Corporate watchdogs

• DOI: http://doi.org/10.1111/fima.12291
• Author: Marco Navone,Thomas To
• Date: 01 December 2020
• Published date: 01 December 2020

DOI: 10.1111/fima.12291

ORIGINAL ARTICLE

Corporate watchdogs

Marco Navone1Thomas To2

1Finance Department, University of Technology

Sydney,Broadway, New South Wales, Australia

2Finance Department, University of Sydney,

Sydney,New South Wales, Australia

Correspondence

MarcoNavone, Finance Department, University

ofTechnology Sydney,PO Box 123, Broadway,

NSW2007, Australia.

Email:marco.navone@uts.edu.au

Abstract

We investigatethe role of financial analysts as corporate watchdogs.

We show that firms that are subject to intense analyst monitoring

are more likely to be investigated by the Securities and Exchange

Commission or to be the subject of a securities class action. Using

cross-sectional variations in managerial entrenchment, we find that

this effect is not a reflection of the “dark side of analyst cover-

age,” analysts pushing executives to misbehave to exceed short-

term expectations.Our findings are robust to different identification

strategies addressing the endogeneity of analyst coveragedecisions.

KEYWORDS

financial analysts, litigation risk, managerial misbehavior

1INTRODUCTION

Financial analysts are in the business of producing valuable firm-specific information that they then sell to interested

investors (either directly or bundled with brokerage services). In the last 10 years, a growing body of literature has

analyzed how this activity affects managerial behavior.

Some authors have showed that the increased information availability improvesfirms’ access to financial markets,

which allows firms to invest more (Derrien & Kecsk´es, 2013; Kelly & Ljungqvist, 2012), whereas others havepointed

out that it mayalso force company executives to focus on meeting short-term earnings expectations and forgo valuable

long-term investment projects (Graham,Harvey, & Rajgopal, 2005; He & Tian, 2013; Irani & Oesch, 2016).

Accounting information produced by the company is often the base for an analyst’s internal evaluation of firm

prospects. In the process of producing earnings expectations and target prices, analysts implicitly (and sometimes

explicitly)judge the quality of the company financial statements. They may, for example,point out that current earnings

appear inflated through accounting practices that, although maybe legal, do not reflect the company’s true profitabil-

ity. Numerous studies (Chen, Harford, & Lin, 2015; Irani& Oesch, 2013; Yu, 2008) show that the number of analysts

covering a firm is inversely correlated with the size of abnormal accruals, widely used in the accounting literatureas a

proxy for “creative”accounting.

In this paper, we investigatethe channel through which financial analysts are able to affect the quality of financial

statements. Specifically, we investigate whether analyst coverageaffects the probability of corporate litigation. The

basic idea is that an unethical corporate executive would decide to misbehave(manipulate earnings) if the expected

c

2019 Financial Management Association International

Financial Management. 2020;49:925–947. wileyonlinelibrary.com/journal/fima 925

926 NAVONEAND TO

benefit exceeds the expected cost. This last quantity can be seen as the product of the probability of being caught

times the damage in case the misbehavior is discovered(criminal charges, reputational loss, legal fees, fines, etc.). Here,

we posit that financial analysts, as information providers, increase the probability that managerial misbehavior will be

ultimately discovered. As a result of this increased litigation risk, other factors being equal, corporate executiveswill

choose to produce higher quality accounting information.

Wefully acknowledge that financial analysts are not the only actors constraining managerial behavior through infor-

mation production and dissemination. Variouscontributions in the literature have analyzed the competing roles of dif-

ferent information providers. Piotroski and Roulstone (2004), for example,explicitly model the competing information

production role of financial analysts, institutional investors, and corporateinsiders (through the mandatory disclosure

of their trading activity). In this paper,we focus on the role of financial analysts while controlling for the level of insti-

tutional ownership in any given company.All our results should thus be interpreted as the “additional effect” of analyst

coverage. Wealso show that information production by financial analysts is a substitute for the action of institutional

investors byshowing that the effect of analyst coverageis weaker in companies with large institutional ownership.

In our empirical analysis, we consider two different types of litigation events:Accounting and Auditing Enforcement

Releases (AAERs) issued by the Securities and ExchangeCommission (SEC) during or at the conclusion of an investiga-

tion against a company or an officer for alleged accounting misconduct, and securities class actions filed by investors

who suffered economic injury as a result of violations of the securities laws. We show that after controlling for firm

characteristicsthat affect the demand for brokerage (and analysts) services as well as for observable measures of man-

agerial misbehavior,an increase of coverage of one standard deviation increases the probability of being involved in a

litigation event by30–53%. 1

Wefully acknowledge that a second, and more sinister, explanation can be given for our empirical evidence. Authors

have recently pointed to a possible “darkside” of analyst coverage: by increasing the visibility of firm (short-term) per-

formance analysts may create excessivepressure for the company executives to meet short-term earnings goals. For

example,company executives may underinvestin research & development (He & Tian, 2013; R & D) or manipulate earn-

ings through, for example, artificially anticipating the timing of sales (Irani & Oesch, 2016). Here, we acknowledge the

possibility that the increase of litigation risk associated with an increase in coverage may not be a function of better

monitoring but of an increase pressure on the executivesto misbehave.

In order to distinguish between these two alternative hypothesis (discipline vs. pressure), we use time-series and

cross-sectional variations in managerial entrenchment. A highly entrenched manager will not feel an excessive pres-

sure to meet short-term goals because he/she cannot be punished for underperforming. Therefore, our pressure

hypothesis predicts that when managerial entrenchment is high, higher coverageshould not lead to more misbehavior

(and thus litigation risk). Conversely in firms with highly entrenched managers is exactly when the externaldiscipline

role of analysts becomes very valuable because mechanisms of internal governance often fails to properly control

entrenched managers (Arena & Ferris, 2007; Hermalin & Weisbach, 1998; Ryan & Wiggins, 2004) and (small) share-

holders in these firms would rely on external sources of information in order to protect themselves either by “voting

with their feet” or through legal means. Our discipline hypothesis thus makesan opposing prediction that in firms with

entrenched managers the relationship between coverageand litigation risk should be particularly strong.

By using different proxies of managerial entrenchment based on the Governance Indexof Gompers, Ishii, and Met-

rick(2003) and on the presence of large institutional investors, we show a uniform support for the discipline hypothesis.

Hence, at least in this case, we find no trace of the “darkside” to analyst coverage. That is, the increase in litigation risk

associated with an increase in the number of analysts following a firm reflects the disciplining role of analysts. This in

turn offers a clearer picture of the channel through which financial analysts are able to affect the behavior of company

executives,at least in terms of the quality of the financial/accounting information provided to the public.

Research on financial analysts has long been aware of the endogeneity of analysts’ coveragedecisions. Unobserved

factors that drive an analyst’s decision to covera specific firm may also drive the SEC to investigate the same firm (or a

1From1.1% to 1.43% for Accounting and Auditing Enforcement Releases and from 1.82% to 2.79% for securities class actions.