Corporate Governance and Firm‐specific Stock Price Crashes

Date01 November 2016
Published date01 November 2016
Corporate Governance and
Firm-specic Stock Price Crashes
Panayiotis C. Andreou
CyprusUniversity of Technology,Departmentof Commerce, Financeand Shipping, 115 SpyrouAraouzou
Street,3036 Lemesos, Cyprus, andDurham University Business School, Mill HillLane, Durham DH1 3LB, UK
Constantinos Antoniou
Warwick Business School, Warwick University, Coventry CV4 7AL, UK
Joanne Horton
Exeter University Business School, University of Exeter, Rennes Drive, Exeter EX4 4PU, UK
Christodoulos Louca
CyprusUniversity of Technology,Departmentof Commerce, Financeand Shipping, 115 SpyrouAraouzou
Street,3036 Lemesos,Cyprus, andDurham University Business School, Mill Hill Lane, Durham DH1 3LB, UK
We investigate whether ownership structure, accounting opacity, board structure
& processes and managerial incentives attributes relate to futurestock price crash
risk. Principal component analysis on the 21 attributes that comprise these four
corporate governancedimensions reveals that they can explain between 13.1%and
23.0% of a one standard deviation in crashrisk. Transient institutional ownership,
CEO stock option incentives and the proportion of directors that hold equity
increasecrash risk, whilst insidersownership,accounting conservatism, board size
and the presenceof a corporate governance policy mitigatecrash risk. Overall these
relationships are more pronounced in environments that accentuate agency risk.
Keywords: crash risk, corporate governance, agency risk, information environment
JEL classification: G38, G34, M48
We express our heartfelt thanks to the Editor, John Doukas, and three anonymous referees
for their constructive suggestions and helpful comments. We also thank Richard Harris,
Rajesh Tharyan, Grzegorz Trojanowksi, Jay Ritter, David Yermack and seminar
participants at Exeter Business School, Cyprus University of Technology and the European
Financial Management Meeting 2012 for useful comments and suggestions. All remaining
errors are our own.
European Financial Management, Vol. 22, No. 5, 2016, 916956
doi: 10.1111/eufm.12084
© 2016 John Wiley & Sons, Ltd.
1. Introduction
The great breadth and depth of corporate governance literature, as shaped by a growing
empirical and theoretical research in the past few decades, is indicative of the signicant
role that corporate governance systems play in protecting shareholderswelfare. This
study investigates which corporate governance attributes, amongst the many that rms
employ, are the most prominent ones in explaining the link between governance and
future stock price crashes.
Stock price crashes are likely to occur among rms with high agency risk (Callen and
Fang, 2013; Kim and Zhang, 2015). Managers, in such rms, due to career concerns and
incentives arising from compensation contracts, may exploit information asymmetries to
conceal negative information and engage in short-sighted price maximisation to better
serve their own interests (Stein, 1989); either through earnings management (Kothari
et al., 2009) or suboptimal investment decisions that cater to prevailing market sentiment
(Bebchuk and Stole, 1993). However, withholding, delaying or accumulating the
disclosure of bad news is unsustainable for long periods and will eventually lead to
signicant stock price crashes when the true fundamentals unexpectedly reveal an
enormous amount of negative information in the market (Bleck and Liu, 2007; Callen
and Fang, 2013; Kim and Zhang, 2015).
A large body of literature nds that corporate governance systems can alleviate agency
risk, curbing such opportunistic managerial behaviour that could be harmful to
shareholders (Karamanou and Vafeas, 2005; Klein, 2002; Masulis et al., 2007; Xie et al.,
2003). Prior research on the effect of corporate governance on various organisational
outcomes typically focuses on individual governance mechanisms or constructs one-
dimensional governance metrics by summing up individual variables (Gompers et al.,
2003). Similarly, the crash risk literature has only focused upon a single governance
mechanism (Callen and Fang, 2013; Hutton et al., 2009; Kim et al., 2011; Kim and
Zhang, 2015).
In contrast, we undertake a comprehensive investigation using a broad set
of governance attributes which provides a more appealing and credible approach
(Ashbaugh-Skaife et al., 2006; Bebchuk et al., 2009; Bhagat et al., 2008) and enables us
to measure the overall quality of a rms governance system and ascertain which are the
most relevant in limiting crash risk.
Drawing motivation from all these studies we examine which corporate governance
attributes mitigate the 1-year-ahead rm-specic stock price crashes.
