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Local Institutions, Audit Quality, and Corporate Scandals of US-Listed Foreign Firms

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Abstract

Using data on shareholder-initiated class action lawsuits in the US, I investigate the corporate scandals of US-listed foreign firms. The shareholders of scandal firms suffer considerable loss in both the short term and the long term. I document that firms domiciled in countries with weak institutions are more likely to be embroiled in corporate scandals, but such a relation can be moderated by the presence of Big 4 auditors. Investors automatically adjust for undiscovered misconduct when valuing the stocks of non-scandal firms (i.e., the spillover effect). Investors rely on the audit quality to form their expectations about the severity of undiscovered misconduct, and thus impose less negative spillovers on firms with Big 4 auditors, especially when the firms are from countries with weak institutions. Taken together, my results suggest that listing on US exchanges does not fully compensate for weak local institutions; voluntarily bonding to a more stringent audit process has an incremental effect on protecting shareholder interests and enhances the confidence of investors in firms’ financial integrity.

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Notes

  1. There is an abundant literature on the causes and consequences of corporate scandals, which focuses on US-based firms or all firms listed in the US (e.g., Beasley 1996; Doyle et al. 2007; Fich and Shivdasani 2007; Karpoff et al. 2008a, b; Krishnan 2005; Miller 2006; Persons 2006; Schrand and Zechman 2012).

  2. See the speech by the SEC Chair, Mary J. White at http://www.sec.gov/News/Speech/Detail/Speech/1365171515952#.U-WY-fQYBgR.

  3. Also, SEC Commissioner Luis A. Aguilar points out both private plaintiffs and the SEC face difficulty in enforcing the law against some foreign firms because the documents and people who have the information about whether there is misconduct are often beyond the reach of subpoena power, and the persons to punish and the assets that could satisfy a judgment may be located outside the United States and harder to access (http://www.sec.gov/news/speech/2011/spch040411laa.htm). These difficulties are expected to be more severe in countries where the legal institutions are weak. Similarly, the potential existence of frivolous lawsuits in my sample would only work against my ability to find spillover effects since the investors in non-sued firms should react less, if at all, when the lawsuits against the peer firms are without justification or have no merits.

  4. Some research also drops class actions related to option backdating (e.g., Bonini and Boraschi 2010). Since the current SCAS database has official identifications only for four types of litigation (i.e., Analyst, IPO Allocation, Mutual Fund and Classic), and it does not flag option backdating-related cases separately, I search for the keyword “backdating” within the official complaint files against US-listed foreign firms. As a result, only one case is found to be related to option backdating, i.e., the lawsuit against UT Starcom from China brought to the court in 2007. A closer look at the case reveals that the option backdating is bundled with other allegations. Among other things, UT Starcom was alleged to have inflated its earnings in 2003, 2004, and 2006. Since this case meets the concept of corporate scandal and is different from typical stand-alone option backdating litigations, it is included in the sample. Nevertheless, removing this case does not change the findings qualitatively.

  5. My findings are not affected if these duplicates are included.

  6. I also require the non-scandal firms in my sample to be covered by both CRSP and Compustat.

  7. All the findings are robust, when financial firms are kept. Moreover, the further exclusion of utility firms with sic codes between 4900 and 4999 does not affect the results qualitatively neither.

  8. The number of observation varies as the variables in the models are different. The two numbers, i.e., 10,569 and 17,139, reported in Table 2 are based on Model 2 from Table 5 and Model 2 from Table 7, respectively.

  9. This number does not include the loss in the firms for which the stock returns cannot be calculated.

  10. Ideally, to completely rule out that the possibility that firms from some countries are more easily to be sued than others, one also needs to identify the firms that should have been sued but actually are not sued. Unfortunately, such cases are not observable. I deal with this in the spillover analysis. I document that firms from countries with weak institutions suffer more negative spillover, which again work against the conjecture the lawsuits against firms from countries with weak institutions are more likely to be frivolous.

