Trust and Reputation Market forces and business misconduct

Trust and Reputation Market forces and business misconduct Jonathan M. Karpoff Metcalfe Professor of Finance Foster School of Business University of Washington Amsterdam Center for Law and Economics Conference To Enforce and Comply: Incentives inside Corporations and Agencies 5 March 2009

Adam Smith’s invisible hand “[Each person] generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it … he intends only his own gain, and he is in this … led by an invisible hand to promote an end which was no part of his intention… By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. ” – Adam Smith Not always? When does the pursuit of selfinterest not promote society’s interest? • Monopoly • Externality • Distributional issues • What else? (IV. ii. 6 -9, page 456 of the 1776 Glasgow Edition of Smith’s works; vol. IV, ch. 2, p. 477 of 1776 U. of Chicago Edition. ) ACLE Conference 05 Mar 09 2

What about liars, cheats, and thieves? Dennis Kozlowski, CEO of Tyco International, Ltd. – “One of the. Top 25 Managers of the Year” (Business Week magazine in 2001) – Now Prisoner 05 A 4820, in jail ACLE Conference 05 Mar 09 3

What to do? n “A more activist SEC is what’s needed. ” – The Christian Science Monitor n “It’s time to stop coddling white-collar crooks. Send them to jail. . . Enough is enough: They lie, they cheat, they steal and they’ve been getting away with it for too long. ” – Fortune magazine ACLE Conference 05 Mar 09 4

What else can we do? “The first thing we do, let's kill all the lawyers. ” – William Shakespeare, in Henry VI “…[L]et's kill all the accountants. ” – New York Daily News ACLE Conference 05 Mar 09 5

The economic problem n n Fraudulent, deceptive, and opportunistic behaviors are difficult to control n Information and contracts are costly n Contracts are incomplete n Contracts are costly to enforce Buyers demand discounts, and sellers demand premiums, for the expected amount of cheating by their counterparties ACLE Conference 05 Mar 09 6

… Leading to the Marxist problem… n That’s Groucho Marx: “I don’t want to trade with anyone who is willing to trade with me…” ACLE Conference 05 Mar 09 7

… This is the “lemons problem” n n At average terms, only lower quality sellers stay in the market. Buyers know this, and demand a higher discount. But at the higher discount, only much lower quality sellers remain… … Markets break down, as no one trusts their counterparties ACLE Conference 05 Mar 09 8

What keeps it all together? Why isn’t fraud the norm in most transactions? ACLE Conference 05 Mar 09 9

Breakdown in trust Will my counterparty perform? Are they solvent? Poor asset quality Small capital base (Bad loans, uncertain value) (Losses and leverage) ACLE Conference 05 Mar 09 10

The breakdown in trust – TED spread What large lenders charge each other minus short-term Treasury rates ACLE Conference 05 Mar 09 11

The breakdown in trust hits the real economy – commercial paper rates What nonfinancial firms have to pay for short term loans (e. g. , to meet payroll) ACLE Conference 05 Mar 09 12

…Creating tremendous uncertainty (The “fear index” (VIX)) Still extremely high today ACLE Conference 05 Mar 09 13

What keeps it all together? Why isn’t fraud the norm in most transactions? ACLE Conference 05 Mar 09 14

What keeps it all together? n Regulations? n Sarbanes-Oxley (2002) n Private Securities Litigation Reform Act (1995) n n n U. S. Sentencing Commission guidelines for organizations (1991) Securities Enforcement and Penny Stock Reform Act (1990) Foreign Corrupt Practices Act (which imposed penalties for financial misrepresentation) (1977) ACLE Conference 05 Mar 09 15

What keeps it all together? n Regulators? n n AFM, SEC, DOJ, CFTC… “European Commission proposes bodies to oversee banking risk and financial regulators” – Telegraph. co. uk, 26 February 2009 n European Systemic Risk Council n n n Chaired by the European Central Bank Pool and analyse all information for financial stability across the continent. European System of Financial Supervisors n Coordinate the work of national regulators. ACLE Conference 05 Mar 09 16

