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Article Excerpt
Inefficient investment allocation induced by corporate fraud, where informed insiders strategically manipulate outside investors' beliefs, has been endemic historically and has recently attracted much attention. We reconcile corporate fraud and investment distortions with efficient capital markets, building on shareholder-manager agency conflicts and investment renegotiation in active takeover markets. Because investments that are ex post inefficient are not renegotiation proof the optimal renegotiation-proof contract induces overstatements by managers, accompanied by overinvestment in low return states and underinvestment in high return states by rational investors. Our framework also helps explain why easy access to external capital appears to facilitate corporate fraud.
1. Introduction
* Corporate fraud has attracted much attention recently because of prominent cases of corporate malfeasance where insiders were able to attract investment through overly optimistic representations of financial performance and economic prospects (e.g., Worldcom and Enron). An important consequence of this type of fraud is investment inefficiency. Compared to the efficient allocation, there is overinvestment in certain industries or sectors as uninformed investors direct capital flows to not only the firms manipulating their beliefs; however, there is underinvestment in other sectors, as the presence of fraud makes investors generally more cautious.
Manipulation of outside investors by better-informed strategic insiders has a long history, and appears to have existed from the onset of organized trading and investment. (1) A historical review points to the crucial role of asymmetric information and agency conflicts in the manipulation of investors' beliefs and the attendant investment distortions. Because of the separation between ownership and control (Berle and Means, 1932), insiders are typically more informed than outsiders about expected returns on investment, especially for new technologies and markets. (2)
However, in spite of considerable anecdotal and more systematic empirical findings emphasizing overinvestment (relative to the first-best) as an attendant cost of corporate fraud, (3) the literature rarely presents frameworks where fraud and overinvestment occur in equilibrium with rational investors. There is in fact a literature arguing that, in efficient capital markets, strategic managerial disclosures aimed at inflating firm prospects should be discounted by rational market participants (e.g., Stein, 1989; Narayanan, 1985). Moreover, models with private information on investment prospects typically predict underinvestment rather than overinvestment, because of the adverse selection problem in equity financing (e.g., Myers and Majluf, 1984; Greenwald, Stiglitz, and Weiss, 1984) or capital rationing by debt markets (e.g., Stiglitz and Weiss, 1983). (4)
Our contribution is to develop a theory of fraud and generalized investment distortions, that is, both under- and overinvestment, with rational expectations and perfect capital markets. Specifically, we construct and characterize an equilibrium with rational investors where under-and overinvestment can both occur with positive probability, that is, low-capital productivity firms receive more than their efficient levels of investment capital, and conversely for high-capital productivity firms.
Our framework is built on two fundamental characteristics of modern corporations operating in well-developed financial markets. First, there are shareholder-management agency conflicts because managers derive private benefits from controlling larger investments and have private information on the investment opportunity set (e.g., Stulz, 1990; Hart, 1995). Second, shareholders cannot credibly precommit to investment that is inefficient ex post, because such investment policies are renegotiated in active takeover markets (e.g., Grossman and Hart, 1986).
As is typical in optimal contracting with asymmetric information, the second-best or ex ante incentive-efficient contract in our setup requires precommitment to investment policies that are inefficient ex post (i.e., conditional on knowing the true state of the world). Relative to the first-best, investment is lowered in the high-productivity state and raised in the low-productivity state. But investment levels that are inefficient expost lead to a transparent undervaluation of the firm and generate a profitable takeover opportunity for any investor who acquires control of the firm and "resets" investment to the ex post efficient levels. Indeed' in our setting, any renegotiation-proof investment policy-- that is, one that does not generate profitable takeover opportunities--must be ex post (or conditionally) efficient. We therefore highlight the influence of an active corporate takeover market on the design of incentive contracts between managers and shareholders, and provide an institutionally compelling motivation for the "renegotiation-proofness" problem (see Dewatripont, 1988; Bolton and Dewatripont, 2005).
Our main insight is that the ex post investment efficiency constraint substantially affects the information optimally induced from the privately informed agent, and therefore also the equilibrium allocation of capital across productivity states. We find that, for a range of model parameters, the optimal renegotiation-proof contract induces misreporting by insiders with a positive probability. The role for randomized reporting arises in our setting because attempts to induce truth telling through wage contracts (when investment is constrained to be ex post efficient) can be costly.
