Three essays in corporate governance, accounting and law
- Autores: Antonio Bernardo Vazquez Lopez
- Directores de la Tesis: María Gutiérrez Urtiaga (dir. tes.), Josep Antoni Tribó Giné (codir. tes.)
- Lectura: En la Universidad Carlos III de Madrid ( España ) en 2019
- Idioma: español
- Tribunal Calificador de la Tesis: Juan Pedro Gómez López (presid.), Beatriz Mariano (secret.), Renée Adams (voc.)
- Programa de doctorado: Programa de Doctorado en Empresa y Finanzas / Business and Finance por la Universidad Carlos III de Madrid
- Materias:
- Enlaces
- Tesis en acceso abierto en: e-Archivo
- Resumen
My dissertation contains three essays related to the areas of corporate gover-nance, accounting and law. Chapter 1 sets out to investigate the intersection of corporate governance and accounting, where we inspect the impact of a corporate governance institution (independent directors) on a measure of accounting quality (real earnings management). Moreover, Chapter 2 links with the previous chapter in that I inspect the impact of independent directors and their legal incentives on the decision whether to payout (dividends or repurchases) or to reinvest. Finally, Chapter 3 connects with the prior two in that it inspects how inside board members impact corporate performance and we derive some policy implications for regulators about inside director participation in outside boards.
In the first Chapter titled “Who is Keeping an Eye on Real Earnings Management? Focused versus Distracted Directors" (joint work with Beatriz García Osma and Cristina Grande-Herrera), we study the effect of independent directors on real earnings management. We focus on real earnings management because the literature has argued that since the adoption of the Sarbanes-Oxley Act in the early 2000's in the United States, managers have switched from managing accruals to managing firms' operations to obfuscate the earnings signal (Zang, 2012). We also focus on independent directors as the corporate governance mechanism that might be on the lookout for this type of earnings management because other classical governance institutions might not be on the lookout (auditors) or even generate the incentives to engage in real earnings management (see for instance, Irani and Oesch (2016); Burnett et al. (2012); Bushee (1998)). This relationship has been explored in the past, but results suggested that there was not a causal impact of increasing board independence on the use of earnings management (Chen et al., 2015; Armstrong et al., 2014). Normally, independent directors should be able to limit real earnings management, as they have incentives to stand up to management to protect the interests of investors (Duchin et al., 2010), and have the ability to detect and reduce accrual-based earnings management, improving firms' information environments (Klein, 2002; Peasnell et al., 2005). However, recent research questions this straightforward answer. Armstrong et al. (2014) do not find that exogenous increases in board independence lower accrual-based earnings management, while Chen et al. (2015) show greater board independence only curbs earnings management in firms that operate in rich information environments.1 This suggests that directors' effectiveness hinges critically on the ease of monitoring, casting doubts over their impact, as it is inherently difficult to monitor real actions aimed at obfuscating the earnings signal (Schipper, 1989; Graham et al., 2005). This is because these actions are well within the discretion of management, and curtailing them requires not only independence, but also high competence and e ort on the side of directors, who should possess: (1) business knowledge to identify sub-optimal decision-making; and (2) accounting practical understanding to endeavor to reverse-engineer and interpret the account-ing outcomes of those decisions. Independent directors may not excel at both, as directors appointed to monitor the accounting process may not be able to identify sub-optimal business decisions; and vice versa for directors appointed primarily to advice management, who may struggle to uncover the accounting motivation underpinning a given transaction. Recent research suggests these limitations exist, and questions if directors are able to both monitor and advice management (Faleye et al., 2011). Further, independent directors may not even consider curbing real actions as part of their duties, given the recent regulatory emphasis on the monitoring of pure accounting decisions.
To develop our predictions, we build on the recent literature that suggests monitors possess limited time and attention and must rationally allocate their effort (Alchian and Demsetz, 1972), challenging the view that all independent directors behave as efficient and diligent monitors (see for instance Yermack, 2004a; Vafeas, 2005; Magilke et al., 2009; Masulis and Mobbs, 2014, 2017). In fact, the results in Masulis and Mobbs (2014) indicate that the same director may behave differently in different boards and suggest that independent directors with multiple director-ships exert greater effort in the boards of larger firms, because these directorships provide them with relatively larger prestige and visibility. Board monitoring over real earnings management is relevant not only because of the growth of these practices in recent years and their economic impact, but also because it links directly with directors' human capital and present and future benefits. Adverse events that destroy shareholder value lead to labor market penalties and lower the likelihood of acquiring new and retaining old directorships (Fama, 1980; Fama and Jensen, 1983).
