Simi Kedia

Explaining the Diversification Discount

Diversified firms trade at a discount relative to similar single-segment firms. We argue in this paper that this observed discount is not per se evidence that diversification destroys value. Firms choose to diversify. Firm characteristics, which make firms diversify might also cause them to be discounted. Not taking into account these firm characteristics might wrongly attribute the observed discount to diversification. Data from the Compustat Industry Segment File from 1978 to 1996 are used to select a sample of single segment and diversifying firms. We use three alternative econometric techniques to control for the endogeneity of the diversification decision. All three methods suggest the presence of self-selection in the decision to diversify and a negative correlation between firms choice to diversify and firm value. The diversification discount always drops, and sometimes turns into a premium, when we control for the endogeneity of the diversification decision. We do a similar analysis in a sample of refocusing firms. Again, some evidence of self-selection by firms exists and we now find a positive correlation between firms choice to refocus and firm value. These results consistently suggest the importance of taking the endogeneity of the diversification status into account, in analyzing its effects on firm value.

Foreign Currency–Denominated Debt: An Empirical Examination*

We examine the determinants of debt issuance in 10 major currencies by large U.S. firms. Using the fraction of foreign subsidiaries and tests exploiting the disaggregated nature of our data, we find strong evidence that firms issue foreign currency debt to hedge their exposure both at the aggregate and the individual currency levels. We also find some evidence that firms choose currencies in which information asymmetry between domestic and foreign investors is low. We find no evidence that tax arbitrage, liquidity of underlying debt markets, or legal regimes influence the decision to issue debt in foreign currency.

The Revolving Door and the SEC's Enforcement Outcomes: Initial Evidence from Civil Litigation

We provide empirical evidence on the consequences of revolving door phenomenon at the SEC. If future job opportunities make SEC lawyers increase their enforcement effort to showcase their expertise, then the revolving door phenomenon will promote more enthusiastic regulatory effort (the “human capital” hypothesis). In contrast, SEC lawyers can relax enforcement efforts in order to curry favor with prospective employers in the private sector (the “rent seeking” hypothesis”). We collect data on the career paths of 336 SEC lawyers that span 284 SEC enforcement actions against fraudulent financial reporting over the period 1990-2007. We find evidence consistent with the “human capital” hypothesis. Specifically, enforcement efforts, proxied by the fraction of losses collected as damages, the likelihood of criminal proceedings and the likelihood of naming the CEO as a defendant, are higher when the SEC lawyer leaves to join law firms that defend clients charged by the SEC. Our evidence does not support popular concerns that revolving doors undermine the SEC’s enforcement efforts. We would like to thank Jonathan Karpoff, Scott Lee and Gerald Martin for graciously sharing their SEC enforcement data. We thank the seminar participants at Fordham University for their comments. We are grateful for financial support from the Foster School of Business, Nanyang Business School, Goizueta Business School and the Whitcomb Center at Rutgers Business School. Does the Revolving Door Affect the SEC’s Enforcement Outcomes? “At a minimum, the revolving door has undermined the integrity of the SEC’s oversight on numerous occasions, and the SEC isn’t policing as aggressively as it should,” said Nick Schwellenbach, POGO’s director of investigations. 1.0 Introduction In this paper, we examine whether revolving doors are associated with compromised regulatory oversight by the SEC. In particular, we investigate whether regulatory enforcement is influenced by the future job prospects of SEC lawyers. It is commonly recognized that there exist revolving doors connecting government regulatory agencies with the firms that they regulate. These revolving doors lead to both the SEC hiring officials from firms that they regulate, as well as, SEC officials leaving to work for firms that are regulated. For instance, Peter H. Bresnan, a former Deputy Director in the SEC’s Division of Enforcement, resigned in December 2007 and joined the law firm of Simpson Thacher & Bartlett LLP. In November 2009, Mr. Bresnan filed a statement advising the SEC that he had been “retained to represent a client [name redacted (b)(7)(C)] in connection with SEC v. Bank of America Corp. (09-Civ-6892 (JSR)) (S.D.N.Y.).” An example of reverse revolving doors relates to the hiring of Robert S. Khuzami, the SEC’s director of enforcement, who was previously the general counsel of Deutsche Bank. Revolving doors are common as the SEC needs industry specific expertise to monitor and regulate its constituents effectively and regulated firms need experience and knowledge of complex regulations to minimize their cost of compliance. However, revolving doors are a problem if prior experience in industry makes SEC personnel unduly sympathetic to the industry’s interests or if the prospect of future employment makes ex-SEC personnel go easier on violations by regulated firms. The media, members of Congress, academics, former employees of the SEC and investors have all raised questions about the impact of the revolving door on the SEC’s efficacy and independence. Despite the inherent importance of the SEC’s SEC Staff’s ‘revolving door’ prompts concerns about agency’s independence” by David S. Hilzenrath. Published May 13, 2011. Available at http://www.washingtonpost.com/business/economy/sec-staffs-revolving-door-prompts-concernsabout-agencys-independence/2011/05/12/AF9F0f1G_story.html 2 The case charged Bank of America with “misleading investors about billions of dollars in bonuses that were being paid to Merrill Lynch & Co. executives at the time of its

