Aurora Borealis
1 May 2017 CFA Institute Journal Review

Corporate Scandals and Household Stock Market Participation (Digest Summary)

  1. Paul Lebo

Corporate fraud reduces participation in the stock market, particularly for households in the place where the fraud occurs. Individual households with a high degree of lifetime experience of corporate scandals reduce their equity holdings. Given the critical importance of positive returns on equities for meeting such goals as education and retirement, corporate fraud has a negative effect on households’ financial well-being.

How Is This Research Useful to Practitioners?

The authors find that local equity fraud reduces local household participation in equity markets even when the household does not hold stock in the fraudulent company. They use two primary tests to determine whether their results are influenced by the US state’s economic condition. The first test studies the demise of Arthur Andersen, formerly one of the “Big Five” accounting firms, in 2002. When Arthur Andersen ceased to exist, clients that were based in many states were forced to find new auditors. When a company switches auditors, the probability that fraud will be exposed is usually higher. The authors show that in the Arthur Andersen case, a rise of one standard deviation in fraud revelation increases the probability that a household will exit the stock market by 7%.
In the second test, the authors explore same-state variations in household experience with fraud. The results show that individuals in a state reduce not only their investments in the stocks of corporations in that state but also their stock market investments overall. The authors attribute this behavior to a rational belief that fraud could be equally present across states and in other firms. Using the second test, they find that a rise of one standard deviation in a household’s lifetime exposure to local fraud reduces that household’s probability of holding stocks by 4% and its ratio of equity to total wealth by 10%.
Although households reallocate their equity positions to such fixed-income securities as bonds and insurance policies, the decline in equities is not dependent on household risk tolerance or actual financial loss. The authors provide evidence that it could be attributable to a decline in trust after feeling cheated and betrayed. Households with high-status individuals reduce their equity positions the most because they have the most to lose; the betrayal costs are high. In particular, college-educated households drive the observed decline. The authors demonstrate that this lack of confidence has a lasting impact on household investing patterns rather than a fleeting effect.

How Did the Authors Conduct This Research?

Using the Federal Securities Regulation (FSR) database, the authors study intentional and material financial misconduct that directly affects shareholder wealth and find 704 enforcement actions involving 695 US companies between 1980 and 2009. They observe households located in the same state where the fraud occurs because these households may be more aware of the fraud. Household demographics are from the Panel Study of Income Dynamics and show that 31% of households participate in the stock market outside of IRAs. The authors use information from a large discount broker to determine which common stocks households hold and sell.
Their results represent the lower range of negative outcomes, because households may have experienced fraud from out-of-state firms as well.
The authors contribute to the financial literature by studying the relationships between trust and economic transactions and between the cumulative lifetime experience of corporate fraud and the demand for equities. Their findings can help corporate executives, insurance companies, financial planners, and portfolio managers understand the effects of widely publicized corporate fraud on shareholder value, shareholder concerns, and investing behaviors.

Abstractor’s Viewpoint

The authors’ behavioral finance research shows the impact of corporate fraud on household investing behaviors. Their findings serve as a reminder to portfolio managers that revelations of corporate fraud may lead their clients to make decisions that are not in their own best interests.

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