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«Johan Sulaeman National University of Singapore Sheridan Titman University of Texas at Austin April 10, 2015 Abstract We find that a corrupt local ...»

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Swimming upstream:

Struggling firms in corrupt cities∗

Christopher A. Parsons

University of California at San Diego

Johan Sulaeman

National University of Singapore

Sheridan Titman

University of Texas at Austin

April 10, 2015


We find that a corrupt local environment amplifies the effects of financial distress.

Following regional spikes in financial misconduct, credit becomes both more expensive

and harder to obtain for nearby borrowers – even those not implicated themselves. This is particularly harmful for cash-constrained firms, which cut investment more sharply and lay off more workers during industry downturns. Moreover, we find that local waves of financial misconduct are a risk factor for bankruptcy.

Keywords: financial misconduct, corporate failure, bankruptcy, loan spread, security issuance, trust We especially thank Jonathan Karpoff, Allison Koester, Scott Lee, and Gerald Martin for making their ∗ data on financial misconduct available, and Justin Murfin for sharing his data on covenant strictness. All errors are ours.

Send correspondence to Christopher Parsons, Rady School of Management, University of California,

San Diego, Otterson Hall, Room 3S137 9500 Gilman Drive #0553 La Jolla, CA 92093-0553; telephone:

858-534-8782; fax: 858-534-0745. E-mail: caparsons@ucsd.edu.

1 Introduction Dallas and Minneapolis are fairly comparable cities in the central United States, each with a fast growing population, vibrant business center, and reputation for cultivating business- friendly climates. Over 100 public firms currently call the Minneapolis region home, placing it 5th in ratio to population among large U.S. cities, with Dallas-Fort Worth (7th ) close behind.

These cities, however, tend to be very different along one very important dimension. From 1970-2010, firms in the Dallas metropolitan area were over twice as likely to be prosecuted for financial misconduct as those headquartered in and around Minneapolis (2.21% versus 0.93%), a disparity peaking in the 1998-2002 time period, during which Dallas produced more cases of financial misconduct (14) than were produced in Minneapolis (10) over the entire four decades.

In this paper, we ask whether proximity to a rash of financial misconduct – like Dallas in the late 1990s – creates a unique set of challenges for resident companies. Similar to foreign investors pulling out of countries following civil unrest or nationalization (Schneider and Frey (1985)), we hypothesize that city-level waves of financial misconduct may temporarily taint an entire region, reducing financiers’ willingness to provide capital to local firms. Among those most reliant on external finance, such frictions may extend to influence real business decisions such as investment and employment, and in extreme cases, even survival.

That banks (and other providers of finance) would be wary of financial misconduct is not a new idea. For one, when a firm’s financial statements are not viewed as credible, it is difficult to estimate its ability to repay, or should it default, the value of its assets upon liquidation. Either will increase the cost of borrowing.1 A second consideration is that a history of financial misconduct reflects poorly on the ‘trustworthiness’ of the firm’s executives.2 A manager that does not respect explicit rules – think about misrepresenting 1 See Francis, LaFond, Olsson, and Schipper (2004) and Hribar and Jenkins (2004) for evidence that concerns regarding earnings quality and restatements, respectively, increase the firm’s cost of capital.

2 The theoretical contracting literature distinguishes between the concepts of trust and reputation; see Cabral (2012). Trust is typically invoked in moral hazard problems (involving hidden actions), whereas the concept of reputation arises in contexts involving adverse selection (involving hidden types). In a pure case earnings or trading on inside information – is unlikely to respect implicit agreements, which are often featured in debt financing.3 At best, a lack of trust imposes additional costs (e.g., writing more complete contracts or enforcing them), and at worst, may prevent financing altogether.

What is new, and the subject of this paper, is whether a firm’s financial misconduct imposes negative local spillovers on nearby firms not (perhaps yet) implicated themselves.

In a recent paper, Parsons, Sulaeman, and Titman (2014) find that financial misconduct occurs in distinct, regionally-concentrated waves, involving firms in a wide variety of sectors.

Regardless of the mechanism responsible for this geographic clustering – common environmental factors in the region, or peer effects between neighboring managers – these results suggest that the determinants of financial misconduct have a regional component, making it possible to predict a firm’s likelihood of committing financial misconduct by observing the behavior of its regional peers. Moreover, as we show in this paper, evidence of financial fraud in a region has a material effect on the credit worthiness of its resident firms.

In our analysis, we will pay special attention to firms with already poor prospects. The reason is that although a corrupt environment may encourage misbehavior even by healthy companies (e.g., manipulating stock prices to maximize the value of option compensation), misrepresentation by struggling firms clearly imposes higher risk to creditors. Accordingly, following a rash of financial misconduct, we expect the weakest firms in the region to bear the brunt of lenders’ skepticism.4 of the former, “trusting” the agent is equivalent to understanding her payoffs given different actions, and thereby being able to predict her actions, e.g., trigger strategies in a repeated prisoner’s dilemma. When both adverse selection and moral hazard are at work, agents can choose actions to build their reputations. This paper makes no distinction between pure trust (moral hazard) games and those where trust and reputation are mixed. What matters is that there exists regional and temporal variation in their determinants, e.g., social punishment being an especially effective deterrent in some cities compared to others.

3 See for example, Eaton and Gersovitz (1981), Gale and Hellwig (1985), Sharpe (1990), and Bharath, Dahiya, Sanders, and Srinivasan (2011) for discussions of implicit contracts in lending relationships.

