Michael L. Lemmon

Back to the Beginning: Persistence and the Cross-Section of Corporate Capital Structure

We find that the majority of variation in leverage ratios is driven by an unobserved timeinvariant effect that generates surprisingly stable capital structures: High (low) levered firms tend to remain as such for over two decades. This feature of leverage is largely unexplained by previously identified determinants, is robust to firm exit, and is present prior to the IPO, suggesting that variation in capital structures is primarily determined by factors that remain stable for long periods of time. We then show that these results have important implications for empirical analysis attempting to understand capital structure heterogeneity. Eccles School of Business, University of Utah; The Wharton School, University of Pennsylvania, and Leeds School of Business, University of Colorado. We are especially grateful for helpful comments from our referee and associate editor. We also thank Franklin Allen, Heitor Almeida, Yakov Amihud, Lincoln Berger, Alon Brav, Mark Flannery, Murray Frank, Sara Ghafurian, William Goetzmann, Vidhan Goyal, John Graham, Mark Leary, Andrew Metrick, Roni Michaely, Vinay Nair, Darius Palia, Mitchell Petersen, Rob Stambaugh, Ivo Welch, Toni Whited, Bilge Yilmaz; seminar participants at University of Arizona, Babson College, Boston College, Cornell University, Drexel University, Harvard University, University of Colorado, University of Maryland, University of Michigan, University of North Carolina, University of Pennsylvania, Queens University, the University of Western Ontario; and conference participants at the 2005 Five-Star Conference, 2005 Hong Kong University of Science and Technology Finance Symposium, 2006 NBER Corporate Finance Conference, and 2006 Western Finance Association for helpful discussions. Roberts gratefully acknowledges financial support from a Rodney L. White Grant and an NYSE Research Fellowship. A fundamental question in financial economics is: How do firms choose their capital structures? Indeed, this question is at the heart of the “capital structure puzzle” put forward by Myers (1984) in his AFA presidential address. Attempts to answer this question have generated a great deal of discussion in the finance literature. Many studies, both before and after Myers’ pronouncement, identify a number of factors that purport to explain variation in corporate capital structures. However, after decades of research, how much do we really know? More precisely, how much closer have previously identified determinants and existing empirical models moved us toward solving the capital structure puzzle? And, given this progress, how can we move still closer to ultimately providing a more complete understanding of capital structure decisions? The goal of this paper is to address these questions. Specifically, we quantify the extent to which existing determinants govern cross-sectional and time-series variation in observed capital structures by examining the evolution of corporate leverage ratios. In doing so, we are not only able to assess the progress of existing empirical work, but more importantly, we are also able to characterize what existing determinants appear to miss – the gap in our understanding of what determines heterogeneity in capital structure. Our analysis, while shedding light on several issues, also presents some new challenges to understanding how firms choose their capital structures. We begin by showing that leverage ratios exhibit two prominent features that are unexplained by previously identified determinants (e.g., size, profitability, market-tobook, industry, etc.) or changes in sample composition (e.g., firm exit). These features are illustrated in Figure 1 (see Section II), which shows the future evolution of leverage ratios for four portfolios constructed by sorting firms according to their current leverage

Ownership Structure, Corporate Governance, and Firm Value: Evidence from the East Asian Financial Crisis

We study the effect of ownership structure on firm value during the East Asian financial crisis that began in July 1997. The crisis represents a negative shock to the investment opportunities of firms in these markets that raises the incentives of controlling shareholders to expropriate minority shareholders. Moreover, the large separation between cash flow and control rights that often arise from the use of pyramidal ownership structures and cross-holdings in these markets suggests that insiders have both the incentive and the ability to engage in expropriation. Using data from over 800 firms in eight East Asian countries, we find evidence consistent with this view. Tobins Q ratios of those firms in which minority shareholders are potentially most subject to expropriation decline twelve percent more than Q ratios in other firms during the crisis period. A similar result holds for stock returns - firms in which minority shareholders are most likely to experience expropriation underperform other firms by about nine percent per year during the crisis period. Further, during the pre-crisis period we find no evidence that firms with a separation between cash flow rights and control rights exhibit performance changes different from firms with no such separation. All of these results are robust to controls for country and industry effects, as well as proxies for differences in risk across firms and the strength of the countrys legal institutions. The evidence indicates that corporate ownership structure plays an important role in determining the incentives of insiders to expropriate minority shareholders during the times of declining investment opportunities. Our results add to the literature that examines the link between ownership structure and firm performance and provide additional guidance to policymakers engaged in the ongoing debate about the proper role and design of corporate governance features and legal institutions in developing economies.

Book-to-Market Equity, Distress Risk, and Stock Returns

This paper examines the relationship between book-to-market equity, distress risk, and stock returns. Among firms with the highest distress risk as proxied by Ohlsons (1980) O-score, the difference in returns between high and low book-to-market securities is more than twice as large as that in other firms. This large return differential cannot be explained by the three-factor model or by differences in economic fundamentals. Consistent with mispricing arguments, firms with high distress risk exhibit the largest return reversals around earnings announcements, and the book-to-market effect is largest in small firms with low analyst coverage. Copyright The American Finance Association 2002.