What keeps it all together? n Personal ethics? n Teaching ethics is big business n n AACSB accreditation requires ethics courses Economists have little influence in these areas n Have abandoned the topic – and the corresponding budgets – to noneconomics based disciplines ACLE Conference 05 Mar 09 17

What keeps it all together? 1. Regulations and regulators 2. Personal ethics 3. Market forces n Repeat contracting, trust, and reputation The focus of this talk ACLE Conference 05 Mar 09 18

Xerox’s cumulated market-adjusted returns January 1997 – December 2006 10/8/99: Xerox warns 3 rd qtr 1999 earnings will be short of projections 1/1/97: Violation period begins 6/16/00: Xerox announces 2 nd qtr 2000 earnings will not meet expectations 7/3/00: SEC starts formal investigation 4/10 -12/02: Wells Notice; SEC files civil complaint ACLE Conference 05 Mar 09 3/26/07: SEC enforcement action concluded 19

SEC enforcement actions for financial misrepresentation, 1978 -2009 80 70 Total # actions = 945 60 50 40 30 20 10 0 1978 1983 1988 1993 ACLE Conference 05 Mar 09 1998 2003 2008 20

The SEC’s enforcement process Trigger Event Period over which books and records are found to be in error Violation Period (avg 27 months) Trigger Event Investigation Examples: Self disclosure Earnings restatement Management change Auditor change Delay in filings Shareholder lawsuits Unusual trading Whistle blower Periodic SEC review - Informal inquiry -Formal investigation If warranted: -Wells Notice Frequently, a class action lawsuit is filed Regulatory proceedings SEC releases: -Administrative release -Litigation release -Accounting and Auditing Enforcement Release (AAER)-secondary designation Resolution Settlement Trial outcome Punishment Last SEC release Enforcement Period (avg 57 months) ACLE Conference 05 Mar 09 21

When firms are caught cooking the books: Stock prices get hammered… Trigger Event Violation Period Trigger event Down 25% Investigation Down 14% more ACLE Conference 05 Mar 09 Regulatory proceedings Down 10% more Resolution Down 4% more 22

The cumulated losses are very large Based on 384 firms with complete data available Mean Median Cumulative Abnormal Return ‑ 38. 06% ‑ 29. 16% Total Dollar Loss ($ millions) 397. 24 21. 49 Aggregate 152, 539. 0 Large losses ACLE Conference 05 Mar 09 23

Legal penalties (from regulations, regulators, and private lawsuits) ACLE Conference 05 Mar 09 24

The 10 largest fines Firm First Action Last Action Fine ($Mill. ) World. Com 1 06/26/02 10/03/06 2, 277. 7 AIG 09/12/03 02/25/08 1, 755. 5 Enron 12/24/01 01/21/08 1, 522. 4 Tenet Healthcare 04/15/94 07/19/96 705. 2 Reliant Resources 05/12/03 12/22/05 605. 8 Health. South 03/19/03 06/28/07 548. 0 Time Warner 12/15/04 07/17/06 510. 0 Bristol Myers Squibb 08/04/04 08/22/05 450. 0 Fannie Mae 05/23/06 04/09/07 400. 0 Salomon 08/26/96 290. 0 1. SEC fine of $2. 25 B satisfied by $500 MM cash + $250 MM stock in bankruptcy. ACLE Conference 05 Mar 09 25

But firms’ losses are much larger than the legal penalties* $25 million Average loss in market cap = = Average SEC fine + class action settlement $397 million *Numbers based on 384 firms with complete data available. Comparisons are similar for larger samples with less complete data. ACLE Conference 05 Mar 09 26

Do prices simply revert to their pre-inflation levels? (Since inflated earnings eventually must pop) ACLE Conference 05 Mar 09 27

Illustration of the readjustment effect: Acme Company, an all-equity firm Before cooking the books: Book value of assets Market-to-book ratio (assumed constant) Market value $100 1. 5 $150 Firm inflates asset values by $10: Book value of assets $110 Market value $165 *When the misrepresentation is discovered, the value will fall back to $150. This is the readjustment effect. ACLE Conference 05 Mar 09 28

But firms’ losses are much larger than the readjustment effect, too $97 million Average loss in market cap = $397 million = Average readjustment effect ACLE Conference 05 Mar 09 29

