Advances in Financial Economics: Volume 6

In a standard security market, it is assumed that market participants are rational, capable of acquiring and utilizing information, fraudulent and opportunistic behaviors do not pay and are avoided, and transaction costs are relatively low. Furthermore, there is no group of participants who are consistent winners or losers; and collectively, no negative net present value projects are undertaken. We label a market as ‘sub standard’ if most of these conditions do not hold. Theoretically sub-standard markets are predicted to not exist at all, i.e. since even the most sophisticated institutional investors with the least transaction and information costs will not participate. This paper presents evidence of the existence of such ‘sub-standard’ security market over an extended period. Specifically, we present an in-depth analysis of twelve IPOs, underwritten by Blinder-Robinson. The IPOs were offered during a period when Blinder-Robinson was fighting unsuccessfully against NASD sanctions and SEC suspensions. The study is unique in several ways. It is the first detailed investigation of the market for the very small penny stock issues in which the per share offering prices of IPOs were at 5¢ or less and the gross IPO proceeds amount to only a few million dollars. We present evidence on the nature of the companies, the background of the executives and the board of directors and the business and financial characteristics of the IPOs. We also document the differences in the rates of return to various groups involved in the financing or management of these companies: the managers, other insiders, the underwriters and outside investors who invested before, at or after the IPOs. Finally, this study performs an original analysis of the microstructure of the penny stockbroker's operations by analyzing inside and outside bid ask quotes. In addition to broker's markups and markdowns, we have also calculated a measure of the market maker/brokerage house's incentive to its brokers to buy from or sell to their customers.

This paper estimates the determinants of the contributions made by top executives to their firm's Political Action Committee (PAC). We find that executive's personal PAC contributions (proxy for the interest of the firm) are positively related to his shareholdings, income and option holdings (proxies for the interests of the executive). Contributions are also higher for CEOs and board members. This is direct evidence that the structure of the contracts between the firm and management, especially compensation, aligns manager's personal behavior with the interests of the firm.

Due to the existence of keiretsu networks and influential bank shareholders, managerial-ownership is not viewed as important in Japan. With the recent decline in the power and influence of Japanese banks, this view might now be obsolete. We present evidence that managerial ownership has become an alternative mechanism for corporate governance in Japan. Using 1993 and 1996 data, we find that firms with significant managerial equity ownership are typically non-keiretsu firms and hold less bank debt. Further, these same manager-owned firms exhibit more control potential and make more discretionary expenditures than do other firms. Overall, our findings suggest that managerial equity ownership is a substitute governance mechanism for monitoring by banks and keiretsu.

This paper develops and empirically tests a dynamic model of dividend smoothing and signaling. Intertemporal dividend smoothing results from a “signal jamming” problem whereby the manager uses dividends not only to convey information about future cash flows but also to influence perceptions of his abilities. Any excess cash left after the dividend is paid must be carried into the future at a dissipative cost, and any cash shortfall arising from promising too high a dividend must be borrowed at a cost. Since these costs are higher for low-ability managers, high-ability managers promise a lower dividend when future cash flows are high and a higher dividend when future cash flows are low. Thus, high-ability managers not only credibly signal their type and the firm's future cash flows, but also smooth dividends more than low-ability managers. Consistent with the model, I find that firms that smooth more have higher future values, larger price appreciations to unexpected dividend increases, and smaller price declines to unexpected dividend decreases. Further, I find that high-ability managers smooth dividends more than low-ability managers.

Large negative stock-price reactions are tied to public announcements regarding informal and formal law enforcement actions taken by the Department of Justice (DOJ), Federal Trade Commission (FTC), and the Securities and Exchange Commission (SEC). Such influences appear especially large for firms with significant reputational capital and growth opportunities. These findings suggest that federal law enforcement plays an important role in monitoring management and represents a powerful corporate governance mechanism. These findings also suggest that public announcements of federal law enforcement actions constitute a flexible tool used to improve suboptimal performance in dynamic competitive environments.

Based on received financial theory, we empirically examine the role of the following firm-specific determinants of leverage: bankruptcy costs, growth, variability, non-debt tax shields, collateral value, profitability, and size. For our sample, to focus on firm-specific aspects, we purposely use pooled time-series cross-sectional data from a single industry (electric and gas utilities) for the twenty-year period, 1975–1994. Our findings largely support theory, with the important exception of variability. We find that leverage is positively related with variability, contrary to the literature. We conjecture that this seemingly perverse relationship may be due to the yet unrecognized effect of variability: firms with greater variability of earnings have a greater chance that their non-debt tax shields may prove to be inadequate, and are therefore expected to take on higher levels of leverage.

Many previous event studies have found unexpectedly large losses to firms involved in negative incidents. Many of these studies' authors explain such losses as “goodwill losses” or “reputation effects.” To test this hypothesis, we search for residual losses (in excess of direct costs) to firms involved in events that produce ill will, but do not affect the quality of the firms' final products nor break implicit labor or supply contracts. Our sample of events is 73 negative environmental events reported in the Wall Street Journal between 1970 and 1992 in which electric power companies or oil firms with listed stocks were involved. We find an overall insignificant capital market response. We interpret this as showing that firms are punished only for actions that actually harm customers or suppliers. Although others have found similar outcomes, our results enhance previous research by extending the findings to a broader range of environmental incidents over a longer time period. Further, our findings suggest that the large residual losses in other event studies may be due to reputation mechanisms (and not measurement errors or event study idiosyncrasies), when defined traditionally — only those who are (potentially) harmed incur the costs of punishment.

We assess valuation effects on creditors holding the private debt of client firms that file for Chapter 11 bankruptcy, and disaggregate the results by type of private creditor, form of bankruptcy resolution, and subsequent control bid activity. Among private creditors holding unsecured claims, losses are consistently more severe for trade creditors than for bank creditors. These losses are mitigated for cases in which petitioning firms subsequently reorganize and become targets of control bids during the Chapter 11 process. Banks holding secured claims sustain zero excess returns regardless of the type of bankruptcy resolution or subsequent control activity. Our results support the view that bank loans are effectively senior debt and that banks have a key role in continuation/liquidation decisions. Moreover, we find that control bids for firms in Chapter 11 are common and generate significant gains to equityholders of firms in Chapter 11 and to bidders, so that corporate control activity is an important element in the bankruptcy process.

This paper examines the association between board composition, ownership structure, and the shareholder wealth of bidding U.S. firms in international acquisitions. Foreign acquisitions represent major investment proposals that demand the involvement of the board in the decision-making process. Hence, the international acquisition process provides a good vehicle to examine the efficacy of the board of directors. Consistent with other studies, our results indicate that U.S. bidders experience significant negative wealth effects at the announcement of the acquisition. In addition, we find that wealth effects are significantly and positively related to board size and to share ownership by independent outside directors and inside directors. Sub-samples based on board size reveal that for small boards, share ownership by directors is significantly related to abnormal returns only for insider dominated boards. For large boards, ownership by independent outside directors is significantly related to abnormal returns only for outsider dominated boards.