Corporate Policies Restricting Trading By Insiders

This paper provides the first systematic examination of policies and procedures put in place by corporations to regulate trading in the stock by the firms own insiders. Over 90 percent of our sample companies have their own policy restricting trading by insiders, and nearly 80 percent have explicit blackout periods during which the company prohibits trading by its insiders. We provide detailed information on: the form of such policies; the incidence of the various types of rules and restrictions; and the monitoring and assistance activities associated with implementation of the policy. In addition, we examine the characteristics of firms that choose to self-regulate, and find that both stock return volatility and insider trading frequency are positively-related to the use of blackout periods. Our data indicate that blackout periods successfully suppress trading by insiders (both purchases and sales) and that the blackout period is associated with a slightly narrower bid-ask spread. Consistent with this small effect on the spread, we find that the profitability of trades made during allowed trading windows is only slightly higher than profitability based on trades made in prohibited blackout periods. Finally, our findings on trading around earnings announcements suggest that experiments designed to address the issues of the effectiveness of insider trading regulations and the efficiency of capital markets are likely to be more powerful if they account for the presence and effects of corporate restrictions on trading.

Breaking Up is Hard to Do? An Analysis of Termination Fee Provisions and Merger Outcomes

This paper provides large-sample evidence pertaining to the use of and wealth effects associated with provisions for termination fees in merger agreements between 1989 and 1998. The evidence suggests that target termination fee clauses are an efficient contracting device through which target managers compensate bidders for the costs associated with bid negotiation and the potential for information expropriation by third parties. While target fees truncate a normal bidding process, target shareholders gain from higher completion rates and greater negotiated takeover premiums in deals that include target termination fee clauses. Our findings regarding bidder fee provisions indicate that these clauses are used to lock-in a portion of target wealth gains in deals with higher negotiating costs and greater costs associated with bid failure. Compensation for bidder fee provisions appears to take the form of concomitant target fee provisions, and lower bid premiums.

Managerial Ownership, Incentive Contracting, and the Use of Zero-Cost Collars and Equity Swaps by Corporate Insiders

Zero-cost collars and equity swaps provide insiders with the opportunity to hedge the risk associated with their personal holdings in the companys equity. Consequently, their use has important implications for incentive-based contracting and for understanding insider trading behavior. Our analysis indicates that these transactions generally involve high-ranking insiders and effectively reduce their ownership by about 25%, on average. Given the potential of these financial instruments to substantially alter the incentive alignment between managers and shareholders, we suggest that increasing the transparency of these transactions may provide valuable information to investors.

Multimarket Trading and Liquidity: Theory and Evidence

We develop a new model of multimarket trading to explain the differences in the foreign share of trading volume of internationally cross-listed stocks. The model predicts that the trading volume of a cross-listed stock is proportionally higher on the exchange in which the cross-listed asset returns have greater correlation with returns of other assets traded on that market. We find robust empirical support for this prediction using stock return and volume data on 251 non-U.S. stocks cross-listed on major U.S. exchanges. Copyright 2007 by The American Finance Association.

Are All CEOs above Average? An Empirical Analysis of Compensation Peer Groups and Pay Design

Companies can potentially use compensation peer groups to inflate pay by choosing peers that are larger, choosing a high target pay percentile, or choosing peer firms with high pay. Although peers are largely selected based on characteristics that reflect the labor market for managerial talent, we find that peer groups are constructed in a manner that biases compensation upward, particularly in firms outside the Standard & Poors (S&P) 500. Pay increases close only about one-third of the gap between the pay of the Chief Executive Officer (CEO) and the peer group, however, suggesting that boards exercise discretion in adjusting compensation. Preliminary evidence suggests that increased disclosure has reduced the biases in peer group choice.

Inference from Streaks in Random Outcomes: Experimental Evidence on Beliefs in Regime Shifting and the Law of Small Numbers

Using data generated from laboratory experiments, we test and compare the empirical accuracy of two models that focus on judgment errors associated with processing information from random sequences. We test for regime-shifting beliefs of the type theorized in Barberis et al. (Barberis, N., A. Shleifer, R. Vishny. 1998. A model of investor sentiment. J. Financial Econom.49(3) 307--343) and for beliefs in the “law of small numbers” as modeled in Rabin (Rabin, M. 2002. Inference by believers in the law of small numbers. Quart. J. Econom.117(3) 775--816). In our experiments, we show subjects randomly generated sequences of binary outcomes and ask them to provide probability assessments of the direction of the next outcome. Inconsistent with regime-shifting beliefs, we find that subjects are not more likely to predict that the current streak will continue the longer the streak. Instead, consistent with Rabin (2002), subjects are more likely to expect a reversal following short streaks and continuation after long streaks. Results of a “test-of-fit” analysis based on structural estimation of each model also favor the model in Rabin. To provide more insight on Rabin, we use an additional experimental treatment to show that as the perception of the randomness of the outcome-generating process increases, subjects are more likely to predict reversals of current streaks.

Insider Trading in Derivative Securities: An Empirical Examination of the Use of Zero-Cost Collars and Equity Swaps by Corporate Insiders

We provide an examination of the use of zero-cost collars and equity swaps by corporate insiders to hedge the risk associated with their personal holdings in the companys equity. These financial instruments have important implications for insider trading and incentive-based contracts. Our analysis indicates that these transactions generally involve high ranking insiders (CEOs, board members and senior executives) and cover over a third of their equity holdings. We also find that insiders appear to initiate hedging transactions immediately following large price runups, prior to increases in stock price volatility, and prior to poor earnings announcements. In addition, abnormal returns following insider hedging activities are more negative than those associated with ordinary insider sales. Overall, the evidence indicates that executives can use these hedging instruments to significantly alter their effective ownership positions in the firm.