Specifically, truth telling can be induced--even with the constraint of renegotiation-proof investment--by paying the low-productivity agent information-based rents (through high wages) that compensate him for the utility loss from receiving a lower investment level relative to the larger investment allocated to the high-productivity state. But these rents can be high if there is a large difference between the efficient investment level in the high- and low-productivity states. Le Chatelier's principle then suggests that it may be cost effective to induce randomized reporting, because randomization lowers expected wage costs by moving the Bayes-rational (or renegotiation-proof) investment in the direction of the second-best. Indeed, the optimal reporting noise (or probability of misreporting) is determined by trading off the expected cost of investment distortion from the incorrect report with the reduction in the expected wage costs.
In our model, there generally can be randomized reporting by both the low- and the high-productivity manager because the incentive compatibility constraints are binding both upward and downward in the second-best. The reason is that the incentive-efficient contract exploits the tradeoffs between wages and utility of control to give zero wages to the high-productivity manager, and make his incentive constraint bind. However, under a range of parameters, it is optimal to induce randomization only by the low-productivity manager. This is because randomization by the high-productivity agent imposes investment distortion costs--because there is underinvestment with positive probability--and increases expected wage costs--because the agent receives positive, rather than zero, wages whenever he reports low productivity. Thus, as long as the a priori likelihood of the high-productivity state is not too low and the capital productivity in the low state is not too high, it is suboptimal to induce randomization by the high-type agent. But under these conditions, it is still optimal to have the low-type randomize as long as the opportunity cost of investment and the manager's subjective benefits of control are in an intermediate range.
In sum, we establish the existence of, and characterize, a noisy revelation equilibrium where the low-productivity manager inflates his reports with positive probability, and there is overinvestment in the low state but underinvestment in the high state. Comparative statics around this equilibrium reveal that the likelihood of fraud is negatively related to the cost of capital (or external financing), and positively related to the ratio of low- and high-capital productivities. These comparative statics allow us to relate the extent of investment inefficiency to salient model parameters.
The desire to understand the causes and consequences of(corporate) fraud as an equilibrium phenomenon dates at least back to Becker (1968). One strand of the existing literature on fraud emphasizes the role of managerial myopia (e.g., Narayanan, 1985; Stein, 1989; Von Thadden, 1995; Kedia and Philippon, 2005). Such myopia is sometimes motivated through imperfections in long-term incentive contracting. Another strand examines fraud in models with limits on communication (e.g., Dye, 1988; Demski, 1998). (5) And a more recent literature assumes some form of market irrationality in reconciling fraud with market equilibrium (e.g., Jensen, 2005; Bolton, Scheinkman, and Xiong, 2005). (6)
Our analysis differs from the literature, because we emphasize the role of capital markets in the incidence of corporate fraud; in fact, capital markets have played a prominent role in several recent corporate scandals and historically in episodes of fraud. Instead of relying on managerial myopia, limitations on communication and contracting, multitasking, or investor irrationality, we focus on the inability of financial markets to resist value-increasing investments. That well-developed (or relatively frictionless) financial markets will exploit the profit opportunities afforded
We thank the editor, Mark Armstrong, and two anonymous referees for very helpful comments. We also thank Larry Ausubel, Michael Fishman, Thomas George, Itay Goldstein, Peter Hammond, Milton Harris, Andrew Hertzberg, Dilip Mookherjee, Oguzhan Ozbas, Adriano Rampini, Avri Ravid, Chester Spatt, Matt Spiegel, Jeremy Stein, S. Vishwanathan, and seminar participants at Ben Gurion University, Haifa University, Hebrew University, University of Houston, Tel Aviv University, the Duke-UNC Corporate Finance Conference (2006), the American Finance Association Meetings (2007), and the Utah Winter Finance Conference (2007) for useful comments. All remaining shortcomings are our responsibility. by transparent undervaluation of assets is a compelling argument; therefore, our perspective appears to rest on rather unexceptionable foundations. (7)
We organize the remaining article as follows. Section 2 sets out the basic model. Section 3 defines optimal contracting and its equilibrium representation. Section 4 records the first- and second-best benchmark outcomes. Section 5 presents the main results, and Section 6 concludes by discussing some implications of the model. All proofs are placed in the Appendix.