Hence, we predict that real earnings management activities are not detected and prevented unless monitoring e ort is high. To test this prediction, we split in-dependent directors into those with high incentives to monitor (focused directors, henceforth), and those with low incentives (dispersed directors). Then, we classify each firm-director pair depending on the `relative importance' of the firm for the director. Relative importance of firm i for a director j refers to the relative ranking of firm i among all the directorships in the portfolio of director j, based on market value.2 Thus, the same person (i.e., with the same skills and knowledge) may be classified as `dispersed' in one firm and as `focused' in another.3 Director-level data is then aggregated at the firm level to create board-level measures. This is consistent with the work of Masulis and Mobbs (2014) and ensures the plausible exogenous nature of the measures, which are independent to a single firm's choices, and to a single director's characteristics, as the allocation of relative importance by independent directors with multiple directorships is driven by changes in the market value of other firms in their portfolio.
Using a large sample of US firms for the period 1987 to 2016, we show that firms with a higher percentage of focused directors experiment a reduction of real earnings management. Similar results are obtained when we focus on their presence in the audit committee or in the chair position of a major committee. In our analyses, we control for the presence of independent directors with low incentives to exert e ort and monitor, i.e., dispersed directors. We make no predictions for their behavior, but our evidence suggests that these directors are, on aver-age, worse monitors than their counterparts. Overall, our main results indicate that individual incentives are important determinants of independent directors monitoring e orts. We also control for board characteristics, real earnings management determinants, and firm controls such as size, operating performance, and market-to-book, as well as for accruals-based earnings management, as increased monitoring over one type of earnings management may create incentives to man-age earnings using alternative instruments (Cohen et al., 2008; Zang, 2012).
To appease endogeneity concerns, we create and validate alternative measures of focused directors based on the percentage market value of each directorship and obtain consistent results. We also exploit the deaths of focused (dispersed) directors to gauge the impact of a departure from the board unrelated to firm choices. We find that focused directors' deaths are linked to increases in real earnings management. Moreover, we repeat our main analyses on a firm-year-director level panel with director times year fixed effects to fully account for unobservable differences among directors. Finally, regarding concerns when using residual-based measures as dependent variables (see Chen et al., 2018, for a detailed discussion), we include the first-stage factors from estimating real earnings management as controls in our main analyses to find that our results weaken but remain significant at sensible levels.
Consistent with the beneficial consequences of focused directors, we find that they are associated with better firm's information environment, as measured by greater future analyst following and trading volume, and lower future analysts' forecast error and dispersion, and volatility. This is consistent with evidence pro-vided by Sila et al. (2017), who show that focused directors improve firms' price informativeness and transparency. We also find that firms with more focused directors present a lower presence of restated earnings, thus successfully avoiding the labor market penalties of restatements (Srinivasan, 2005). More specifically, firms with more focused directors show a lower presence of restatements that lead to understatements of past earnings.
The issue of what corporate governance mechanisms may be effective in lower-ing real earnings management is relatively unexplored.4 We contribute to this area and to the recent work that questions the effectiveness of board independence in lowering earnings management (e.g., Armstrong et al., 2014; Chen et al., 2015). In doing so, we reconcile it with the extant prior research showing beneficial effects of independent directors. Our results indicate that merely increasing the number of independent directors may not yield clear effects, as independent directors possess different individual incentives to monitor. To the best of our knowledge, we are the first to analyze the relationship between board independence and earnings management considering individual directors' incentives to monitor. Thus, we also contribute to prior studies on the influence of individual incentives (e.g., Masulis and Mobbs, 2014; Jiang et al., 2016).
In the second Chapter titled “Boards of Directors' Legal Incentives and Corporate Outcomes", I investigate the impact of change in the legal incentives of boards of directors on firms' payout and investment policies. I exploit the adoption of a set of United States laws known as Non-Shareholder Constituencies Acts (NSH-CAs, hereafter) as a source of plausible exogenous variation in the legal incentives of boards of directors. These laws allow boards of directors to deviate from their fiduciary duties to shareholders in favor of other non-shareholder constituencies, i.e., creditors, employees, customers, and the community.5 I exploit this plausible source of exogenous variation to test a direct and measurable channel through which the legal incentives of the board affect corporate outcomes in the US legal setting. The estimates suggest that firms with positive payouts incorporated in a state that adopts an NSHCA exhibit an average net payout yield that is 10.8% smaller after the passage of the law.
Boards of directors are in charge of overseeing the structural and operational decisions of firms (Adams et al., 2010). According to US corporate law, boards of directors hold fiduciary duties towards the shareholders of the corporation. These fiduciary duties are the duty of loyalty and duty of care. On the one hand, the duty of loyalty states that directors should run a firm's operations in the interest of the shareholders instead of their own. On the other hand, the duty of care indicates that directors need to pay careful attention in their decision making process, i.e., directors must try to make good decisions (Black, 2001). Unfortunately, boards of directors possess a different utility function from shareholders. Shareholders are the diversified residual claimants of corporations, whereas board members could have undiversified and fixed claims on the corporation. Given this conflict of interests, the effectiveness of boards of directors critically relies on their incentives to uphold their fiduciary duties (Bebchuk and Weisbach, 2010). These incentives include remuneration, reputation and legal incentives, which have received vast attention in the corporate governance literature. First, remuneration incentives should align the interests of the board with those of the shareholders but are limited and controversial.6 Additionally, reputation incentives can work against shareholders' interests provided that board members might wish to create manager-friendly reputations if their future career outcomes depend on the man-agers' decision (Levit and Malenko, 2016). Finally, legal incentives indicate that boards of directors are expected to uphold their fiduciary duties given that their decisions could be subjected to judicial review by courts (Laux (2010), Brochet and Srinivasan (2014)).