Firms’ losses are more than 3 X the legal penalties plus readjustment effect $122 million Average loss in market cap = $397 million = Average readjustment + class action + SEC fines What accounts for the discrepancy? ACLE Conference 05 Mar 09 30

Reputation losses … the big hammer ACLE Conference 05 Mar 09 31

Reputation: The missing link n n Reputation is the present value of the cash flows (quasi-rents) earned when you continue to hold up your end of the deal, i. e. , you perform as promised. E. g. , see Klein-Leffler JPE 1981. ACLE Conference 05 Mar 09 32

Lost reputation… n n … Is the present value of the higher costs and/or lower revenues when firms are discovered to have cheated their investors, suppliers, employees, or customers. It occurs because counterparties stop doing business with the firm, or change the terms with which they are willing to continue to do business with the firm. ACLE Conference 05 Mar 09 33

How a reputation loss shows up: n A higher cost of capital n n n Murphy, Shrieves, and Tibbs (Journal of Financial and Quantitative Analysis 2009) Lower future sales n Barber and Darrough (Journal of Political Economy 1996) n Karpoff, Lee, and Vendrzyk (Journal of Political Economy 1999) n n Graham, Li, and Qiu (Journal of Financial Economics 2008) Murphy, Shrieves, and Tibbs (Journal of Financial and Quantitative Analysis 2009) Executive turnover and leadership disruption n Desai, Hogan, and Wilkins (Accounting Review 2006) n Karpoff, Lee, and Martin (Journal of Financial Economics 2008) n Agrawal and Cooper (working paper 2008) ACLE Conference 05 Mar 09 34

Xerox’s reputation loss Market cap before the misrepresentation was discovered Less: Readjustment to uninflated value $16. 864 b $1. 139 b Fines and class 0. 523 b action amounts Lost reputation 3. 338 b Total loss when the misrepresentation was discovered Value after the misrepresentation was discovered ACLE Conference 05 Mar 09 5. 000 b $11. 864 b 35

Xerox’s reputation loss… Price inflation during the violation period } } Hypothetical value without the short-term inflation from cooking the books } Readjustment (back to $15. 725 b) = 23% of loss Losses due to legal penalties = 10% of loss Reputation loss = 67% of loss Actual price path ACLE Conference 05 Mar 09 36

Xerox’s experience is close to the norm: Fines 3% Class actions 6% Readjustment 25% Reputation loss 66% *Numbers based on 384 firms with complete data available. Comparisons are similar for larger samples with less complete data. ACLE Conference 05 Mar 09 37

Enron’s share price in 2001 90 80 16 Oct 2001: $618 million 3 rd quarter loss and $1. 2 billion reduction in equity 70 60 50 8 Nov 2001: restates 19972001 earnings from $2. 7 billion to $2. 1 billion 40 30 20 10 7 /9 12 /1 7 /9 11 /1 7 /9 10 /1 1/ 97 9/ 1/ 97 8/ 1/ 97 7/ 1/ 97 6/ 1/ 97 5/ 1/ 97 4/ 1/ 97 3/ 1/ 97 2/ 1/ 1/ 97 0 ACLE Conference 05 Mar 09 38

Satyam Computer Services, Ltd. (SAY) 7 Jan 2009: Chairman B. Ramalinga Raju confesses to falsified accounting and inflated earnings ACLE Conference 05 Mar 09 39

Ahold’s 2003 misrepresentation 23 Feb 2003: Announced that U. S. subsidiary overstated profits by $0. 5 billion ACLE Conference 05 Mar 09 40

Product recalls Direct cost = 23% Sources: Jarrell and Peltzman (JPE 1985), Rubin, Murphy, and Jarrell (Regulation 1988), Barber and Darrough (JPE 1996) ACLE Conference 05 Mar 09 41

Frauds of private parties Direct cost = 7% Sources: Karpoff and Lott (JLE 1993), Alexander (JLE 1999), Murphy, Shrieves, and Tibbs (JFQA 2009) ACLE Conference 05 Mar 09 42

Airplane crashes (when airline bears some blame) Direct cost = 38% Reputation loss = 62% Sources: Chalk (Econ Inq. 1986), Mitchell and Maloney (JLE 1989), Borenstein and Zimmerman (AER 1988) ACLE Conference 05 Mar 09 43

