Corporate Misconduct

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2. Literature Review

Because company wrongdoings can be costly and harmful to its reputation, which may also impose real effects on firm’s cash flow. The payments of fine, restitution and legal fares following the prosecutions and convictions alone can be pecuniarily costly for the firm as well. Moreover, being involved in an allegation could also induce a decrease in the present value of the firm’s cash flows if investors, customers and suppliers change the terms of trade based on a firm’s misconduct. As it is addressed in some of related research (Karpoff et al., 1993, 2005, 2014), some costs or negative effect to the criminal firm, by which legal penalties can hardly explain, are considered as reputational loss.

Most of related studies focus the effect of the criminal act on equity market; however, taking potential effects mentioned above into consideration, we expect corporate convictions can affect firm’s financing costs as well in at least two ways. First, convictions may affect lending banks’ evaluation of a company through revisions in perceptions about the firm’s business prospect as well as credibility. Second, when borrowing companies are sanctioned with fine or restitution, their cash flow are directly affected, which may be different from lender’s evaluation of the firm before conviction.

In view of these effects, we expect there are adjustments on bank loan terms before and after corporate convictions. Followings are some of the related studies in criminal action, its impact, and possible challenges in database collaboration marked for related studies in corporate misconducts. Based on these results, we may develop more comprehensive perspectives on how the events of being prosecuted may affect bank loan contracting in syndicated loan market.

2.1 Corporate Misconduct

Recent studies on corporate crimes concerns various types of violation, including fraudulent crime (eg. defraud US, false statement, misbranding), environmental act (eg.

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clean water act, migration of birds, hazardous material emissions), bribery (illegal payment to foreign government/FCPA), antitrust etc. Alexander (1999) finds that when criminal allegations arise, they are often surrounded by reports of terminated or suspended customer relationships along with potential management or employee turnover. These reports are more frequent if the parties affected are customers, as in fraud, than if they are third parties, such as those in environmental crime. In the research toward fraud-related misconduct, Karpoff and Lott (1993) find that initial press reports of allegations or investigations of corporate fraud against private parties correspond to an average decrease of 1.34 percent, or $60.8 million, in the values of the common stock of affected companies. For frauds against government agencies, the loss in value is 5.05 percent, or $40 million. Based on a subset of firms with sufficient data indicated in this paper, only 6.5 percent of the loss represents court-imposed costs, with penalties and criminal fines accounting for 1.4 percent. Even though legal sanctions are imposed on these criminal firms, the loss in terms of stock value implies that there’s certain degree of loss (reputational cost) incurred as the penalty for these firms’ criminal act.

Corporate fraud usually impose direct cost on parities with whom the firm does business with, such as firm’s suppliers, customers and investors. Hence, when a firm commits fraudulent misconducts, their counterparties may respond in a way that would compel the firm to lower its output prices or endure higher input prices, affecting its expected future cash flow.

Furthermore, as in their studies on environmental violations, Karpoff et al. (2005) develop the measurement of reputational loss as the difference between losses in the market value of the firms violating environmental laws and the legal penalties on which they are imposed. They find that firms investigated or charged with violation of environmental regulations experience statistically significant and economically meaningful decreases in common share values. The loss in share value, while

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significant, is not on average larger than the legal penalties imposed on the violating firm, implying that the share value losses are more likely due to prospective legal penalties instead of reputational costs.

In addition, Karpoff et al. (2014) find that the costs for firms that are prosecuted for bribery depend on whether the bribery is comingled with charges of financial fraud.

The firms facing bribery charges without any sorts of involvement in financial fraud face total costs that averages up to only 2.4% of their market capitalization from the bribery enforcement action, usually in the form of large regulatory fines and penalties.

On average, however, the bribery charges do little harm to the firm’s business relationship with its customers, suppliers, or investors. Firms do not suffer large reputational losses when they are caught bribing; However, when the bribe is accompanied by financial fraud, the reputational loss tends to be large. Fraud-related bribe-payers tend to face higher future costs or lower revenues as their counterparties tend to change the terms with which they do business with the firm, resulting in reputational loss that averages up to 18.8% of firm equity value, and the ex post NPV of bribery related to financial fraud is negative, -25.2%. Their findings show that in its impact on firm reputation, the action of bribery is more like an environmental violation and less like consumer fraud. That is, the firms’ counterparties tend to care more for whether the firms’ financial statement are misrepresented. In general, they don’t vary their willingness to do business with the firm when it is caught bribing.

Consistent with results in Karpoff et al (1993), studies show that when companies are found concealing information or making adjustments to the preceding messages, it places uncertainty about the companies’ reported financial information in the perspectives of banks. Graham, Li and Qiu (2008) find that financial restatement implies that the information previously known to the lending banks is imprecise. In order to correct formerly perceived information of the company, lending banks may use

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contracting tools such as spread, debt maturity, covenants, collateral requirements etc.

as precautions against information asymmetry, showing uncertainty to the credibility of a restating firm. In this study of relationships between restatement effect and the cost of raising bank debt, it is found that loans initiated after restatement show significant increase in loan spread (the increase in spread is significantly larger for fraudulent restating firms) with shorter maturity, higher likelihood of being secured, and more covenant restrictions. Moreover, on average, each loan has fewer lenders after restatement and presumably to compensate for monitoring activities, the upfront and annual fees charged by lenders are higher for restating firms.

According to these studies, we expect the adjustments coming along with corporate convictions to be different in degrees, concerning violation types. We assume that fraud-related crimes are to display more influence on ex post loan term, because fraud-related crimes usually demonstrate direct costs on the firms’ stakeholders, who, in return, could directly affect company’s profit and loss, potentially imposing larger loss than other types of crimes. Other types of violations concerning environment or bribery, since they tend to pose costs on indirect third party, are expected to have less impact on the difference of ex ante and ex post loan terms compared to fraud-related misconduct.

There are many research papers that examine the causes and effects of financial misconduct. Most of those research papers compile samples using four databases－

SCAC, AAER, AA and GAO. Karpoff et al. (2014) identify four different types of challenges frequently faced when conducting research on financial misconduct using these database. The challenges are late initial revelation dates, scope limitations, potentially extraneous events, and complete and partial data omissions. First of all, the initial public revelations of financial misconduct may have occurred months before the initial coverage in these databases. Moreover, these databases may have omitted other

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relevant announcements that can affect a researcher’s use of the events or they may miss large numbers of events they were designed to capture. Lastly, most of the events captured by these databases are unrelated to financial fraud. In this paper, we use Garrett’s corporate conviction database. Although Garrett’s corporate conviction database is not discussed in the research of Karpoff et al. (2014), we apply alternative way as an effort to mitigate the potential biasness mentioned by Karpoff in this paper.