Evidence on Contagion in Earnings Management

50 billion acquisition of the firm.” See the 2011 report by the Project on Government Oversight (POGO). 1 revolving door phenomenon, there is surprisingly little systematic evidence on the matter. Our paper attempts to provide such evidence. Crucial to whether revolving doors enhance or compromise regulatory effort is why the regulator is being hired by industry. If the regulator is being hired for his knowledge of the complex regulatory environment and his technical expertise, he will have an incentive to invest in his human capital to increase his future prospects in the regulated industry. Such increased investment in human capital will have a positive effect on the regulators’ performance in office (Che 1995). A similar positive effect on regulatory oversight may also arise if SEC personnel aggressively monitor constituents to signal their competence to their prospective employers in industry. In contrast, if the SEC employee is being hired for his ability to lobby decision makers at the agency, the presence of revolving doors is likely to undermine enforcement. 3 In this paper, we investigate the influence of future job opportunities of SEC employees on the SEC’s regulatory effort. In particular, we examine whether SEC employees invest in human capital that is reflected in aggressive monitoring while at the SEC to improve their future job opportunities (labeled the “human capital” hypothesis). Alternatively, the SEC employee could relax oversight of firms to increase his chance of getting a lucrative future job with potential future employers (labeled the “rent-seeking” hypothesis). We test these hypotheses by hand-collecting data on the career profiles of a sample of lawyers involved with SEC enforcement. For each lawyer that prosecuted on behalf of the SEC, we collect data on whether he left the SEC and if so the name of his future employer. The “rent-seeking” hypothesis implies that lawyers that leave the SEC to work in a private law firm, also referred to as “revolvers,” are associated with lenient or lax enforcement while at the SEC. In contrast, the “human-capital” hypothesis implies that “revolvers” will be associated with aggressive enforcement efforts while at the SEC. 3 The SEC seeks to control such potential conflict of interest via post-employment restrictions. These restrictions bar former employees from (i) appearing before the SEC; or (ii) assisting others in appearing before the SEC on matters in which they participated personally and substantially while they were at the Commission. The SEC also requires former employees to file statements when they expect to appear before the agency on behalf of outside parties for two years after leaving. The Project on Government Oversight (POGO 2011) reports that between 2006 and 2010, 219 former SEC employees filed 789 statements with the SEC declaring their intent to represent outside clients before the Commission.

