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Regulatory effects on Analysts' conflicts of interest in corporate financing activities: Evidence from NASD Rule 2711
Accepted Manuscript Regulatory effects on Analysts' conflicts of interest in corporate financing activities: Evidence from NASD Rule 2711
Peter Chen, Kirill Novoselov, Yihong Wang PII: DOI: Reference:
S0929-1199(17)30075-5 https://doi.org/10.1016/j.jcorpfin.2017.12.020 CORFIN 1328
To appear in:
Journal of Corporate Finance
Received date: Revised date: Accepted date:
2 February 2017 27 October 2017 11 December 2017
Please cite this article as: Peter Chen, Kirill Novoselov, Yihong Wang , Regulatory effects on Analysts' conflicts of interest in corporate financing activities: Evidence from NASD Rule 2711. The address for the corresponding author was captured as affiliation for all authors. Please check if appropriate. Corfin(2017), https://doi.org/10.1016/ j.jcorpfin.2017.12.020
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Regulatory Effects on Analysts’ Conflicts of Interest in Corporate Financing Activities: Evidence from NASD Rule 2711*
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Peter Chen† Hong Kong University of Science and Technology [email protected] Phone: (+852) 2358-7572
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Kirill Novoselov Nazarbayev University [email protected]
This version: Oct. 2017
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Yihong Wang Shanghai University of Finance and Economics [email protected]
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We thank David Burgstahler, Mingyi Hung, Richard Sloan, Shiheng Wang, Wayne Yu, Haifeng You, Guochang Zhang, and workshop participants at the Hong Kong University of Science and Technology and Shanghai University of Finance and Economics. † Corresponding author.
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Regulatory Effects on Analysts’ Conflicts of Interest in Corporate Financing Activities: Evidence from NASD Rule 2711
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Abstract: We investigate the effects of NASD Rule 2711 on analysts’ conflict of interest in corporate financing activities. Specifically, we examine the relations (1) between analysts’ guidance in earnings forecasts and recommendations and corporate external financing and (2) between external financing and future stock returns during the 1994–2010 period. We find a positive relation of analysts’ guidance in earnings forecasts and recommendations (especially long-term growth forecast and recommendations) and corporate financing activities, but the relation is weaker in the post-Rule period than in the pre-Rule period. We also find a negative relation between corporate external financing and future stock returns, but the relation is weaker in the post-Rule period. Moreover, the changes of these relations after the implementation of the Rule are greater for firms with greater conflicts of interest. Our empirical results suggest that Rule 2711 has reduced the extent of analysts’ conflicts of interest in corporate financing activities.
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Keywords: Conflicts of interest; NASD Rule 2711; analysts’ guidance; external financing; stock returns.
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1. INTRODUCTION Sell-side analysts face the dual task of providing independent earnings forecasts/stock recommendations for investors and marketing their employers’ financial services to corporate managers. Analytical valuation models and empirical findings show that analysts are capable of guiding market valuation
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through their earnings forecasts and recommendations (e.g., Miller and Modigliani 1961; Ohlson 1995;
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Lys and Sohn 1990; Womack 1996; Jegadeesh, Kim, Krishche and Lee 2004). Analysts, however, may
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divert their ability to guide market valuation to curry favor with corporate managers in selling overvalued securities. In return for their optimistic guidance, analysts are compensated with commissions on ongoing
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investment banking and brokerage business. Meanwhile, investors who purchase the underwritten securities on analysts’ guidance suffer subsequent losses. Consequently, analysts’ conflicts of interest
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have been under considerable regulatory and academic scrutiny in recent decades. Ever since the collapse of the internet and telecom stocks in the early 2000s, analysts have been
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scrutinized for hyping securities during the boom of financing activities (e.g., Shiller 2000, 2012;
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Groysberg and Healy 2013). Securities and Exchange Commission (SEC) approved NASD Rule 2711 in May 2002 (hereafter, the Rule) that prohibits employers from linking analysts’ compensation to their
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investment banking transactions and prohibits analysts from offering favorable research or a specific rating or price target to a company as consideration or inducement for future business. These prohibitions
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reflect the belief that linking analysts’ pay to their employers’ investment banking business leads analysts to make more optimistic forecasts and recommendations to curry favor with managers.1 Prior studies find
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that analysts’ bias in forecasts and recommendations has decreased and the relation between analysts’ recommendations and fundamental valuation (V/P) has strengthened in the post-Rule period (Barber, Lehavy, McNichols, and Truman 2006; Barniv, Hope, Myring, and Thomas 2009; Chen and Chen 2009; Guan, Lu, and Wong 2012; Kadan, Madureira, Wang and Zach 2009). These studies, however, do not directly examine whether the implementation of the Rule has changed the relation between analysts’ 1
Besides investment banking, other conflicts of interest identified by the regulators are (i) positive research reports to trigger higher trading volumes and in turn generate larger commissions for the analysts’ firms and (ii) ownership of equity by the analyst or the brokerage firm in the companies that the analyst covers. See the SEC Acting Chair Laura Unger’s written testimony before the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, Committee on Financial Services, U.S. House of Representatives on July 31, 2001.
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ACCEPTED MANUSCRIPT optimistic guidance on valuation and corporate financing activities, which was the regulator’s primary concern. In addition, prior studies provide little evidence on whether the Rule has redressed the imbalance in the relation between the interests of analysts and those of investors who purchase the securities underwritten by the analysts’ employers.