  11. For descriptive purposes, the CRSP and Compustat data are not matched along the time dimension in Table 3. That is the reason why the number of fraudulent cases is smaller in this analysis. This number of firm-year observations (11,959) is the same as the one reported in Table 5, model 5.

  12. Cash holdings are deflated by net-of-cash total assets. The correlation between cash holdings and total assets is −0.2. Therefore, the results are not driven by multicollinearity.

  13. In three countries, i.e., Greece, Finland, and Sweden, the spillovers are positive. Given the extremely small sample sizes, these positive outcomes might be random. One alternative explanation is that investors have preferences for stocks from certain regions. When a firm from one country is involved in a scandal, investors may shift their investment to other firms from the same country. If investors do not have many alternatives from that country, the stock prices of non-sued firms might increase instead of decreasing.

  14. For example, when the latest event for a case is “dismissed voluntarily” or “dismissed by the court without prejudice,” the case was given a status of “dismissed,” despite the fact that the plaintiff may amend and refile the complaints in the future. In contrast, some cases that were dismissed in earlier stages are given the status of “ongoing” or “settled” when the latest event is a repeal or amendment.

  15. I conduct two sets of tests. One includes settled, dismissed, and ongoing cases, and the other includes only settled and dismissed cases. The results are robust.

  16. The number of observations in these tests decreases drastically because not only dismissed cases but also ongoing cases (i.e., “uncertain” cases, around 18 % of all cases) have to be excluded.

  17. These results are based on the model where the institution is measured by legal origin; all the control variables are used as in Table 5, Model 2.

  18. A possible explanation for the weaker moderating effect of Big 4 on the spillover is that ADR listing and Big 4 are positively correlated. For instance, I find Chinese firms that use ADRs tend to be bigger and hire Big 4 auditors. Their smaller counterparts, in contrast, tend to choose direct listings. Some of these small firms go public via reverse mergers which normally involves much less reputable auditors. Consequently, these firms are more likely to be sued. A more in-depth analysis regarding the relations among financial scandals, Big 4 auditors, and reverse mergers/ADRs is beyond the scope of the paper.

  19. In my sample, the firms are from 60 different countries, among which 48 countries have anti-director indices and all the countries have rule-of-law scores. The anti-director index ranges between 1 and 5, and the mean is 3.48; the rule-of-law score ranges between −0.91 and 1.98, and the mean is 0.74.

  20. There is some weak evidence that Big 4 may reduce corporate scandal for British firms. However, unlike the Chinese case, the significance of Big 4 in the UK case is very sensitive to the specification of the model, and a simple t test even suggests that no difference exists in terms of scandal likelihood between British firms that hire Big 4 and British firms that do not. Therefore, I still conclude that Big 4 does not play a role in reducing corporate scandals in the UK.

  21. The main results reported in this section can be found in the internet appendix.

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Authors and Affiliations

  1. School of Accounting, Southwestern University of Finance and Economics, Chengdu, 611130, China

    Lei Chen

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Correspondence to Lei Chen.

Additional information

This paper has benefited from comments and suggestions from Ahmed Ebrahim, Julian Franks, Bjorn Jorgensen, Brandon Julio, Frank Moers, Henri Servaes, Ann Vanstraelen, Jun Yao, an anonymous referee, and participants of PhD seminars at London Business School (2012), the 10th International Conference on Corporate governance at the University of Birmingham (2012), Maastricht University (2012), the London School of Economics and Political Science (2012), Southwestern University of Finance and Economics (2014), the 2013 JCAE Symposium, and the 2013 AAA Annual Meeting. A substantial amount of the work was done when I was at Maastricht University and at London School of Economics and Political Science.

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Appendix

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See Table 10.

Table 10 The definitions and sources of the variables used in this paper
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Chen, L. Local Institutions, Audit Quality, and Corporate Scandals of US-Listed Foreign Firms. J Bus Ethics 133, 351–373 (2016). https://doi.org/10.1007/s10551-014-2370-x

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