In this paper, I focus on the legal incentives of boards of directors for two reasons. First, evidence regarding the legal incentives of boards of directors in the US setting is scarce (see for instance Grinstein and Rossi, 2015) probably because the disclosure of directors' and officers' insurance information (commonly known as D&O insurance) is not compulsory. For instance, in China and Canada, the reporting of D&O insurance premiums and coverage is mandated by the regulator, which spurred an increased number of published papers regarding the legal incentives of boards (Chen et al. (2016), Lin et al. (2011), Lin et al. (2013), Yuan et al. (2016)). The caveat is that the institutional and legal settings in China might endanger the external validity of their results, but this concern is lower in studies conducted using Canadian data. Furthermore, even if D&O insurance information was available in the US, the fact that its contract is a firm choice adds to the difficulty of identifying the causal impact of lessened legal incentives. Even Canadian studies suffer from the lack of plausible exogenous variation in D&O insurance. Second, compared to the possible heterogeneous impact of remuneration and reputation incentives on different board members, legal incentives should affect all board members the same. To circumvent both issues, I exploit the staggered adoption of NSHCAs in the US. These laws state that boards of directors may consider making their decisions in the interests of stakeholders other than shareholders, which can imply a deviation from their role as shareholders' fiduciaries. The adoption of NSHCAs can act as plausible exogenous variation in the level of the legal incentives of boards as their decisions could be shielded from judicial review.
The results show that the passage of an NSHCA leads to lower dividends, re-purchases, and total and net payout yields. Specifically, on average, adopting an NSHCA leads to a 15.5% lower total payout yield (15.1% of the net payout of capital issues) in a sample of firms with positive payout levels. Thus, NSHCAs likely have a statistically significant impact on boards' decision-making processes. These results show that NSHCAs have a positive impact on non-CAPEX and net investment. Additionally, I discuss the case of firms in settings that are subjected to high levels of shareholder litigation. The impacts of NSHCAs on shareholder remuneration and investment seem to suggest that firms subjected to high levels of litigation risk benefit more from the decreased judicial review of their decisions. Thus, I examine the impact of NSHCAs on a subset of firms that belong to industries with high levels of litigation (Kim and Skinner, 2012). These results show that the impact of NSHCAs on firms in settings that are prone to litigation is greater than that on firms in other settings in which the ex-ante litigation risk is not as high. Furthermore, I test whether NSHCAs have a larger impact on pay-out and investment levels in settings in which shareholders might have short-term investment horizons. In these settings, the conflict among shareholders, corporate officers and directors can be more acute as insiders usually possess longer investment horizons. As expected, NSHCAs have a stronger effect on investment in settings in which firms possess relatively low levels of ownership by long-term institutions as defined by Bushee (2001). Additionally, I inspect the impact of NSHCAs on firms with different levels of governance to assess whether this shift in payout and investment could respond to the increased leeway of the corporate executives that could be using the NSHCAs to extract rents from shareholders. These results suggest that the impact of the adoption of an NSHCA does not differ between firms with high and firms with low governance levels. Finally, I show that the adoption of an NSHCA leads to significantly lower (higher) levels of payout (investment) in firms that possess high growth opportunities compared to those in firms that are subjected to the statutes but do not have as many positive NPV projects to invest in.
This study contributes to the literature on the effects of boards of directors' legal incentives on payout and investment policies by identifying a clear and direct channel through which shareholders are affected. Specifically, I attempt to identify the effects of change in litigation risk on the managerial decision-making process that negatively affects payout policy and increases investment. This study provides evidence supporting the negative impact of possible excessive payouts to shareholders that could be used to improve firm value through new investment opportunities.
Finally, Chapter 3 comes from a work-in-progress project provisionally titled \CEO Overboard! Corporate Performance Consequences of CEO Participation in Other Boards" (joint work with Faiza Majid). We test whether focal firms whose CEOs sit on multiple boards can suffer decreases in performance due to transient attention-grabbing events in firms where CEOs sit as independent directors. We exploit extreme returns (positive and negative), extreme earnings and extreme volatility in firms where CEOs sit as independent directors and find that such distraction leads to an average decrease of approximately 1% of focal firms' ROA, Q, market returns and ROE. This effect is stronger for focal firms that are geo-graphically more distant to firms where CEOs sit as independent directors, which suggests that distraction is costlier in such situations. Additionally, we show that distraction is greater for CEOs that sit on the audit committee or chair a major sub-committee. Finally, we show that these distraction events also lead to lower CEO compensation and higher forced turnover. This paper contributes to the current debate on whether or not shareholders should ban managers from holding board seats in other rms.
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