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A stream of finance studies documents a negative relation between corporate financing activities
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and future stock returns and suggests that analysts’ optimism around corporate financing events may
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contribute to this negative relation (Loughran and Ritter 2004; Ritter 2003). Building on prior findings on stock returns after various financing activities, Bradshaw, Richardson, and Sloan (2006) construct
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comprehensive measures of corporate financing using statements of cash flow data for the 1971–2000 period and report evidence of systematic negative relations between corporate financing activities (debt or
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equity) and future stock returns. 2 Furthermore, they find that, although analysts’ forecasts and recommendations are too optimistic for firms raising new capital regardless of investment banking ties,
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affiliated analysts are slightly more optimistic than non-affiliated analysts.3 Their findings of the negative
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relation between external financing and future stock returns are consistent with analysts’ conflicts of interest, even though these findings are also consistent with market timing. These relations reported by
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Bradshaw et al. (2006) in the pre-Rule period may have changed, however, if the Rule, implemented in 2002, has attenuated the degree of analysts’ conflicts of interest in corporate financing.
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In this study, we provide evidence on whether Rule 2711 has changed the extent of analysts’ conflicts of interest in corporate financing activities. To infer the effects of the Rule, we investigate (1)
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the relation between analysts’ guidance in earnings forecasts and recommendations and corporate external financing, and (2) the relation between external financing and future stock returns. If the prohibitions stipulated in the Rule have weakened analysts’ incentive to issue overly optimistic guidance in selling new securities, we hypothesize that the relation between analysts’ guidance in earnings forecasts and recommendation ratings and firms’ external financing is weaker in the post-Rule than in the pre-Rule 2
Bradshaw et al. (2006) report an annual return of 15.5%, using a hedge strategy based on net external financing. Bradshaw et al. (2006) find that analysts’ earnings forecasts and recommendation ratings are optimistic following the external financing activity. In this study, we investigate whether analysts’ earnings forecasts and recommendations are too optimistic in the year of external financing. 3
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show a positive relation between analysts’ guidance in earnings forecasts and recommendation ratings
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and external financing, but this relation is weaker in the post-Rule period. Among the four analysts’
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variables in our empirical tests, the effects of the Rule on analysts’ long-term growth forecasts and recommendations are more evident than on one-year and two-year-ahead earnings forecasts. In addition,
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the Rule has a stronger effect on equity financing than on debt financing. Our empirical results also show a negative relation between external financing and future stock returns, but the relation is weaker in the
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post-Rule than in the pre-Rule period.
To enhance the likelihood that these changes in relations are attributable to the implementation of
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the Rule, we partition the sample into two groups based on the firm’s level of conflicts of interest. We use
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the supply of investment banking services from the analysts’ employers as a proxy for the firm’s potential conflicts of interest. We find that the changes in the relation between analysts’ guidance and external
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financing and in the relation between external financing and future stock returns from the pre-Rule to the post-Rule period are greater for firms with greater conflicts of interest. These empirical results provide
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further evidence that the reforms implemented by the Rule have attenuated analysts’ conflicts of interest in corporate financing activities.
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We acknowledge that our inferences on the effects of the Rule are subject to limitations. In particular, we cannot rule out the possibility that the changes in the relations we document are attributable to concurrent regulatory events such as the passage of the Sarbanes–Oxley Act (SOX) in 2002 and changes in investment opportunities. In additional analyses, we perform several tests and robustness checks to enhance our confidence that our results are attributable to the Rule and are not driven by alternative explanations. First, we perform similar analyses on whether Rule 2711 has attenuated the analysts’ conflicts of interest arising from trading commissions because this was also a part of the regulatory reform. Using the firm’s share turnover (per share) in the year of external financing as a proxy 3
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for potential conflicts from trading commissions, we find effects of the Rule similar to those of the investment banking. Interestingly, we find no such effect of the Rule for a sample of firm-year observations with no analyst following. We also perform empirical tests to show that our results on the change in the relation between
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external financing and future stock returns (H2) are not attributable to market timing and the passage of
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SOX. With respect to marketing timing, we find our result remains unaffected after controlling for market
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timing variables, past 24 month stock returns, and investment sentiment (Chang, et al. 2006; Baker and Wugler 2006). Prior studies report evidence that firms manage accruals before equity financing, but
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accrual-based earnings management declines because of strengthened regulatory oversight on financial reporting in the post-SOX period (e.g. Teoh, Welch, and Wong 1998; Cohen, Dey, and Lys 2008). We
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include measures of accruals in our regression of future stock return on external financing. Our results on the relation between external financing and future stock returns attributable to analysts’ conflicts of
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interest are unaffected after controlling for the effect of accruals. By conducting these tests, we also rule
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out the possibility that the change of the above-mentioned negative relation is attributable to the accrual anomalies (Sloan 1996; Richardson et al. 2005; Cohen and Lys 2006). In addition, we perform tests to
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show that our results are not attributable to changes in the firm’s investment opportunity set in the postRule period (Lyandres, Sun, and Zhang 2007; Chen and Zhang 2007). Specifically, we include both
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accounting profitability (return of equity) and the change in profitability after external financing in the regression of future stock returns and external financing. Our results on the effects of the Rule remain
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unchanged by including these variables. In addition to the above tests, we perform several robustness checks. We repeat our analysis with observations within ±4 years around the implementation of the Rule and obtain even stronger results on the effects of the Rule. We use affiliated analysts as the alternative measure of analysts’ conflicts of interest and obtain qualitatively similar results. Our study makes several contributions. First, by focusing on the role of analysts in corporate financing activities, we provide new empirical evidence on the effects of Rule 2711. Our empirical results on the changes in the relation between analysts’ guidance in earnings forecasts and recommendations and 4
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external financing as well as the relation between external financing and future stock returns in the postRule period provide further evidence to differentiate the role of analysts’ conflicts of interest versus market timing in corporate financing activities. Although prior studies show that analysts have changed their assignments of Buy and Sell recommendations toward more objective valuations, these studies do
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not show whether the Rule has resulted in the change of analysts’ guidance to market overvalued new
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issuances, as targeted by the Rule. Unlike Bradshaw et al (2006) and consistent with Kadan et al. (2009)
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and Guan et al. (2012), we find that analysts’ conflicts of interest, controlling for external financing, are associated with more optimistic guidance in pre-Rule period. Unlike Kadan et al. (2009) and Guan et al.
