Market Manipulation with Outside Incentives

Much evidence has shown that prediction markets, when used in isolation, can effectively aggregate dispersed information about uncertain future events and produce remarkably accurate forecasts. However, if the market prediction will be used for decision making, a strategic participant with a vested interest in the decision outcome may want to manipulate the market prediction in order to influence the resulting decision. The presence of such incentives outside of the market would seem to damage information aggregation because of the potential distrust among market participants. While this is true under some conditions, we find that, if the existence of such incentives is certain and common knowledge, then in many cases, there exists a separating equilibrium for the market where information is fully aggregated. This equilibrium also maximizes social welfare for convex outside payoff functions. At this equilibrium, the participant with outside incentives makes a costly move to gain the trust of other participants. When the existence of outside incentives is uncertain, however, trust cannot be established between players if the outside incentive is sufficiently large and we lose the separability in equilibrium.Engineering and Applied Science

Managers’ Incentives to Manipulate Earnings in Management Buyout Contests: An Examination of How Corporate Governance and Market Mechanisms Mitigate Earnings Management

In an MBO contest, managers offer to buy the firm from public shareholders at a premium to the current market price and thus have incentives to buy the firm “cheap.” Prior studies have found evidence that managers, on average, manipulate earnings downward prior to an MBO offer in an attempt to convince shareholders that their offer is fair. We extend this finding by attempting to explain the substantial cross sectional variation in the degree of manipulation across firms reported in these earlier studies. We find that boards with more independent directors and higher levels of incentive based compensation for the CEO act to discourage such manipulation. Additionally, our results show that some shareholders, minority and preexisting large outside blockholders, appear to be misled by the manipulation. However, new blockholders that acquire large shareholdings in the year before the offer are not. We also discover that managers are more likely to revise their bid upwards when the manipulation is most severe and that these new blockholders put pressure on managers to make these revisions. Finally, we investigate whether the manipulation has an impact on the final buyout contest outcome. We find that downward manipulation does not prevent managers from retaining control of the firm; however, they pay a higher premium

Maintaining a reputation for consistently beating earnings expectations and the slippery slope to earnings manipulation

This paper investigates whether maintaining a reputation for consistently beating analysts’ earnings expectations can motivate executives to move from “within GAAP” earnings management to “outside of GAAP” earnings manipulation. We analyze firms subject to SEC enforcement actions and find that these firms consistently beat analysts’ quarterly earnings forecasts in the three years prior to the manipulation period and continue to do so by smaller “beats” during the manipulation period. We find that manipulating firms beat expectations around 86 percent of the time in the twelve quarters prior to the manipulation period (versus 75 percent for control firms) and that manipulation often ends with a miss in expectations. We document that executives of manipulating firms face strong stock market and CEO pressure to perform. Prior to the manipulation period, these firms have high analyst optimism, growing institutional interest, and high market valuations, along with powerful CEOs. Further, we find that maintaining a reputation for beating expectations is more important than CEO overconfidence and is incremental to CEO equity incentives for explaining manipulation. Our results suggest that pressure to maintain a reputation for beating analysts’ expectations can encourage aggressive accounting and, ultimately, earnings manipulation

Efficient contracting, earnings smoothing and managerial accounting discretion

Purpose – The purpose of this paper is to examine whether the contracting incentives (i.e. bonus plans, debt covenants, political costs hypotheses), and income smoothing can explain accounting choices in an emerging country, Egypt. Design/methodology/approach – The paper uses the ordinary least square regression model to examine the relationship between earnings management and reporting objectives. A sample of 438 non-financial firms listed on the Egyptian Exchange over the period 2005-2007 is used. Findings – The paper finds that the contracting objectives explain little of the variations in accounting choices (i.e. discretionary accruals) in the Egyptian context. However, the paper finds that mangers are likely to smooth the reported earnings by managing the accrual component in an attempt to reduce the fluctuation in reported earnings by increasing (decreasing) earnings when earnings are low (high) in attempt to reduce the variability of the reported earnings. Research limitations/implications – The empirical results rely on the ability of earnings management proxies to adequately capture earnings manipulation activities. Practical implications – The findings of the study should be of substantial interest to regulators and policy makers. The results implicitly contribute to the ongoing argument in relation to the optimal flexibility permitted by standard setting and the argument that tightening the accounting standards and mandating International Financial Reporting Standards are likely to improve reporting quality and reduce opportunistic earnings management. The results reveal that many of the weaknesses related to corporate reporting in emerging countries may result from the inadequate enforcement of the law and the weak legal protection of minority shareholders. The results also highlight the crucial role of understanding the reporting incentives, which is mainly shaped by institutional and market forces and the legal environment, in explaining accounting choices. Originality/value – Unlike previous studies that tested an individual objective, this study examines the trade-offs among various reporting objectives in an emerging economy