The Effect of CEO’s Risk-Taking Incentives on Relationship-Specific Investments by Customers and Suppliers

In this paper, we examine the importance of contagion in earnings management, proxied by 2,376 earnings restatements announced during the years 1997-2008. Controlling for industry and firm-level characteristics, we find that firms are more likely to begin managing earnings after the public announcement of a restatement by another firm in their industry or in their geographical neighborhood. Such contagion in earnings management is absent when the restating firm is subject to SEC enforcement or a class action lawsuit, pointing to the deterrent effects of enforcement activity. Contagion among peers is observed in the same account as the one restated by the target firm. Moreover, contagion is more likely to occur when (i) larger and hence more visible target firms restate; or (ii) when the target firm’s restatement is less severe; (iii) when the target firm’s restatement is prominently disclosed via a press release. Contagion in earnings management stops during the years 2003-2005, possibly due to the rigorous enforcement associated with developments surrounding the Sarbanes-Oxley (SOX) Act. However, it reappears in the 2006-2008 period presumably because the sting of SOX related enforcement has worn off. Our results are unlikely to be attributable to (i) industry wide payoffs to earnings management; or (ii) mechanical time trends in earnings management. Our findings suggest that a peer firm’s decision to manage earnings is not made in isolation. Rather, the decision seems to incorporate the nature of the restatement, the target firm announcing the restatement and the reaction of the regulators and litigators to the target firm’s announcement.

Local Market Makers, Liquidity and Market Quality

A firm’s customers and suppliers make relationship-specific investments (RSI) whose value reduces if the firm undertakes risky investments. We hypothesize that the risk-taking incentives in the firm CEO’s compensation will lower the RSI by firms up and down in the vertical channel. We provide significant evidence that customer/supplier RSI declines with the risk-taking incentives of the firm’s CEO. Moreover, we find that RSI is more sensitive to the CEO’s risk-taking incentives when they are more likely to increase the firm’s cash flow volatility. Our findings are robust to correcting for endogeneity and several measures for RSI and risk taking.

The SEC's Enforcement Record against Auditors

We examine the role of geographically proximate (local) market makers in providing liquidity and improving the quality of a dealer market. Firms with active participation of local dealers enjoy lower quoted and effective spreads, as well as more informative prices. The beneficial effects from local market makers are not confined to a few “top” local dealers and they cannot be attributed to their participation in the firms IPO syndicate or industry specialization. Further, we find that days with aggressive bidding from local market makers relative to their non-local counterparts are associated with significant positive abnormal returns, consistent with local market makers possessing information advantages. In summary, our results suggest that the information advantages of local market makers may be a contributing factor to the reduction in the cost of trading.

Corporate Philanthropy, Employees and Misconduct

We investigate the effectiveness of regulatory oversight exercised by the SEC against auditors over the years 1996-2009. The evidence suggests that the SEC is significantly less likely to name a Big N auditor as a defendant, after controlling for both the severity of the violation and for the characteristics of companies more likely to be audited by Big N auditors. Further, when the SEC does charge Big N auditors, the SEC (i) is less likely to impose harsher penalties on the Big N; and (ii) is less likely to name a Big N audit firm relative to individual Big N partners. Moreover, the SEC relies overwhelmingly on administrative proceedings, instead of the tougher civil proceedings, against auditors. One interpretation of these patterns is that the SEC’s enforcement against auditors is relatively mild. Other interpretations of these results are also discussed. Though private litigation against auditors is associated with a loss of market share for the auditor, there is no evidence of such product market penalty subsequent to SEC action.

The Impact of Performance-based Compensation on Misreporting

Corporate charitable programs help attract and retain socially aware employees and directors. As these employees and directors are likely to be conscious of the social harm caused by corporate misconduct, they are less likely to tolerate wrongdoing. Consistent with this notion, we document that employees at philanthropic firms are more likely to whistle blow when they observe wrongdoing. Moreover, directors at giving firms are more likely to force out a CEO after misconduct is revealed. The higher likelihood of whistle blowing along with greater penalties upon discovery should lower the propensity to engage in misconduct. In line with this, we find that corporate philanthropy is associated with less misconduct. To address the endogeneity of corporate giving, we instrument it by peer giving, with qualitatively similar results. The results are robust to differing approaches for defining misconduct and employer attractiveness, and also in different subsamples of the data. Our findings highlight the role of non-financial imperatives of employees and directors in mitigating misconduct.