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(2012), we provide direct evidence on whether the change of the Rule has changed the relation of analysts’ guidance and financing activities as well as on the relation between future stock return and financing
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activities in the post-Rule period. Our empirical results contribute to those based on the change of the relation of analysts’ recommendation with fundamental valuation (V/P) in prior studies (Barniv et al.
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2009; Chen and Chen 2009; Groysberg et al. 2011).
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Second, for regulators, our empirical results on the change in the relation of external financing and future stock returns suggest that Rule 2711 redresses the misalignment between the interests of
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analysts and those of investors in the underwritten securities. Several studies find that the Rule has resulted in unintended consequences, such as loss of pay and funding to analysts and reduced analysts’
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coverage, and conclude that the reforms provide little benefit to investors based on the accuracy of analysts’ forecasts and the profitability of analysts’ recommendations (Kadan et al. 2009; Guan et al.
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2012; Groysberg and Healy 2013). By providing evidence on the Rule’s intended purpose, our empirical results help regulators assess the economic consequences of the Rule. The results also have implications for studies on the wealth transfers among ongoing investors and new investors as a result of financing activities (e.g., Sloan and You 2015). To the extent that misaligned incentives of analysts, managers, and other market participants result in wealth transfers via financing transactions, the regulators must remain vigilant. Third, our study enhances our understanding of the role of analysts in guiding market valuation. Our empirical results show that conflicts of interest that compel analysts to guide optimistic valuation are 5
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more evident in long-term growth forecasts and recommendations than in short-term earnings forecasts. These results suggest that using short-term earnings forecast errors to infer analysts’ conflicts of interest may lead to unwarranted conclusions (Guan et al 2012, Cowen et al. 2006). Our results complement prior findings on the relation of long-term growth forecasts and recommendations with future stock returns
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(Dechow and Sloan 1997; Dechow et al. 2000; Bradshaw 2004; Jegadeesh et al. 2004; Purnanandam and
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Swaminathan 2004). Additionally, our empirical results show that analysts’ forecasts and
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recommendations have a stronger relation with equity financing than with debt financing, consistent with the greater impact of analysts’ guidance on equity valuation than on debt valuation.
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The rest of the paper is organized as follows. Section II discusses the related literature and develops our research hypotheses. Section III lays out the research design, while Section IV describes
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measurement of variables and the sample. Section V presents the main empirical results. Section VI presents the results from tests of alternative explanations and robustness checks. Section VII concludes
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the paper.
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2. RELATED LITERATURE AND HYPOTHESIS DEVELOPMENT 2.1. Analysts’ Conflicts of Interest and Corporate External Financing
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Valuation models show that security valuation requires forecasts of earnings and earnings growth (Miller and Modigliani 1961; Ohlson 1995). Financial analysts are specialists in forecasting earnings and making
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stock recommendations. To develop an informational edge, they collect and process various industry- and firm-specific information. A large body of empirical evidence shows that analysts’ forecasts of earnings
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serve as a better proxy for market expectation than time-series models (Fried and Givoly 1982; O’Brien 1988), that analysts’ forecasts of earnings and earnings growth serve as key valuation metrics in explaining stock price (Frankel and Lee 1998; Liu, Nissim, and Thomas 2002), and that changes of analysts’ forecasts and their recommendation ratings are associated with predictable stock returns (Lys and Sohn 1990; Womack 1996; Barber et al. 2003). Both valuation theories and empirical studies support the notion that financial analysts guide market valuation through their forecasts and recommendations. Sell-side analysts also perform a valuable role in selling new securities and making a liquid market for their clients (e.g. Womack 1996; Groysberg and Healy 2013). Analysts’ ability to guide 6
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market valuation, however, may be diverted to curry favor with corporate managers by issuing optimistic guidance on newly issued securities. In return, issuers compensate analysts and their employers with commissions on current and future investment banking business. Besides their access to corporate managers, analysts have a natural advantage over other market participants in generating future
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investment banking business because in forecasting earnings and earnings growth, analysts are able to
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anticipate the firm’s future demand for external financing. 4 Linking analysts’ compensation to investment
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banking business strengthens their incentives to divert effort from generating objective forecasts and valuation to the marketing of overvalued securities. However, analysts’ conflicts of interest during
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financing activities benefit analysts or their corporate clients at the expense of investors who purchase the newly issued securities.5 This wealth transfer was a major concern that led to regulatory reforms in the
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Rule.
Valuation models discussed above have implications for the different types of earnings forecasts
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and recommendations that analysts issue to guide valuation. Because the value of a firm is the capitalized
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stream of its expected future earnings, analysts’ optimism in their long-term growth guidance has a multiplier effect on valuation that is much greater than a similar level of optimism in short-term earnings
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forecasts would have.6 Analysts’ stock recommendations signal their private valuation relative to current market valuation. A Buy or Strong Buy rating indicates the analyst’s valuation that is higher than current
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market valuation and vice versa for a Sell or Strong Sell rating. Accordingly, analysts’ recommendations influence market valuation through more direct guidance of investors’ trading than earnings forecasts.