4 It may also be the case that financially distressed firms have higher incentives to commit financial misconduct, and that being surrounded by similarly misbehaving peers lowers the cost of doing so (e.g., via reduced social stigma or sharing of fraud-related information or techniques). Although the literature is ambiguous regarding the relationship between a firm’s financial condition and its likelihood of engaging in financial misconduct (see Dechow, Ge, and Schrand (2010) for a review of this literature), a negative relation would further reinforce the hypothesis proposed above.

2 The source for our financial misconduct data is the hand-collected sample by Karpoff, Koester, Lee, and Martin (2013), hereafter KKLM. We describe the sample, and discuss the types of events identified as financial misconduct in Section 2.

We begin our analysis by exploring the link between regional rates of financial misconduct and the costs of syndicated bank loans in Section 3. When a region experiences a wave of financial misconduct, bank credit becomes temporarily more expensive for nearby firms. For regions in the top quartile of financial misconduct, resident firms pay, on average, about 14 basis points higher in interest costs. Consistent with our hypothesis that firms with poor prospects are most sensitive to spikes in local corruption, the effect is over twice as strong for borrowers with either low or no credit ratings (17 basis points, t = 10.01) versus those more creditworthy (8 basis points, t=2.08). Note also that because our regressions include city fixed effects (in addition to standard firm-specific controls), these estimates are identified by time-series variation in financial misconduct (i.e., local waves) within each area.

A second indication of lenders’ collective wariness is that loan covenants become stricter following a rash of local financial misconduct. As with the cost of credit, the covenant effects are stronger for firms with either low or no credit ratings, for which information and monitoring concerns are likely the most severe.

We also observe effects in the quantity of credit supplied, with firms in cities that have higher fraud rates borrowing less frequently and/or lower amounts. Though the results differ across specifications, firms above the median rate of financial misconduct are about 10-15% less likely to issue significant amounts of debt (defined as greater than 5% of total assets).

These reductions are not offset by additional equity issuance; consequently, regional waves of financial misconduct are associated with less overall inflow of external capital.

In summary, we find the following: (1) firms are less likely to obtain external financing following regional spikes in financial misconduct; (2) for those that are able to obtain financing, firms in cities that have higher fraud rates are less likely to issue debt; and (3) for those that are able to obtain loans, they face higher rates and/or stricter covenants. It is worth reiterating that when predicting these credit market effects, none of the firms we consider were prosecuted for financial misconduct themselves; rather, these are due to regional spillovers from firms (revealed to have) engaged in financial misconduct to those that have not.

The next part of the paper explores whether these elevated credit market frictions have real effects, influencing either the firm’s investment (Section 4.1) or employment (4.2) policies. As before, we focus our attention on firms with poor prospects, but now measure these using industry-wide declines in performance.5 Also, in an attempt to focus on firms most reliant on external capital markets, for which any type of credit market friction should have the largest real effects, we identify “financially constrained” firms as those in the top decile of the ‘Kaplan-Zingales’ index, as described by Lamont, Polk, and Sa´-Requejo (2001). For a these firms, we find dramatically elevated sensitivities to industry downturns. In response to a decline of at least 10% in industry-level investment, constrained firms headquartered in cities experiencing the top quartile of financial misconduct cut investment by almost twice as much compared to constrained firms in less corrupt locations.

We observe similar patterns when analyzing employment changes in response to negative industry shocks. Again focusing on firms in the top KZ-index decile, we find that constrained firms in areas ranking in the top quartile for financial misconduct reduce employment by about 50% more in downturns. Interestingly, we observe consistent effects using a different data set on city-level employment, collected by the Bureau of Labor Statistics. Following regional spikes in financial misconduct, we observe slower employment growth at the city level, even accounting for prior trends in the dependent variable. In addition to providing robustness to our earlier analysis, these latter results explicitly relate spikes in regional misconduct to local labor markets, a feat not possible using firm-level employment data from COMPUSTAT.

In our final analysis (Section 5), we consider the ultimate sequelae of local waves of 5 Traditional models of investment include firm-level variables like Tobin’s q and cash flows. This is less desirable in our setting, as the firm’s own stock price might already capitalize the negative effects of being headquartered in a region with high rates of corporate fraud.

4 financial misconduct – bankruptcies in the region. A cursory look at the data indicates a strong cross-city correlation between rates of financial misconduct and rates of corporate failure, as shown in Figure 1. The vertical-axis graphs the average bankruptcy rate for firms headquartered in each of the 20 largest cities in the U.S. from 1970-2010, and the horizontal axis plots the average rates of financial misconduct for each city over the same horizon.

The positive cross-city correlation (0.65) is clearly apparent, indicating that cities with high average rates of financial misconduct are strongly associated with high average failure rates.

Similar patterns emerge in the time-series. That is, it is not simply that cities such as Dallas have higher than average bankruptcy rates, but rather that firms headquartered in Dallas are particularly likely to fail following spikes in financial misconduct, such as 1998Moving from the 25th to 75th percentile in the regional rate of financial misconduct, or an increase of about 1.5 percentage points, increases by about 10% (0.15-0.20 percentage points) the likelihood that a resident firm will declare bankruptcy over the following year.

Thus, in addition to firm-specific variables typically employed in failure models, these results indicate that regional information on financial misconduct provides additional explanatory power.

While previous research has studied the costs, both direct (e.g., SEC penalties) and indirect (e.g., increased cost of capital), of committing financial misconduct (Karpoff, Lee, and Martin (2008)), the effect of any spillovers to nearby firms is less understood. In this respect, the most similar paper to ours is Giannetti and Wang (2014), which finds that following accounting scandals, local investors – such as those in Houston after the Enron debacle – lose faith in the stock market, reducing their exposure to equity in general. Complementing their results for retail investors, our work suggests that even highly sophisticated financial institutions can be put off by financial misconduct; moreover, as we show, firm policies and even survival are affected by these perceptions.

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