NYU Stern
Share / Print
Research Highlights

How Managers Behave When They Have Something to Hide

By David Yermack

David Yermack_article

Because participation in a cartel generally results in a large increase in profits within a short time, it is necessary for management to hide their windfall from regulators, analysts, customers and oftentimes even their boards of directors.

In their recent paper, “Smokescreen: How Managers Behave When They Have Something to Hide,” David Yermack, Albert Fingerhut Professor of Finance and Business Transformation, and his co-authors, Tanja Artiga González and Markus Schmid from the Swiss Institute of Banking and Finance, examine how managers behave when they are trying to hide wrongdoing. The researchers studied 216 U.S. companies accused of price fixing by antitrust authorities, looking at the companies’ financial reporting and corporate governance practices. While they focused only on firms engaged in price fixing, the researchers expect that their findings should apply generally to all companies in which managers seek to conceal poor performance or personal wrongdoing.

Decisions to participate in price-fixing cartels are usually made by a firm’s top management and implemented by intermediate management. Because participation in a cartel generally results in a large increase in profits within a short time, it is necessary for management to hide their windfall from regulators, analysts, customers and oftentimes even their boards of directors. The researchers documented a range of accounting and governance strategies these firms employed to evade legal liability.

Some accounting strategies the researchers pinpointed in cartel firms were frequent earnings smoothing, reclassifications of industrial segments (to make year-over-year performance comparisons more difficult) and a 50 percent higher incidence of financial restatements. Additionally, they changed auditors less frequently than the control sample.

In terms of corporate governance, a company is able to participate in a cartel either with or without the knowledge of its board of directors. The researchers hypothesized that in either situation, cartel firms should be reluctant to replace directors who resign or retire because recruiting a new monitor from outside the company creates a risk of the cartel being exposed or stopped. Their findings supported this idea, showing that directors resign or retire more frequently in cartel firms, and that companies are more likely to allow the board to shrink rather than hire replacement directors. They found that, in general, cartel firms favor outside directors who are based in foreign countries or busy (serving on three or more boards simultaneously) – both types of directors have been shown in recent papers to be poor monitors due to distraction, distance or lack of familiarity with U.S. accounting rules.

Two additional findings were that cartel managers exercise their stock options faster than managers of other firms – perhaps due to a desire to withdraw their equity compensation before the cartel gets exposed and stocks drop – and that cartel firms are sued for securities fraud three times more often than other companies. The litigation is rarely connected to the price-fixing activity itself, but rather to the “signal-jamming” behaviors that the cartel firms engage in, such as frequent earnings restatements and segment reclassifications.

The researchers believe their findings should apply to many scenarios in which managers seek to hide information from their own monitors and from outside parties.

___
David Yermack is the Albert Fingerhut Professor of Finance and Business Transformation.