We jointly
consider four central dimensions of governance mechanisms: (i) ownership structure,
(ii) accounting opacity, (iii) board structure & processes, and (iv) managerial
incentives, which comprise a broad set of 21 attributes. Each of these corporate
governance dimensions are designed to increase or enhance the monitoring of
managements actions to promote effective decision-making, limit their opportunistic
behaviour and reduce the information asymmetry between the rm and its external
stakeholders (Ashbaugh-Skaife et al., 2006). Although we motivate the use of each of the
corporate governance attributes employed, we do not expect that all 21 would equally
Kim and Zhang (2014) also examine the relationship between nancial reporting opacity
and ex-ante (or perceived) crash risk, as reected in the steepness of implied volatility smirks.
We use the terms rm-specic stock price crash and crash risk interchangeably to refer to
1-year-ahead crash risk that results from sharp stock price declines.
© 2016 John Wiley & Sons, Ltd.
Corporate Governance and Firm-specic Stock Price Crashes 917
affect a rms propensity to stock price crashes since some attributes might have little or
no relevance to the phenomenon under scrutiny. Hence, in this study, we rely on various
regression model specications from principal component analysis (PCA) to a
horse-race approach to identify which of these dimensions and attributes are responsible
for explaining future rm-specic stock price crashes and under what circumstances.
Our regression approach i s carefully implemented to ta ckle econometric problem s
previously identied in the corpo rate governance literature and w hich often cloud the
interpretation of resul ts, for example simultaneo us causality and dynamic en dogeneity
issues (Bhagat and Bolton, 200 8; Callen and Fang, 2013; Creme rs and Ferrell, 2014;
Kim and Zhang, 2015) and the limiting i nterpretation of a single or comp osite
corporate governance index (Ashbaugh-Skaife et al., 2006 ; Cremers and Ferrell,
Overall, our results are cons istent with the notion that a rms gover nance system
can be set up to mitigate the occu rrence of future stock price cr ashes. Specically, the
principal component anal ysis reveals that, dependi ng on the regression estim ation
setting, the statistica l signicant factors that eme rge from the governance attr ibutes
can explain overall between 1 3.1% and 23.0% of a one standard devi ation of future
crash risk. Thus, the effect of co rporate governance on crash r isk is not just
statistically signicant bu t also important in economic ter ms. Further detailed analysi s
reveals that the governance attributes pertaining to both ownership structure and
accounting opacity provide a rst-order effect in mitigating the occ urrence of future
crash risk, and can explai n on their own approximatel y 9.0% and 3.4% of a one
standard deviation of futur e crash risk, respectively . Whilst the remaining dimensi ons,
namely board structure & processes and manage rial incentives add very li ttle, if any,
on their own, to the explana tory power of the model that l inks the governance factor s
to crash risk.
Analysis of the 21 governance attributes employed, reveals seven which appear to be
the most prominent ones to explain the occurrence of future stock price crashes.
Specically we nd that crash risk increases with transient institutional ownership, CEO
stock option incentives and the proportion of outside directors that hold equity in the
company. Furthermore, despite the widespread claim that directorsshare-ownership
aligns managerial and shareholders incentives, our results with respect to outside
directors suggest that this incentive mechanism may not reduce crash risk, but rather
increase it instead, consistent with Song and Windram (2004). We also nd that crash
risk decreases with insidersownership, the level of conditional accounting conservatism
in the nancial reports, board size and the presence of corporate governance policy in a
rms mandate. In this respect, rms with larger boards and a clear dened corporate
governance policy are also more likely to reduce the agency conicts that induce crash
Interestingly, unlike prior research, we do not nd that the opacity of the nancial
reports increases stock crashes (Hutton et al., 2009). Further analysis reveals that this
lack of a positive relationship is driven by the nancial crisis, an economic downturn
period in which managers had limited opportunities and fewer incentives to stockpile
negative information through earning management practices (Ahmad-Zaluki et al.,
2011; Bertomeu and Magee, 2011; Chia et al., 2007; Filip and Raffournier, 2014; Jenkins
et al., 2009) a precursor situation to stock price crashes.
Finally, we examine whether industry or rm characteristics, which are known to
affect the effectiveness of corporate governance systems (Giroud and Mueller, 2010),
© 2016 John Wiley & Sons, Ltd.
918 P. C. Andreou, C. Antoniou, J. Horton and C. Louca

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