A Scandalous Raising of Capital
The development of financial markets over the past twenty years has been accompanied by significant impacts of debt and equity of the companies involved on market values. Even if the effect of financial fraud is rarely fatal, like it was in the Enron case, falsification of accounts, inaccurate communication of information relevant to the market, the manipulation of investment results in research and development and progress reports for products, if discovered, translate into legal litigation which imposes high costs for companies in the form of damages and loss of reputation.
For example, on 7 February 2007, LG Philips was sued in court with a security class action by minor shareholders, for keeping market prices artificially high in violation of antitrust regulations. This management choice allowed the company to communicate significantly higher margins to the market for over 3 years, and therefore keep share value high. When these practices were discovered, share prices crashed, creating a loss in capitalization of 1.6 billion dollars. The company has recently proposed a monetary transaction to close the lawsuit.
Academic research has begun to dedicate increased attention to this phenomenon with the objective of understanding the effects of actions taken by management and shareholders to control the system of financiers and investors. A recent study (Stefano Bonini, Department of Finance, and Diana Boraschi-Diaz, Phd School, Corporate Scandals and Capital Structure, Journal of Business Ethics, forthcoming) analyzed the effect of financial scandals on financing choices and market values of equity and debt of the companies involved. The research hypothesis mainly stated that fraud emerges long after its real beginning and that managers, anticipating the possible effects of hidden or distorted information, take advantage of this asymmetry to maximize the collection of capital to assign to multiple purposes: acquisitions, overinvestment, personal gain through the use of stock options.
The study analyzed 1,544 US companies quoted on the stock market involved in a financial scandal: identified as involvement in a security class action lawsuit by one or more classes of investors. The period of reference was from 1995 to 2008, in order to analyze the long-term effects of the financial structure of the companies involved.
The results (see figure) demonstrate that, against even fundraising over time by their competitors in the same industry sector, the companies subject to financial scandals raise an average of 30% more during the years prior to the lawsuit with highs reaching 55%. This result is surprising in light of the effects on the price of shares and the quality of debt following disclosure of the fraud. In fact, the immediate effect of price on equity is an direct decrease of 20% (cumulative abnormal return) which persists in the long-term. Similarly, the effect on debt is a degradation of an average rating of 1.1 units, but, more importantly, the loss of the investment grade status which ensures a much lower cost for raising capital. Results obtained are significant even when controlling for many factors typically associated with fundraising choices, such as size, level and tangibility of assets, profitability and risk.
These results suggest various questions on market efficiency and the effectiveness of disciplinary tools for issues of agency. If on one hand markets seem able to sanction managers' deviant behavior after the fact, fraud risk prevention tools do not seem adequate, leaving investors exposed to significant, potentially destabilizing, risk factors for choices on raising capital for companies.