Shane A. Johnson

Managerial Incentives and Corporate Fraud: The Sources of Incentives Matter*

Operating performance and stock return results imply that managers who commit fraud anticipate large stock price declines if they were to report truthfully, which would cause greater losses for managerial stockholdings than for options because of differences in convexity. Fraud firms have significantly greater incentives from unrestricted stockholdings than control firms do, and unrestricted stockholdings are their largest incentive source. Our results emphasize the importance of the shape and vesting status of incentive payoffs in providing incentives to commit fraud. Fraud firms also have characteristics that suggest a lower likelihood of fraud detection, which implies lower expected costs of fraud. Copyright 2009, Oxford University Press.Executives at fraud firms face greater financial incentives to commit fraud than do executives at industry- and size-matched control firms. After controlling for various firm, governance, and CEO characteristics, the likelihood of fraud is positively related to incentives from unrestricted stock holdings and is unrelated to incentives from restricted stock and unvested and vested options. Executives at fraud firms exercise larger fractions of their vested options, sell more stock, and receive greater total compensation during the fraud years than the control executives. Operating performance measures suggest executives commit corporate fraud following declines in performance. Stock prices fall approximately twenty percent on average upon the disclosure of potential fraud, which suggests that frauds inflated stock prices during the fraud period. Our results imply that optimal governance measures depend on the strength of executives’ financial incentives, especially following periods of poor performance, and that restrictions on an executive’s ability to sell shares could deter fraud. Corresponding author: Prof. Shane A. Johnson Dept. of Finance—MS 4218 Mays Business School Texas A&M University College Station, TX 77843-4218 Tel: (979) 862-3318 Email: sjohnson@mays.tamu.edu Acknowledgements: We thank Hao Li, Huihua Li, Stephen Smith, and Brooke Stanley for excellent research assistance, and Andrew Christie, Jay Hartzel, Jayant Kale, Omesh Kini, Scott Lee, Adam Lei, Kevin Murphy, Steve Smith, Bob Parrino, Jeff Pontiff, and seminar participants at the University of Arizona, Georgia State University, Notre Dame University, University of Waterloo, Queens University, McMaster University, and Drexel University for helpful comments. Johnson and Tian thank the Social Sciences and Humanity Research Council of Canada for financial support.

The Value and Incentive Effects of Nontraditional Executive Stock Option Plans

We examine the value and incentive effects of six nontraditional executive stock options: premium options,performance-vested options, repriceable options, purchased options, reload options, and indexed options. With reasonable parameter values, four options have lower value than a traditional option when granted, and large differences in value are evident across the types. Holding option value constant, five options create stronger incentives than traditional options to increase stock price, five create stronger incentives to increase risk, and three create stronger incentives to reduce dividend yield. Changing various option-specific parameters can produce large changes in incentive strengths.

Firm size and the information content of bank loan announcements

Abstract We examine share price responses to announcements of bank credit agreements for exchange listed and NASDAQ firms and test whether there are systematic differences between large and small capitalization firms. For small firms both renewals and initiations of loan agreements generate significantly positive share price effects. In contrast, for large firms there is little evidence that bank credit announcements convey information to the capital market. Our results are consistent with arguments of Fama and Diamond that it is primarily small, less prestigious firms that receive benefits from screening and monitoring services associated with bank loans.

Indexed executive stock options

We design and derive a pricing model for an executive stock option with a strike price indexed to a benchmark and investigate its valuation and incentive implications. In both up and down markets, the indexed option filters out common risks beyond the executives control, thereby increasing the efficiency of incentive contracts. The indexed option has a different payoff structure and much lower initial value than a traditional option. Incentive effects of the indexed option also differ from those of traditional options. We design an optional penalty function to reduce the payoff if executives manipulate specified model parameters such as volatility.