The Economics of Corporate Executive Pay

[Excerpt] In the past ten years, the pay of chief executive officers (CEOs) has more than doubled, and the ratio of median CEO to worker pay has risen to 179 to 1. High and rising executive pay could be an issue of public concern on two different grounds. First, it is contributing to widening income inequality that may be of concern from an equity perspective. Second, it could be the result of economically inefficient labor markets. It is difficult to determine whether executive pay is excessive across the board since executives’ marginal product cannot be directly observed. An upward trend in pay over time is not sufficient proof that the market is not efficient since factors determining supply and demand, such as the skills required of the position, can change over time. To show that pay is excessive from an economic perspective, one must first demonstrate that there is a market failure that is preventing the market from functioning efficiently. The market failure could originate in the division in large modern firms between management and ownership, which is typically dispersed among millions of shareholders. Shareholders’ interests are represented by a board of directors. Critics of executive pay have argued that boards have all too often been “captured” by the executive and are no longer negotiating pay packages that are in the shareholders’ best interests. They point to a number of common practices that they call “stealth compensation” which are inconsistent with arm’s length contracting. These include “golden parachutes,” generous severance packages, company-provided perks, and bonuses that are unrelated to firm performance. Stock options have been the fastest growing portion of executive pay since the 1990s, and critics believe this pattern can also be explained through the prism of stealth compensation. Rewarding executives with employee stock options was often justified in terms of the “pay for performance” mantra, but options are usually designed to reward absolute, not relative, performance. This means that in the bull market of the 1990s, when virtually all stock prices were rising, a company could fall behind its competitors and its executives could still receive handsome options payouts. Indeed, a sizeable portion of the increase in executive pay in the 1990s was likely due to options that turned out to be much more valuable than expected because of the unprecedented price increases of the bull market. Many of the recent corporate scandals appear consistent with stealth compensation as well. Stock options backdating, earnings manipulation, and accounting fraud might have been motivated by attempts to covertly increase executive pay. If short-term fluctuations in the stock price are not good proxies of firm performance, then tying compensation to the stock price can create incentives for executives to engage in activities that are detrimental to shareholders. Policy proposals mostly focus on improving transparency, increasing board independence, and strengthening shareholder control rather than attempting to curb pay directly. S. 1181 (Obama) and H.R. 1257 (Frank), which the House approved on April 19, 2007, would give shareholders a non-binding vote on executive pay. Another proposal would modify the limit on deductibility of executive pay from corporate taxation. More broadly, income inequality could be reduced by increasing the progressivity of the tax system. For current developments and legislation, see CRS Report RS22604, Excessive CEO Pay: Background and Policy Approaches