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Therefore, we expect that analysts’ guidance of market valuation during external financing activities is more effective through stock recommendations and long-term earnings growth forecasts than through 4
The valuation models in Miller and Modigliani (1961) show various links between the forecast of earnings and the forecast of external financing, given the firm’s investment policy. 5 Consistent with investment banking-related incentives, Groysberg et al. (2011) find that at leading investment banks, the average sell-side analyst compensation increased dramatically during the 1990s, leading to a peak of around $1.11 million in 2000 and then declined by 44% between 2003 and 2005 after the implementation of Rule 2711. These changes are largely driven by bonus awards related to investment banking. During the same period, the percentage of Strong Buy or Buy recommendations increases from 45% to 70% in 2000 while the percentage of Sell recommendations drops from 9.7% to 1.4%. 6 Analysts are also more constrained in issuing optimistic short-term earnings forecasts because of reputation concerns as well as the availability of other information such as management forecasts and earnings reports (Cowen et al. 2006).
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short-term earnings forecasts. Analysts’ guidance in earnings forecasts and recommendations may vary with the type of securities to be issued. Unlike equity holders, who have a residual claim on the firm, debtholders do not participate in the success or the upside potential of the firm beyond the promised claim in the debt
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contract. On the other hand, debtholders share the downside risk if the firm’s future cash flows cannot
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meet its debt obligations. Therefore, the valuation of equity (debt) has a convex (concave) relation with
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analysts’ optimisms in earnings and earnings growth forecasts as well as recommendations (Black and Scholes 1973; Zhang 2000). This implies that, to the extent that analysts guide overvaluation before
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external financing to curry favor with managers, analysts’ guidance in earnings forecasts and recommendations has a stronger relation with equity issuance than with debt financing.
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Prior research reports mixed evidence on whether investment banking affects the quality of analysts’ forecasts and recommendation ratings. Affiliated analysts are slower to downgrade from Buy
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and Hold recommendations and faster to upgrade from Hold, suggesting that investment banking ties
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increase analysts’ reluctance to reveal negative opinions about the firms they cover (Lin and McNichols 1998; O’Brien, McNichol and Lin 2005). Cowen, Groysberg, and Healy (2006) examine how the level of
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optimism in analyst forecasts and recommendations varies with the types of their employer for the 1996– 2002 period and report that analysts whose employers have significant underwriting and trading activities
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actually make less optimistic forecasts and recommendations than those at brokerage houses without underwriting. Cowen et al. attribute these results to reputation as the primary cause of reduced optimism
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of large underwriters. However, these authors’ evidence on analysts’ forecasts and recommendations is not conditional on corporate financing activities. While analysts’ affiliations likely reflect conflicts of interest arising from recent investment banking ties, unaffiliated analysts may also have incentives to issue favorable research reports to induce future investment banking business and to stay on friendly terms with managers, who serve as a valuable source of information (Mayew 2008). While prior studies measure conflicts of interest at the analyst level, in this study we measure conflicts of interest around financing activities at the firm level. Specifically, we use the supply of investment banking services from the analysts’ employers as a proxy for the level of 8
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the analysts’ affiliation.
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The regulator’s primary concern is that linking analysts’ compensation to investment banking
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business motivates analysts to attract and retain investment banking clients for their employer and as a consequence makes analysts accountable to investment banks for their earnings forecasts and
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recommendation ratings. 8 Our first research question is whether the Rule has changed the relation between analysts’ guidance in earnings forecasts and recommendations and external financing. Several
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recent studies find that analysts’ bias in forecasts and recommendations is smaller and the relation of analysts’ recommendations with fundamental valuation (V/P) is stronger in the post-Rule than in the pre-
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Rule period, consistent with improved analysts’ independence (e.g., Barber, et al. 2006; Barniv et al.
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2009; Chen and Chen 2009; Guan et al. 2012). These studies, however, do not directly examine whether the Rule has changed the relation between analysts’ forecasts and recommendations to guide market
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valuation and specific corporate financing activities. If the implementation of the Rule has attenuated the extent of analysts’ conflicts of interest associated with financing activities, we expect the relation of
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analysts’ guidance in earnings forecasts and recommendations with future external financing to be weaker in the post-regulation period.
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The above discussion leads to our first hypothesis: The relation between analysts’ guidance in earnings forecasts and recommendations and future external financing is weaker in the post-Rule than in the pre-Rule period.
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The supply is computed as the sum of reputation score of the analysts’ employers in Loughran and Ritter (2004). Underwriters with a rank of 8 to 9 are the prestigious national underwriters. Those with a rank of 5 to 7.9 are considered to be quality regional underwriters. Underwriters with a rank of 0 to 4.9 are associated with penny stocks. The reputation rank is based on the underwriter’s position as lead underwriter or syndicated underwriter in the tombstone announcements of the IPOs (Carter and Manaster 1990; Loughran and Ritter 2004). 8 SEC Acting Chairman Laura Unger’s testimony before the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, Committee on Financial Services, U.S. House of Representatives on July 31, 2001. Available at http://www.sec.gov/news/testimony/073101ortslu.htm.
