How Managers Behave When They Have Something to Hide
By David Yermack
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.
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.