Stock Options: The Backdating Issue

[Excerpt] Employee stock options are contracts giving employees the right to buy the company’s common stock at a specified exercise price, at a specified time or during a specified period, and after a specified vesting period. The value of the option when granted lies in the prospect that the market price of the company’s stock will increase by the time the option is exercised (used to purchase stock). At the grant date for the options, rather than selecting an exercise price based on the current market price for the stock, officials at some companies have selected a prior date with a lower market price; that is, they backdated stock options to an earlier grant date. If this backdating occurred without public disclosure, the recipient of the stock options received increased compensation in violation of Securities and Exchange Commission (SEC) regulations, generally accepted accounting rules, and tax laws. Some backdating is said to involve “sloppiness,” not fraud. The backdating of stock options has imposed costs on shareholders, employees, bondholders, and taxpayers. A corporate official who has profited from undisclosed backdating of stock options may not be responsible or even knowledgeable of the backdating. “Nonqualified” stock options, which have no special tax criteria to meet, are the focus of the backdating controversy primarily because they can be granted in unlimited amounts. The magnitude of stock option grants grew dramatically in the 1990s, subsequent to passage of the Omnibus Budget Reconciliation Act of 1993, a stock market boom, and revised accounting rules. Recent corporate disclosure changes have reduced the opportunities and rewards for backdating stock options. Empirical studies about backdating have been done by academics and investigative journalists. Four recent regulatory actions may have reduced the backdating of stock options, but problems persist. On December 16, 2004, the Financial Accounting Standards Board issued new rules requiring companies to subtract the expense of options from their earnings. After August 29, 2002, the Sarbanes-Oxley Act required that companies notify the SEC within two business days after granting stock options. In 2003, the SEC required increased disclosure of stock option plans. The SEC issued enhanced option grant disclosure rules effective December 15, 2006. Policy options to further reduce backdating and other timing manipulation include changes in SEC regulations and a change in the tax law. The SEC, various state prosecutorial, and Department of Justice (DOJ) probes into backdating abuses are ongoing. In addition, many firms have mounted their own internal probes into possible abuses. By November 2007, the SEC’s investigation caseload had fallen from a peak of 160 to about 80, and the SEC had brought civil enforcement actions against seven companies and 26 former executives associated with 15 firms. And according to reports from the DOJ, there were at least 10 criminal filings against defendants for backdating. As of January 2, 2008, the only CEO to be convicted of charges related to backdating was Greg Reyes, former Brocade CEO. This report will be updated as issues develop or new legislation is introduced

Online Manipulation: Hidden Influences in a Digital World

Privacy and surveillance scholars increasingly worry that data collectors can use the information they gather about our behaviors, preferences, interests, incomes, and so on to manipulate us. Yet what it means, exactly, to manipulate someone, and how we might systematically distinguish cases of manipulation from other forms of influence—such as persuasion and coercion—has not been thoroughly enough explored in light of the unprecedented capacities that information technologies and digital media enable. In this paper, we develop a definition of manipulation that addresses these enhanced capacities, investigate how information technologies facilitate manipulative practices, and describe the harms—to individuals and to social institutions—that flow from such practices. We use the term “online manipulation” to highlight the particular class of manipulative practices enabled by a broad range of information technologies. We argue that at its core, manipulation is hidden influence—the covert subversion of another person’s decision-making power. We argue that information technology, for a number of reasons, makes engaging in manipulative practices significantly easier, and it makes the effects of such practices potentially more deeply debilitating. And we argue that by subverting another person’s decision-making power, manipulation undermines his or her autonomy. Given that respect for individual autonomy is a bedrock principle of liberal democracy, the threat of online manipulation is a cause for grave concern

Imperfect Legal Unbundling of Monopolistic Bottlenecks

We study an industry with a monopolistic bottleneck (e.g. a transmission network) supplying an essential input to several downstream firms. Under legal unbundling the bottleneck must be operated by a legally independent upstream firm, which may be partly or fully owned by an incumbent active in downstream markets. Access prices are regulated but the upstream firm can perform non-tariff discrimination. Under perfect legal unbundling the upstream firm maximizes only own profits; with imperfections it considers to some extend also the profits of its downstream mother. We find that reducing imperfections in legal unbundling (keeping ownership fixed) generally increases total output. Increasing the incumbent's ownership share increases total output if imperfections are sufficiently small, otherwise the effects are ambiguous. Surprisingly, higher ownership shares of the downstream incumbent may sometimes lead to lower degrees of imperfections. Our analysis suggests that consumers may benefit most from legal unbundling with strong regulation and parts of ownership given to a minority outside shareholder.Network industries, regulation, vertical relations, ownership, corruption, sabotage

Technology, Information Production, and Market Efficiency

A well functioning securities market relies on the availability of accurate information, a broad base of investors who can process this information, legal protection of these investors’ rights, and a liquid secondary market unencumbered by excessive transaction costs or constraints. When these conditions are satisfied, securities markets are likely to be broader and more efficient, with felicitous consequences for investment and resource allocation. This paper explores the effect of technological advances on these features of the market, emphasizing the incentives facing the producers of financial information.