Reputation losses also are large for: n Product tampering Mitchell (Econ Inq. 1989), Dowdell, Govindaraj, and Jain (JFQA 1992) n Deceptive advertising Peltzman (JLE 1985), Leffler and Sauer (AER 1990) n Corporate crime Strachan, Smith, Beedles (Fin. Rev. 1983) n Salomon’s misleading Treasury-bidding practices Smith (J. Applied Corp. Finance 1992) n IPO underwriters who perform poorly Beatty, Bunsis, and Hand (JFE 1998) ACLE Conference 05 Mar 09 44

Environmental violations Reputation loss = 0% Sources: Klassen and Mc. Laughlin (Mgmt. Sci. 1996), Karpoff, Lott, and Wehrly (JLE 2005) ACLE Conference 05 Mar 09 45

“Third-party” violations (e. g. , check-kiting, currency reporting violations) Reputation loss = 0% Sources: Alexander (JLE 1999), Murphy, Shrieves, and Tibbs (JFQA 2009) ACLE Conference 05 Mar 09 46

Why is reputation important for some types of misconduct and not for others? n Product recalls, frauds n n n Environmental violations Firm has repeat business with harmed parties, or potentially harmed parties n Customers, suppliers, employees change the terms of contract to reflect the higher probability that they will be harmed n n ACLE Conference 05 Mar 09 Harmed parties do not in general do business with the firm Parties with whom the firm does business suffer little or no direct harm Customers, suppliers, employees have no incentive to change the terms of contract 47

Do managers and directors pay? ACLE Conference 05 Mar 09 48

For culpable managers… The total picture is not pretty § 92% are ousted by the final proceeding § 60% are explicitly fired § 39% debarred from serving as an officer or director § $8. 3 million in regulatory fines and disgorgement § $2–$23 million in dissipated shareholdings § 27% indicted (4% acquittal rate among the indicted) § 5. 1 year jail sentences § 3. 1 year probationary sentences 49

What affects the speed of ouster? The quality of firm governance: • • • Board independence Outside blockholders Shareholdings of non-respondent insiders Other factors: • • • The severity of the harm to shareholders Firms in development stage Firms in financial distress 50

Do directors suffer long-term consequences? ACLE Conference 05 Mar 09 51

For outside directors of firms sued for misconduct: n n Tainted directors lose ~50% of their board seats in other firms Particularly true for directors on the audit committee Lost reputation is greatest when the misconduct is particularly egregious Well-governed firms are especially likely to kick out fraudaffiliated directors Source: E. M. Fich and A. Shivdasani, 2007, Financial fraud, director reputation, and shareholder wealth, J. Fin. Econ. 86, 306 -336. ACLE Conference 05 Mar 09 52

Takeaways… ACLE Conference 05 Mar 09 53

Adam Smith’s invisible hand “[Each person] generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it … he intends only his own gain, and he is in this … led by an invisible hand to promote an end which was no part of his intention… By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. ” – Adam Smith ACLE Conference 05 Mar 09 Exceptions: • Monopoly • Externality • Distributional issues • Cheating, opportunism Market forces – “Reputation” – limit and control such opportunism

Think about the total costs of misconduct Fines 3% This is the larger part of the story Class actions 6% Legal headaches are relatively small Readjustment 25% Reputation loss 66% *Numbers based on 384 firms with complete data available. Comparisons are similar for larger samples with less complete data. ACLE Conference 05 Mar 09 55

For regulators: Coordinate with market-based penalties n Focus energy, fines, and sanctions where reputation effects are small n n Rely on market-based discipline where reputation effects are large n n E. g. , environmental violations E. g. , financial misrepresentation Consider interaction effects n Legal penalties advertise the misconduct and boost reputation effects ACLE Conference 05 Mar 09 56

For managers: Avoid the Pinto (myopia) problem n Trust and reputation are valuable assets … affecting all aspects of your business model The Ford Pinto memo calculated the cost of reinforcing the rear end ($121 million) versus the potential payout to victims ($50 million). ACLE Conference 05 Mar 09 57

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