2. The model
* Technology. There are three time periods in the model, t = 0, 1, 2. The firm has a technology that stochastically converts investment at time t = 1, denoted by k, to earnings (or output) at time t = 2, denoted by y. For simplicity, we normalize units so that earnings take only two possible values: a high value, y = 1, and a low value, y = 0. The probability distribution of earnings is influenced by the firm's capital productivity, s [member of] {[s.sub.h], [s.sub.l]}, 1 > [s.sub.h] > [s.sub.l] [greater than or equal to] 0, and investment (k). The probability of high earnings is given by sf(k), where f = 2 [square root of k] is defined on the feasible investment set [0, [k.sup.max]], such that [k.sup.max] [less than or equal to] 1/4[s.sup.2.sub.h] (8)
Ownership, control, and managerial preferences. The firm is controlled by a risk-neutral manager who receives two types of utility from managing the firm. He receives utility from consuming wages, w, that are paid at the time of the firm's liquidation. The manager also receives benefits from control that are a mixture of subjective utility and noncontractible pecuniary benefits, and they increase with the size of the capital assets. We represent these benefits by a b(k) = [psi] k, where [psi] > 0. Therefore, the manager's utility from possibly uncertain wages and investment level k is U(w, k) = E(w) + [psi]k. Moreover, the manager has no initial wealth and enjoys limited liability, and therefore wages must be nonnegative. Finally, the manager's reservation utility is normalized to zero. (9)
The firm is publicly held and its shares are traded in a frictionless capital (or equity ownership) market. For simplicity, we assume that all of the firm's shares are held by a risk-neutral active shareholder--hereafter, the original owner. Firm ownership and control, however, may vary over time. In particular, a potential raider may gain control of the firm (we discuss this in detail below). The original owner and the potential raider have a common opportunity cost of investment, namely the gross rate of return R. (10)
In the last period, time t = 2, output y is realized, wages w are paid to the manager, and the firm is liquidated. The payoff to the owner of the firm at the time of liquidation, given an investment level k, output y, and wage w is v(w, k, y) = y - w - Rk.
Information. The manager privately observes the productivity of the firm (s) before investment takes place, that is, before time t = 1. At t = 0, the manager and the investors share common prior beliefs about the realizations of s; the probability of observing [s.sub.h] and [s.sub.l] is [mu] and 1 - [mu], respectively. All investors know that the manager will privately observe s. Everything else in the model, besides the realization of s, is observable and common knowledge.
Contracting and the market for control. From an institutional perspective, shareholders delegate the responsibility of wage contracting (with management) to the board of directors. These employment contracts are enforceable in the sense that managers can move the courts to enforce prior wage contracts even though the ownership of the firm changes, as the set of equity holders itself changes. (11) However, owners' ability to credibly commit to arbitrary investment in the firm is limited by the possibility of a change in control of the firm ex post through a takeover. Because investment at any given point in time is legally the domain of the current capital owners, the new owners can choose any desirable (and feasible) investment level.
To see the basic point, imagine a situation where shareholders' planned investment does not maximize efficiency, conditional on knowing the true productivity state. But this (inefficient) investment will lead to a transparent undervaluation of the firm's assets, relative to the ex post efficient investment level. However, transparent undervaluation is not a viable situation with a frictionless market for control. This is because there is a clear positive net present value (NPV) opportunity for a potential raider to purchase the firm at the undervalued price, reset the investment to the expost efficient level, and sell (or even hold) the firm.
We can incorporate the commitment issues with respect to investment by appealing to the notion of renegotiation-proof mechanisms or contracts (see Bolton and Dewatripont, 2005). We will say that the mechanism is renegotiation proof if and only if the potential raider cannot benefit from gaining control of the firm and changing investment. Therefore, the investment policy described above is not renegotiation proof because there are incentives for the potential raider to offer an alternative arrangement to increase efficiency--implemented by purchasing the shares of the original owner. We formalize the notion of renegotiation proofness below.
Incentive mechanisms or contracts. We will allow the manager to communicate with the owners regarding his private information on the firm's productivity. Owners can therefore design an incentive mechanism (or contract) at the beginning of time t = that is contingent on the manager's communication of the productivity and on the publicly observable earnings. This communication occurs later during this time period, following the manager's observation of the actual productivity.
Specifically, the contract is a wage and investment menu. It determines the shareholders' investment policy as a function of the manager's communication; it also determines the manager's wages as a function of his communication and the observed earnings at time t = 2. However, the investment may change if the ownership changes (prior to the investment decision). The possibility of investment revision or renegotiation implies that the revelation principle fails to hold in our setting. (12)
A contract therefore specifies a noisy reporting policy for the manager, contingent on his type....
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