Knowledge that Transforms

Ratings shopping is a well-documented cause for ratings inflation by credit rating agencies (CRAs). Its unobservability makes it difficult for market participants to undo it. In this paper, we exploit a unique regulation in India that requires CRAs to disclose ratings that were solicited but were eventually rejected by issuers. This regulation, which aims to enhance the transparency in the ratings process, allows us to empirically examine whether these disclosures influence ratings shopping and, consequently, ratings inflation. We find that the disclosure requirements result in an increase in the incidence of future downgrades and type 1 errors and a decrease in the occurrence of type 2 errors. These results are consistent with the view that the enhanced disclosure requirement did not reduce shopping and instead led to unintended consequences, such as an increase in implicit shopping, where issuers selectively engage lenient CRAs to obtain favorable ratings.

This study examines whether an increase in the transparency of investment transactions facilitates portfolio mimicking. While there are reported benefits of transparency in enhancing regulatory monitoring and discipline, an increase in the transparency of investment transactions can also facilitate mimicking of peer firms’ investment strategies. I exploit an exogenous increase in the broad dissemination of transaction-level investment disclosures of U.S.-based insurers and find a significant increase in portfolio similarity at the individual security level. Increases in portfolio similarity are more pronounced in smaller, less sophisticated insurers mimicking their larger, more sophisticated peers. Shared asset positions and common exposures to risk can exacerbate collective risk across firms. Accordingly, I find that the detectable increases in portfolio similarity are positively associated with measures of systemic risk, especially in those smaller insurers mimicking their peers. This study adds to a nascent literature on portfolio mimicking and highlights a potential negative externality of increased transparency.

This paper examines which municipal disclosures provide informational value to investors. Using the entire universe of post-issuance financial and event disclosures from 2009 to 2022, we find that most municipal bonds do not trade in the weeks following a disclosure. However, some disclosures do provide enough new information to increase trading. Investors trade more on credit-relevant disclosures, such as adverse credit event disclosures, and less on required annual financial statements. Trading after disclosures also increases more when a bond is large or risky. Moreover, we find that credit rating agencies respond to disclosures, lending support to the idea that some disclosures have informational value. In further analyses, we find that trading before the disclosure, lack of timeliness, illiquidity, and information processing constraints contribute to the limited trading on the average disclosure. The findings suggest that reconsidering a one-size-fits-all approach to regulating post-issuance municipal disclosures may be worthwhile.

We investigate whether consistent non-GAAP reporting is associated with investment efficiency. Prior research finds a positive association between non-GAAP reporting and investment levels, concluding that it represents overinvestment. We corroborate this positive association, but additional tests are not consistent with the conclusion of inefficient overinvestment. Specifically, we explore the relation between investment and future cash flows as a proxy for the realization of investments in positive net present value projects. We find that the investments of firms that consistently report non-GAAP metrics are associated with similar or higher future cash flows than the investments of firms reporting only GAAP earnings, which is consistent with efficient investment. We observe similar associations in multiple specifications, performance horizons, and outcome variables, including future returns and earnings. Given the prevalence of non-GAAP reporting and the SEC's ongoing concern with the consequences of non-GAAP disclosure, our analyses offer timely evidence relevant to this important discussion.

We examine the objective function of the SEC against financial misconduct by estimating a structural model of the interactions between the SEC and a regulated firm. The SEC considers social costs, enforcement costs, and firms' compliance costs when making enforcement decisions. Identification exploits SOX as a shock to enforcement intensity. Four insights emerge from counterfactual analyses. First, marginal social costs have a greater impact on the SEC's perceived welfare than marginal enforcement costs. Second, the SEC's current enforcement mitigates earnings management to a level close to the first-best scenario. Third, a “hawkish” regulator, who perceives high social costs of financial misconduct, would impose excessive costs on society. Lastly, removing regulatory discretion would result in higher penalties and lower welfare, with little effect on earnings management.

We examine quantitative investors’ ability to navigate a common and occasionally material change to the financial data generating process: new accounting standards. Returns of quantitative mutual funds temporarily decrease relative to funds that rely more heavily on human discretion following the implementation of a few standards that significantly change key financial statement variables; however, other standards do not appear to have a differential effect. Our result is stronger for quantitative funds using more accounting terminology in their prospectuses and using value strategies, which leverage accounting signals. Excess portfolio turnover following the implementation of accounting standards appears to be a driving factor of the quant underperformance. Additional evidence connects the fund-level results to the specific stocks that were affected by the accounting standards. Overall, our results suggest quant funds are generally proficient at adapting to accounting changes, although material changes occasionally put them at a temporary disadvantage relative to discretionary investors.

We study the influence of political partisanship in SEC investigations and AAER enforcement actions against financial misconduct. We find that the SEC is more likely to launch an investigation against a firm that is misaligned with the agency’s political ideology than other firms. The likelihood of an AAER appears unaffected by political misalignment, but once named in an AAER, a misaligned firm faces harsher penalties than other firms. We find evidence that collectively points to potential misallocation of scarce enforcement resources due to partisanship: conditional on investigation, misaligned firms are less likely to receive an enforcement action, and conditional on misreporting, non-misaligned firms are less likely to be investigated.

We provide estimates of profit shifting for over 2 million firm-year observations in 100 countries over the period 2009–2020. Employing nonparametric estimation techniques within a mainstay model of profit shifting, we examine how the profits of both parent and subsidiary firms within a multinational group respond to marginal changes in the composite tax indicator. The key advantage of this approach is that it yields firm-year estimates of profit shifting. Multinational firms engage in extensive profit shifting by maintaining affiliates in low-tax countries and zero-tax havens. Multinational groups with an ultimate tax-haven owner exhibit the largest profit response to tax incentives. Our new database opens important avenues for analyzing the sources and effects of profit shifting.

We examine whether requiring insiders to sell their stock shares based on pre-disclosed plans can mitigate opportunistic insider selling activities and, more importantly, to what extent insiders can circumvent this regulation. Using China's mandate enacted in 2017 as the setting, we demonstrate that a sell-by-plan mandate can reduce opportunistic selling activities. However, insiders can circumvent this mandate by strategically initiating their plans before bad news. We find that this gaming practice is widespread in China. It is concentrated in firms with weak governance but largely absent in firms with strong governance. We also find that China's stock market cannot discern whether a plan is opportunistically motivated upon its announcement. Overall, this paper highlights a new form of opportunism in insider trading—opportunistic planning—and proposes a method to identify such plans. Our results also suggest that government regulation, without strong governance, could be ineffective in curbing corporate executives' opportunistic behaviors.

We study contingencies written in firms' material product market contracts, focusing on the theoretical prediction of uncertainty as an important determinant. We identify contract contingencies from firms’ public regulatory filings and examine the effects of general business uncertainty and specific innovation-related uncertainty. To enhance causal inference, we utilize two major business shocks (i.e., the 2008 Financial Crisis and the COVID pandemic) and the diffusion of 29 disruptive innovation shocks (Bloom et al., 2021). We also explore the effects of re-negotiation costs and writing costs. Overall, our empirical results are consistent with predictions from dynamic models of incomplete contracting.