Buyer–Supplier Contracts Versus Joint Ventures: Determinants and Consequences of Transaction Structure

When a buyer firm and a supplier firm plan to transact, what factors drive their choice of mechanism to govern the relationship? Focusing on contract-governed versus joint venture–governed relationships, the authors present a theoretical framework that specifies the conditions that make one or the other form of relationship structure more appropriate. This study was designed to address potential limitations regarding measurement, financial consequences, and context in the extant literature. The authors employ measures derived from Standard & Poors Compustat financial database and an overall measure of firm reputation to examine empirically differences in firm characteristics across the two types of relationships. To examine the financial consequences of relationship structure, the authors use event-study techniques that tie stock price reactions to the governance mechanism choice. The results suggest that buyers and suppliers are more likely to form a joint venture (versus simple contract) when (1) the suppliers degree of asset specificity is high, (2) monitoring the suppliers behavior is difficult, and (3) the supplier has a poorer reputation. The authors find that vertical joint ventures (between buyers and suppliers) are economically similar to contracts, to the extent that abnormal wealth gains go solely to the supplier firms. Horizontal joint ventures (partners are at the same level of the value chain), however, provide bilateral, synergistic wealth gains. The results suggest that buyers and suppliers can use joint ventures to reduce certain governance problems rather than to gain synergies.

A Reexamination of Corporate Governance and Equity Prices

We reexamine long-term abnormal returns for portfolios sorted on governance characteristics. Firms with strong shareholder rights and firms with weak shareholder rights differ from the population of firms and from each other in how they cluster across industries. Using well-specified tests under this industry clustering, we find statistically zero long-term abnormal returns for portfolios sorted on governance. Our results have important implications for interpreting studies that link governance to firm value and stock returns, demonstrate the importance of the coarseness of industry definitions in financial research, and shed light on addressing statistical problems created by industry clustering in samples. The Author 2009. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org., Oxford University Press.

The Effect of Bank Debt on Optimal Capital Structure

I examine the relation between leverage and bank debt use to analyze the effects of bank screening and monitoring on capital structure. The analysis joins capital structure models in which asymmetric-information problems reduce optimal leverage with recent banking firm models in which screening and monitoring mitigate these problems. I find a positive relation between leverage and the use of bank debt, which is robust to controlling for other determinants of leverage. The relation appears to be created partly by bank debt use attenuating potential asset-substitution problems. The results imply that the choice of debt source is an important element of the capital structure decision.

The Effect of Bank Reputation on the Value of Bank Loan Agreements

I examine the effect of bank characteristics on changes in client firm value occasioned by bank loan announcements to assess the importance of commercial bank reputation. I find that valuation effects are positively related to bank deposit size and capital ratio, and inversely related to the loan loss provision ratio. The results imply that high-quality firms that need to raise external capital have an incentive to develop relationships with large, high-quality banks to avoid pooling with other bank loan customers or issuers of public securities. The results suggest that, despite regulation, the market does not view banks as a uniform set of suppliers of capital. Instead, in a manner consistent with previous empirical findings for auditing firms and investment bankers, variation among commercial banks facilitates the markets ability to differentiate among firms.

Dividend Payout and the Valuation Effects of Bond Announcements

Recent theoretical models suggest debt and dividends can serve as substitute free cash flow control or signaling devices. I examine share price responses to announcements of straight debt issues and test whether there are systematic differences between low and high dividend payout firms. Share price response is significantly positive for low growth-low dividend payout firms, and is negatively related to cross-sectional dividend payout. The results support arguments that debt and dividends are substitutes. The results also support arguments that debt provides free cash flow or signaling benefits, but suggest the benefits are significant only for firms with low levels of substitutes. I also document that low growth-low dividend payout firms enter capital markets less frequently, but find no relation between share price response and this frequency.

The valuation effects of the 1977 Community Reinvestment Act and its enforcement

Abstract We examine the wealth effects of the passage of the Community Reinvestment Act (CRA) of 1977 for commercial banks and savings and loan associations. we find significantly negative average excess returns for small NYSE/AMEX banks and SL in contrast, there is no evidence that large NYSE/AMEX institutions or NASDAQ institutions experience wealth losses. We also study the effects of individual CRA protests against institutions and find they produce significantly negative excess returns which are not reversed when the protests are resolved. Our results have implications for proposed changes to CRA and for the future consolidation of the financial services industry. The results also demonstrate the difficulties associated with studying returns from the early years of the NASDAQ market.