in great need of capital

  11. Contributions • Add to the corporate fraud literature (Karpoff, Lee, and Martin, 2008a, b; Karpoff and Lou, 2010; Dyck, Morse and Zingales, 2010; Wang, Winton and Yu, 2010) by showing that corporate fraud exerts significant impacts on firm’s financing costs, decisions and policies. • Contribute to the liquidity management literature (Campello, Graham, and Harvey, 2010; Campello, Giambona, Graham, and Harvey, 2011) by showing that how fraudulent firms manage internal sources of fund in response to costly external finance.

  12. Data • Corporate fraud • Stanford Securities Class Action Clearinghouse (SCAC) • Dyck, Morse, and Zingales (2010); Wang, Winton, and Yu (2010) ; Lin and Paravisini (2010) and Tian, Udell, and Yu (2011) • Others • Cost of debt, syndicate bank loan: Dealscan; Compustat; CRSP

  13. Data • Non-meritorious (frivolous) litigation problem (Choi, 2004) • Restricted to the period after the passage of the Private Securities Litigation Reform Act of 1995 (PSLRA), which aims to discourage frivolous litigation (Choi, Nelson, and Pritchard, 2009; Johnson, Kasznik, and Nelson, 2000) • Drop cases where the judicial review process leads to their dismissal • For settled ones, keep those cases where the settlement is no less than 2 million US dollars, a threshold level of payment which are used to separate meritorious ones from frivolous ones as advocated by Grundfest (1995) and Choi, Nelson, and Pritchard (2009) • We exclude the cases with the nature of IPO allocation, mutual fund timing, and analyst malpractices

  14. Data • Post fraud indicator • Commonly use the filing date in the misconduct dataset (e.g. Graham, Li, and Qiu, 2008) • Initial trigger date misidentification of databases (Karpoff, Koester, Lee, and Martin, 2012) • Identify the trigger date of corporate fraud from SEC filings, Factiva, and Lexis-Nexis • The date staleness issue: filing date are 117 days behind the trigger date on average

  15. Data

  16. Cost of debt • Log loan spread / Contract Strictness = f(Post fraud, Loan characteristics, Borrower characteristics, Macro variables, Industry effect, Loan purpose, Loan type, Year effect, Firm effect) (1) • Price items: Log value of loan spread • Non-price items: contract strictness (Murfin, 2012) (in appendix)

  17. Loan spread

  18. Loan spread

  19. Interaction with governance (loan spread) • Governance quality may change in response to corporate fraud (Agrawal, Jaffe, and Karpoff, 1999) and therefore result in endogenous issue • Use the E-index of Bebchuk, Cohen, and Ferrell (2009) as proxy of corporate governance quality • E-index is quite stable across time (Bebchuk, Cohen, and Ferrell, 2009) and thereby avoid the endogenous problem • Hand-checking the changes of E-index across time in our sample, among 129 fraud cases with E-index information, only 5 cases have a slightly improvement of governance around the fraud incident • firm-year observations with E-index>=4 to be 1, indicating the weak governance sub-sample, and 0 otherwise • As in Giroud and Mueller (2011), using a cutoff of E ≥ 4 ensures that the weak governance subsample contains sufficiently many observation relative to the remaining.

  20. Interaction with governance (loan spread)

  21. Interaction with governance (loan spread)

  22. Cost of debt • Costly and restrictive external financing cost evidence by finding that corporate fraud significantly increases loan spread and contract strictness • Direct evidence of firm value loss associated with corporate misconduct as in Karpoff, Lee, and Martin (2008a) • The cost of corporate fraud is more severe for firms with weak governance • Underline the importance of governance in mitigating the cost of corporate fraud (Agrawal, Jaffe, and Karpoff, 1999; Farber, 2005)

  23. Corporate cash holdings • Empirically investigate the corporate cash holdings before and after corporate fraud in panel regression • To guarantee we obtain the accurate effect, we use the quarterly data in cash holdings estimation following Duchin, Ozbas, and Sensoy (2010) rather than annual data • Firm characteristics including log firm size, market to book ratio, cash flow to asset ratio, net working capital to asset ratio, capital expenditure to asset ratio, leverage, industry cash flow risk, dividend payout dummy, R&D to sales ratio, and acquisition to asset ratio (Bates, Kahle, and Stulz (2009))

  24. Corporate cash holdings

  25. Value of Cash • To equity holders Faulkender and Wang (2006) • To firm value (Pinkowitz and Williamson (2006), Dittmar and Mahrt-Smith (2007), and Fresard and Salva (2010))

  26. Value of Cash (equity holders)

  27. Value of Cash (Firm value)

  28. Value of Cash (Firm value)

  29. Cash flow sensitivity • Almeida, Campello, and Weisbach (2004) • Dependent variable is the change of cash to asset ratio

  30. Cash flow sensitivity

  31. Interaction effects • External finance dependence • Construct the industry external finance dependence proxy following Duchin, Ozbas, and Sensoy (2010) and create the Ex. depnd. indicator based on the industry median value of our sample (Ex. depend.=1 for high dependence, 0, otherwise). • Governance • Provides us additional test to see whether our results are robust after controlling the governance factor regarding the importance of governance in cash literature (see Harford, Mansi, and Maxwell (2008) for the governance on cash; Dittmar and Mahrt-Smith (2007) for the governance on value of cash) • to avoid endogenous issue between governance and cash, we use the initial value of Eindex to construct the O. Eindexdum. as in Dittmar and Mahrt-Smith (2007) (O. Eindexdum.=1 for initial Eindex>=4, 0, otherwise)

  32. Interaction with governance (cash)

  33. Interaction with governance (value of cash)

  34. Interaction with governance (value of cash)

  35. Interaction with governance (cash flow sensitv.)

  36. Conclusions • Examine channels through which corporate fraud affects corporate values. • Corporate fraud significantly increases the external financing cost • In line with the costly and restrictive external finance, fraudulent firms retain more cash to better cope with adverse shocks • Consistent with the precautionary motive argument, shareholders and outsiders value more for an additional dollar of cash after corporate fraud • Corporate fraud contribute to financial constrains by finding that fraudulent firms save more cash out of cash flow • Further confirm by examining the interaction effect son cost of debt, cash, value of cash, and cash flow sensitivity of cash.

  37. Thanks

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