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2.2. Corporate External Financing and Future Stock Returns Prior studies in finance report a negative relation between corporate external financing activities and future stock returns. In particular, future stock returns are consistently low in the periods following initial public offerings (Ritter 1991; Dechow et al. 2000), seasoned equity offerings (Loughran and Ritter 1997),
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debt offerings (Spiess and Affleck-Graves 1999), and bank borrowing (Billett, Flannery, and Garfinkel
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2006). In contrast, stock repurchases are associated with high future stock returns. These results suggest
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that corporate managers are able to time the market by selling overvalued and repurchasing undervalued securities (Baker and Wurlger 2006). Corporate managers may have an advantage over other market
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participants in arbitraging the mispriced securities; however, regulators and researchers want to know whether analysts’ conflicts of interest in marketing the newly issued securities contribute to overvaluation
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and thus explain the negative relation between external financing and future stock returns. Dechow, Hutton, and Sloan (2000) report evidence that analysts’ long-term earnings growth
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forecasts at initial public offerings are overly optimistic, especially among affiliated analysts. Dechow et
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al. also show that such optimistic forecasts are reflected in stock prices. Bradshaw et al. (2006) find that analysts’ forecasts and stock recommendations are overly optimistic following corporate financing
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activities. Bradshaw et al. attribute the negative relation between external financing and future stock returns to mispricing and propose a number of potential causes, including analysts’ conflicts of interest
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and managers’ market timing.
Our second research question is whether Rule 2711 has led to a weaker relation of external
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financing with future stock returns in the post-Rule period. Two streams of theoretical studies are relevant to our research question. First, the theory of collusion in organizations (e.g., Kofman and Lawarrée 1993) shows that one way to reduce collusion between the analysts (“the supervisors”) and corporate managers (“the agents”) is to reduce the supervisors’ stake in the agents (Tirole 1986; 2006). By delinking the analysts’ compensation from investment banking, the regulator intended to redress the balance between the interests of analysts and those of investors. Second, the theory of incentives in multi-task settings (Holmström and Milgrom 1991; Feltham and Xie 1994) suggests that analysts would allocate more effort to independent and objective valuation if the regulations were to weaken their incentives to induce 10
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investment banking business by guiding overvaluation. Several studies investigate whether Rule 2711 changes the accuracy of earnings forecasts and profitability of analysts’ recommendations (Barber et al. 2006; Kadan et al. 2009; Ertimur et al. 2007; Guan et al. 2012). The evidence in these studies suggests that the Rule has not benefited investors based
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on the profitability of analysts’ recommendations. In contrast, we investigate whether the Rule has led to
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a change in the relation between external financing and future stock returns to infer the efficacy of the
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reform in mitigating the adverse consequences of misaligned interests of analysts and those of investors trading in the newly issued securities. If the negative relation between external financing and future stock
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returns were attributable to analysts’ conflicts of interest in the pre-Rule period, we expect a weaker relation between external financing and future stock returns following the implementation of the Rule. On
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the other hand, if the negative relation between external financing and future stock returns were only attributable to market timing by managers, we should not find any evidence that the relation is weaker
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because the Rule does not constrain managers’ freedom to time the market in external financing activities.
H2:
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This leads to our second hypothesis stated as follows: The relation between external financing and future stock returns is weaker in the post-Rule than
3. RESEARCH DESIGN
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in pre-Rule period.
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Our hypothesis H1 states that the relation of analysts’ guidance in earnings forecasts and recommendation ratings with future external financing is weaker in the post-Rule period. Following Bradshaw et al. (2006),
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we employ four analyst variables to represent analysts’ guidance: one-year and two-year-ahead earnings forecasts, the long-term growth forecast, and the recommendation rating.9 To test H1, we estimate the regression of analysts’ variables following the release of financial statements of year t–1 on external financing in year t: Analysts’ Variableit = α0 + α1RULEit + α2ΔXFINit + α3ΔXFINit × RULEit + it.
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(1)
We do not examine the analyst’s target price due to data availability. Because analysts’ forecasts of target prices on IBES only become available in 1999, the number of observations with target price in the pre-Rule period is not sufficient large (less than 3,000) to perform tests comparable with those in our main empirical analyses.
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Our dependent variables are four analyst variables: F1ERROR, F2ERROR, LTG, and REC. F1RRORit (F2ERRORit) is the analysts’ one-year-ahead (two-year-ahead) earnings forecast error, i.e., realized earnings per share minus consensus forecasted earnings per share, scaled by stock price at the month of forecast; LTGit is the analysts’ forecast of long-term growth; 10 and RECit is the analysts’ mean
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recommendation rating. RULEit equals 1 if the observation is in the post-Rule (i.e., post-2001) period, and
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0 otherwise. ΔXFINit is net external financing of firm i in year t. To capture the analysts’ guidance for
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firms with external financing in year t, analysts’ earnings forecasts and recommendation ratings are based on the fourth month after the fiscal year end of t-1 because most firms have released their financial results
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by this time, hence analysts shift to earnings forecasts in year t and anticipate their clients’ external financing activities in year t.11 Prior studies find a positive relation between analysts’ optimistic guidance
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and external financing. We, therefore, predict the coefficient α2 to be negative for F1RRORit and F2ERRORit and positive for LTGit and RECit. Our primary interest, however, is in the coefficient α3,
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which we predict to be positive for F1RRORit and F2ERRORit and negative for LTGit and RECit.
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Following Bradshaw et al. (2006), we separate net external financing into net debt financing (ΔDEBTit) and net equity financing (ΔEQUITYit) to examine whether the relation of analysts’ guidance
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with equity issuance is different from the relation with debt issuance. Our earlier discussion predicts the relation to be stronger for equity financing than for debt financing.
