Divergence of Cash Flow and Voting Rights, Opacity, and Stock Price Crash Risk: International Evidence

• DOI: http://doi.org/10.1111/1475-679X.12185
• Published date: 01 December 2017
• Author: MICHAEL WELKER,HYUN A. HONG,JEONG‐BON KIM
• Date: 01 December 2017

DOI: 10.1111/1475-679X.12185

Journal of Accounting Research

Vol. 55 No. 5 December 2017

Printed in U.S.A.

Divergence of Cash Flow and Voting

Rights, Opacity, and Stock Price

Crash Risk: International Evidence

HYUN A. HONG,

∗JEONG-BON KIM,

†AND MICHAEL WELKER

‡

Received 10 June 2013; accepted 2 April 2017

ABSTRACT

This study investigates whether and how the deviation of cash flow rights

(ownership) from voting rights (control), or simply the ownership-control

wedge, influences the likelihood that extreme negative outliers occur in stock

return distributions, which we refer to as stock price crash risk. We do so using

a comprehensive panel data set of firms with a dual-class share structure from

20 countries around the world for the period of 1995–2007. We predict and

find that opaque firms with a large wedge are more crash prone than opaque

firms with a small wedge. In addition, we predict and find that the positive

relation between the wedge and crash risk is less pronounced for firms with

more effective external monitoring and for firms with greater growth oppor-

tunities. The results of this study are broadly consistent with Jin and Myers’s

∗University of California at Riverside; †City University of Hong Kong and University of

Waterloo; ‡Queen’s University.

Accepted by Christian Leuz. We are grateful to an anonymous referee, Darren Henderson,

and Ph.D. seminar/workshop participants at City University of Hong Kong, Concordia Uni-

versity, Fudan University,Sun Yat-sen University, University of Waterloo, and the Ivey Business

School at the University of Western Ontario for comments on a previous version of the paper.

J.-B. Kim acknowledges partial financial support for this project from the J. Page R. Wadsworth

Chairship in Accounting and Finance at University of Waterloo. M. Welker acknowledges re-

search support from the KPMG Fellowship at the Smith School of Business at Queen’s Univer-

sity. All errors are, of course, our own. An online appendix to this paper can be downloaded at

http://research.chicagobooth.edu/arc/journal-of-accounting-research/online-supplements.

1167

Copyright C, University of Chicago on behalf of the Accounting Research Center,2017

1168 H.A.HONG,J.-B.KIM,AND M.WELKER

theory that agency costs, combined with opacity, exacerbate stock price crash

risk.

JEL codes: G12; K22; M41

Keywords: ownership-control wedge; stock price crash risk; information

opacity; IFRS

1. Introduction

This study investigates the firm-level relation between corporate ownership

structure and stock price crash risk. Todo so, we construct a comprehensive

panel data set of firms with dual-class equity structures (or simply dual-class

firms) from 20 countries for the period of 1995–2007. We draw on the past

literature to suggest that dual-class firms may be characterized by agency

problems that lead to the consumption of private benefits of control and

opacity. These two features of dual-class firms match the two factors that

jointly determine crash risk in a theory developed by Jin and Myers [2006,

hereafter JM]. Our main empirical results are consistent with JM’s main

prediction: stock price crash risk is increasing in the severity of agency prob-

lems when firms are opaque.

In JM, controlling insiders have the ability to expropriate resources and

hide that activity from outsiders through earnings smoothing. When good

news arrives, controlling insiders do not release it to the market, and in-

stead report lower earnings, and then capture cash flows that are not an-

ticipated by outsiders. When there is bad news, this information cannot be

credibly revealed to outsiders, and the insiders thus absorb (or hide) it by

reporting higher earnings and capturing less, possibly negative, cash flows.

If the bad news accumulates to a tipping point, insiders no longer conceal

it and the sudden revelation of this bad news leads to a stock price crash.1

Using cross-country data, JM provide country-level evidence support-

ing a positive association between country-level financial reporting opacity

and stock price crash risk. Using U.S. data, subsequent studies provide

firm-level evidence that financial reporting opacity is positively associated

with ex post realized crash risk (Hutton, Marcus, and Tehranian [2009])

and ex ante expected crash risk proxied by options implied volatility

smirk (Kim and Zhang [2014], Kim et al. [2016]). However, these stud-

ies do not focus on agency conflicts between controlling insiders and

outside minority investors as causes of crash occurrence. As a result, we

have little evidence relating directly to the JM prediction that this agency

conflict, combined with financial reporting opacity, exacerbates firm-level

crash risk. Our study aims to provide direct evidence consistent with this

prediction.

1In the JM model, the opacity occurs independently of the agency conflict, but in prac-

tice these two arise jointly and are mutually reinforcing to facilitate insiders’ consumption of

private control benefits at the expense of outsiders.

DIVERGENCE OF CASH FLOW RIGHTS FROM VOTING RIGHTS 1169

For our empirical analysis, we use a sample of dual-class firms from 20

countries for the following reasons. A dual-class ownership structure exists

when a firm has at least two classes of shares with different voting rights,

creating a wedge between cash flow rights (ownership) and voting rights

(control). This ownership-control wedge is prevalent among international

firms and is a major source of agency problems in many countries around

the world (Shleifer and Vishny [1997], La Porta et al. [1999], Lins [2003]).

The use of dual-class firms provides us with a unique opportunity to directly

measure the severity of the agency conflicts between the two parties, using

the ownership-control wedge that has been commonly used in the literature

(e.g., Shleifer and Vishny [1997], La Porta et al. [1999], Zingales [1995]).

We discuss measurement of this variable in detail and provide related sensi-

tivity analyses later. Controlling insiders have incentives to consume private

control benefits at the expense of outside minority shareholders (Zingales

[1994], Nenova [2003], Doidge [2004]). These insiders use the dual-class

structure to facilitate extracting private control benefits and then provide

opaque reporting to conceal that activity from outside stakeholders (Leuz,

Nanda, and Wysocki [2003]).

Our sample of dual-class firms from 20 countries produces measurable

variation in the two factors, that is, agency conflicts and opacity, that influ-

ence stock price crash risk in the JM model, and also allows us to empirically

highlight that having only one of these factors does not necessarily engender

crash risk. Further, the use of the international sample in this study allows

us to examine whether and how country- and firm-level external monitor-

ing mechanisms (which should increase the expected costs of extracting

private control benefits) affect the agency conflict-crash risk relation that

JM predict.

In our empirical tests, we focus on the relation between the ownership-

control wedge and firm-specific crash risk (after netting out common risk).

Following the literature (e.g., Chen, Hong, and Stein [2001], Jin and My-

ers [2006], Hutton, Marcus, and Tehranian [2009], Kim, Li, and Zhang

[2011a,b]), we proxy for firm-specific crash risk using three distinct mea-

sures: (1) negative conditional skewness of firm-specific weekly returns; (2)

the ratio of firm-specific weekly return volatility in down markets to that in

up markets, simply called the down-to-up volatility; and (3) the likelihood

that extreme negative firm-specific weekly returns occur in each year.

To measure the ownership-control wedge (i.e., the deviation of voting

rights from cash flow rights), we first identify dual-class firms that issue two

classes of shares with the same cash flow rights but with different voting

rights in each sample country. The superior voting shares (e.g., having 10

votes per share) have significantly greater voting rights relative to their cash

flow rights, compared to the inferior voting shares (e.g., having one vote

per share). The superior voting shares are typically owned, in large part,

by the controlling insiders (managers and directors) of the firm and cre-

ate a considerable wedge between their voting and cash-flow rights. The

ownership-control wedge is then defined for a dual-class share firm as one