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To test H2, which posits that the relation between external financing and future stock returns is
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We use analysts’ long term earnings growth forecast (LTG) rather than long-term earnings growth forecast error for two reasons. First, as a key valuation metric (e.g., PEG ratio), the role of analysts’ long-term growth forecast in guiding valuation is of interest by itself. Unlike one-year ahead and two-year ahead earnings forecasts, long-term growth forecast does not have a specific horizon of the forecasted growth (see Miller and Modigliani 1961), which complicates the meaning and measurement error in the long-term growth forecast error. Second, because our research focus is on the effect of the Rule rather than the relation of LTG with external financing, the use of LTG allows us to infer more directly the effect of the Rule. Nevertheless, we perform sensitivity analyses with long-term earnings growth forecast errors following Bradshaw et al. (2006). Our conclusions are not affected by using this alternative measure. 11 Bradshaw et al (2006) measure analyst variables at the 4th month following the fiscal year end of the external financing t. In other words, our analyst variables are measured one year ahead of those in Bradshaw et al. Since analysts’ conflicts of interest in guiding overvaluation before external financing can lead to their commitment to maintain the optimistic guidance even after external financing, the relation of analyst variables with external financing activities may persist in the months following external financing, as reported in Bradshaw et al. (2006). Furthermore, In Panel E of Figure 2 of Bradshaw et al. (2006), analysts’ recommendation ratings for the highest external financing decile peak around month –8, consistent with analysts’ optimistic guidance in the year of external financing.
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weaker in the post-Rule period, we estimate the following regression model: SRETit+1 = 0 + 1RULEit + 2ΔXFINit + 3ΔXFINit × RULEit + it+1,
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where SRETit+1 is the size-adjusted stock returns of firm i in year t+1. Following Bradshaw et al. (2006), we accumulate the 12-month stock return, starting the fourth month after fiscal year t to ensure that all
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financial statement information is available to the public. We expect 2 and 3 to be negative and positive
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respectively.
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Given the regulator’s concern about analysts’ conflicts of interest related to investment banking and the prohibition of linking analysts’ pay with investment banking business in the Rule, we expect that
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firms with greater potential conflicts of interest should experience a greater change in the relation of analysts’ guidance in earnings forecasts and recommendations with external financing. To provide further
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evidence on the effect of the Rule on analysts’ conflicts of interest related to investment banking, we
Analysts’ Variableit
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estimate the following regression model:
= α0 + α1RULEit + α2ΔXFINit + α3ΔXFINit × RULEit+ α4IBit (3)
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+ α5RULEit × IBit + α6ΔXFINit × IBit + α7ΔXFINit × RULEit × IBit + it,
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where IBit is an indicator variable that is set to 1 if the firm has an IB score higher than the sample median in year t and to zero otherwise. The IB score is computed as the sum of underwriter reputation scores
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(Loughran and Ritter 2004) for the employers of the analysts who have issued recommendations for firm i in the fourth month after fiscal year t–1. The interaction variables, RULEit × IBit, ΔXFINit × IBit, and
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ΔXFINit × RULEit × IBit, are included to capture the incremental effects of IBit on RULEit, ΔXFINit, and ΔXFINit × RULEit in explaining the analysts’ variables. Other variables are defined as those in regression model (1). If investment banking-related conflicts of interest led analysts’ overly optimistic guidance in pre-Rule period, we expect the coefficients α6 to be significant with the same signs as α2 for the respective analyst variables. In addition, if investment banking-related conflicts are attenuated by the Rule, we expect coefficients α7 to be significant with the same signs as α3. Similarly, if the negative relation between external financing and future stock returns is attributable to analysts’ conflicts of interest related to investment banking, we expect that firms with 13
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higher levels of conflicts of interest should experience a larger change in the relation between external financing and future stock returns from the pre-Rule to the post-Rule period. To provide further evidence on whether the change of the relation between external financing and future stock returns is attributable to investment banking-related analysts’ conflicts, we estimate the following regression model, which
= 0 + 1RULEit + 2ΔXFINit + 3ΔXFINit × RULEit + 4IBit
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SRETit+1
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includes IBit:
(4)
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+ 5RULEit × IBit + 6ΔXFINit × IBit + 7ΔXFINit × RULEit × IBit + it+1,
where IBit is the indicator variable as defined above. The interaction variables, RULEit × IBit,
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ΔXFINit × IBit, ΔXFINit × RULEit × IBit, are included to capture the incremental effects of IBit on RULEit, ΔXFINit, and ΔXFINit × RULEit in explaining future stock returns. If the negative relation of external
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financing with future stock returns is attributable to analysts’ conflicts of interest arising from investment
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banking business, we expect 6 to be negative and 7 to be positive. 4. SAMPLE SECTION AND DESCRIPTIVE STATISTICS
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4.1. Variable Definition and Data Sources
We obtain one- and two-year-ahead earnings forecasts, long-term earnings growth forecasts, and stock
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recommendations from the I/B/E/S/ summary statistics files. We define year t as the year in which
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corporate external financing is measured. To measure the analyst variables before corporate financing activities, we obtain the mean consensus analysts’ forecasts and recommendation ratings in the 4th month
variables:
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after the fiscal year t–1. The following description provides the details of the measurement of our analyst
F1ERRORit: one-year-ahead earnings forecast error, computed as the realized annual earnings per share for the upcoming year minus the corresponding monthly consensus forecast of annual earnings, scaled by the stock price at the end of the forecast month. F2ERRORit: two-year-ahead earnings forecast error, computed as the realized annual earnings per share for the year after the upcoming year minus the corresponding monthly consensus forecast of annual earnings, scaled by the stock price at the end of the forecast month.
14
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LTGit: Long-term earnings growth forecast, i.e., the corresponding monthly consensus forecast of the long-term earnings growth rate. RECit: The mean consensus analysts’ stock recommendation rating coded on a 1–5 point scale.12 We invert the standard coding of stock recommendations so that 1 = strong sell, 2 = sell, 3 = hold,
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4 = buy, and 5 = strong buy.
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RULEit: an indicator variable that equals 1 if the observation is from post-Rule period (year greater than
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2001) and zero otherwise.13
Our measure of analysts’ conflicts of interest from investment banking, IBit, the indicator variable
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of investment banking-related conflicts, is constructed based on reputation scores of the employers of the firm’s analysts. Specifically, IBit is set to 1 if the firm has an IB score higher than the sample median in
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year t and to zero otherwise. We obtain the name of the analyst’s employer from the I/B/E/S detailed files. The IB scores are reputation scores computed as the sum of underwriter prestige rankings from Loughran
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and Ritter (2004) for the employers of the analysts who have issued recommendations for firm i in the
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fourth month after fiscal year t–1.14
Following Bradshaw et al. (2006), we measure the net amount of cash received from external
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financing activities (ΔXFINit) as:
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ΔXFINit = ΔEQUITYit + ΔDEBTit,
where ΔEQUITYit represents net cash received from the sale (and/or repurchase) of common and preferred
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stock less cash dividends paid (Compustat data item SSTK less data item PRSTKC less data item DV) and ΔDEBTit represents net cash received from the issuance (and/or repayment) of debt (Compustat data item DLTIS less data item DLTR less data item DLCCH). We require that all of these data items be
12
Following prior studies, we use the mean (instead of median) consensus recommendations because of the greater variation of means rating across companies. 13 Even though NASD Rule 2711 was passed in May, analysts might have anticipated the Rule in the month prior to its passage. For this reason, we consider year 2002 to be within the post-Rule period. However, our empirical results are not affected by excluding this year from the post-Rule period. 14 As a robustness check, we also performed our analysis using affiliation with an investment bank as our proxy for analysts’ conflicts of interest. The dummy variable using affiliation has 93% correlation coefficient with our IB in the full sample. We obtain qualitatively similar empirical results using this alternative measure.
15
ACCEPTED MANUSCRIPT available.15 All variables are scaled by average total assets (data item AT) to represent the amount of new financing relative to the existing asset base. Stock returns are measured using compounded buy-and-hold returns with dividends and other distributions. Returns are calculated for a 12-month period beginning at 4 months after the end of the
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fiscal year. All results reported in the tables are based on size-adjusted returns.
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4.2. Sample Selection and Descriptive Statistics
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We collect and merge the data from the Compustat annual files, the CRSP monthly returns files, and the I/B/E/S summary files. Our sample consists of all firm-years with sufficient data during the period from
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1994 to 2010. The number of years is approximately balanced around the passage of the Rule in 2002. The number of observations in our empirical tests investigating the relation between analysts’ forecasts
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and recommendations and external financing (H1) ranges from 38,767 (LTGit) to 47,782 (F1ERRORit) due to data availability. The number of observations in empirical tests on the relation between external
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financing and future stock returns (H2) is 65,533, and the number is 40,051 if the investment banking-
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related conflicts of interest variable, IBit, is introduced into the regression model. Table 1 reports the descriptive statistics of the external financing and analyst variables and pair-
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wise correlations for the full sample. The mean values of ΔXFINit, ΔEQUITYit, and ΔDEBTit are 0.046, 0031, and 0.015 respectively, indicating an overall tendency of raising additional external capital. The
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median values of these financing variables are close to zero, however, implying that the positive means are driven by the right tail of the distribution. Equity financing has a larger variation (standard
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deviation = 0.152) than debt financing (standard deviation = 0.106). The mean value of F1ERRORit and F2ERRORit are -0.081 and -0.117, respectively, indicating analysts’ optimism in earnings forecasts before external financing. These forecast errors are more than twice the forecast errors at the year-end of financing activity, as reported in Bradshaw et al. (2006). The mean of LTG is 17.483 and the mean recommendation rating is 3.819. The average number of analysts
15
By drawing a random sample, Bradshaw et al. (2006) verify that ΔEQUITYit mostly reflects initial public offerings (IPO) and seasoned equity offerings (SEO), while ΔDEBTit includes convertible debt, subordinated debt, notes payables, debentures, and capitalized lease obligations.
16
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following a firm is 6.797. Panel B of Table 1 reports the pair-wise Pearson correlations between external financing and analyst variables. Note first that there is a negative correlation between ΔEQUITYit and ΔDEBTit (correlation coefficient = -0.082 significant at p < 0.001), suggesting that a few firms engage refinancing by issuing equity to repurchase debt or by issuing debt to repurchase equity. Note also that the
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correlation between ΔXFINit and ΔEQUITYit is greater (correlation coefficient = 0.787) than the
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correlation between ΔXFINit and ΔDEBTit (correlation coefficient = 0.538). In addition, equity financing
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(ΔEQUITYit) is negatively associated with firm profitability in the year of financing and in the year prior to financing activity, but there is little evidence that the same relation holds for debt financing (ΔDEBTit).
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With respect to the correlation with analysts’ optimism, equity financing (ΔEQUITYit) has a higher correlation with analysts’ one-year-ahead and two-year-ahead earnings forecast errors (F1ERRORit,
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F2ERRORit), long-term earnings growth forecasts (LTGit), and recommendation ratings (RECit) than debt financing. These results suggest that analysts’ guidance on overvaluation is more oriented to investors in
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the equity market than to those in the debt market.
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Consistent with prior research, the correlations between each of the financing variables and cumulated future stock returns or size-adjusted future stock returns are all negative and significant.
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Interestingly, net external financing (ΔXFINit) has larger negative correlation coefficients with future stock returns (CRET or SRET) than with either equity financing (ΔEQUITYit) or debt financing (ΔDEBTit).
(2006).
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This result is indicative of refinancing activities and is consistent with similar findings in Bradshaw et al.
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Before performing empirical tests, we partition our annual samples into the high and low external financing groups and plot the monthly means of analyst forecast errors, F1ERRORit, F2ERRORit, LTGit, and RECit over our sample period. Consistent with analysts’ optimism, Figure 1 shows that the values of F1ERRORit are negative, with the magnitude increasing steadily in the years leading to the peak of the dot-com bubble around 2000, followed by a reversal with decreasing forecast errors. In addition, the values of F1ERRORit are more negative (i.e., analysts are more optimistic) for the high external financing group than for the low external financing group and the gap between the two has narrowed in the postRule period. Figure 2 shows a similar pattern for F2ERRORit. 17
ACCEPTED MANUSCRIPT Figure 3 shows the means of analysts’ long-term forecasts of earnings growth (LTGit). For both high and low financing groups, LTGit shows an ascending trend in the years leading to 2000 followed by a dramatic drop in 2002. The gap in mean LTGit between the high-financing group and the low-financing group becomes smaller in the post-Rule period. Figure 4 shows annual analyst recommendation ratings
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over the sample period for high and low external financing groups. The mean recommendation ratings
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show an ascending trend up to year 2000 for both groups and then a dramatic drop in 2002, consistent
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with results reported in prior studies (Barber et al. 2006; Chen and Chen 2009). The plot further shows that, although analyst recommendations for the high-financing group are higher than those for the low-
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financing group, the gap between the two narrows in the post-Rule period. Consistent with prior findings (Bradshaw et al. 2006), analysts’ forecasts and recommendations are strongly related to external
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financing. Our following empirical analysis employs multiple regressions to examine the effects of Rule 2711 on these relations.
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5. EMPIRICAL RESULTS
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5.1. The Effect of the Rule on the Relation between Analysts’ Guidance and External Financing In this section, we present results on the effect of the Rule on the relation between analysts’ guidance in
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earnings forecasts and recommendations and corporate external financing. Table 2 reports the results of regression model (1). Panel A of Table 2 presents the results of regressing analyst variables on net
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external financing (ΔXFINit). Columns 1, 2, 3, and 4 show that the coefficients of ΔXFINit are -0.104 (t = -5.54), -0.207 (-7.36), 0.198 (41.02), and 0.710 (29.54), respectively, for analyst variables
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F1EERORit, F2ERRORit, LTGit, and RECit. These coefficients are consistent with prior findings that there is a positive relation of analysts’ optimism in forecasts and recommendations with external financing. Examining the coefficients of RULEit across the four analyst variables, these coefficients are consistent with the patterns in Figure 1 and significant except for F2ERRORit. They are consistent with the Rule having the effect of reducing analysts’ optimism. The coefficients of ΔXFINit×RULE it for the four analyst variables are insignificant for F1ERRORit and F2ERRORit and are significant for LTGit and RECit. The latter two coefficients suggest that the relations of LTGit and RECit, respectively, with external financing are weaker in the post-Rule period. In addition, the difference in the effect of the Rule on the short-term 18
ACCEPTED MANUSCRIPT earnings forecast errors is consistent with our expectation that analysts’ guidance has a stronger effect on valuation through LTGit and RECit than through short-term earnings forecasts. Previously Figure 1 and Figure 2 show that the effect of Rule is more evident in the relations of F1ERRORit and F2ERRORit with external financing in the years close to 2002. Therefore, we perform
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additional analyses by restricting our sample to ±4 years around the Rule (untabulated). Our results show
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that the coefficient of ΔXFINit×RULEit is significant for F1ERRORit (0.073, t = 2.05) but not for
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F2ERRORit (0.061, t = 1.12). Overall, our results show that the relation of analysts’ optimism in forecasts and recommendations with external financing is weaker in the post-Rule period and thus support H1.
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Panel B of Table 2 reports the results of regressing analyst variables on equity financing and debt financing. The results in the Panel B show that relations of the four analyst variables with equity
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financing are significant but neither F1EERORit nor F2ERRORit has any relation with debt financing. In addition, the effect of the regulatory reform is significant for LTGit and RECit but not for short-term
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analysts’ forecasts, consistent with findings in Panel A. However, if we focus on the ±4 years around the
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Rule, the coefficient of ΔEQUITYit×RULEit is significant for F1ERRORit (1.38, t = 2.69) while the coefficient of ΔDEBTit×RULEit is not (-0.01, t = –0.03). None of these two coefficients is significant for
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analysts’ variable F2ERRORit. Overall, our results in Table 2 show that the relation between analysts’ guidance (especially long-term growth forecasts and recommendations) and external financing is weaker
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in the post-Rule period, supporting H1.
5.2. The Effect of the Rule on the Relation between External Financing and Future Stock Returns
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Table 3 reports the results on whether the Rule has changed the relation between external financing and future stock returns. Column 1 shows the result of regressing future stock returns on net external financing. The coefficient of ΔXFINit is –0.265 (t = –14.09), consistent with the negative relation reported in Bradshaw et al. (2006). The coefficient of ΔXFINit×RULEit is 0.166 (t = 5.70) as predicted, suggesting that the negative relation of external financing with future stock returns is weaker in the postRule period. Columns 2 and 3 show the separate results of regressing future stock returns on equity financing and debt financing, respectively. The coefficients of ΔEUITYit and ΔDEBTit are both significantly negative. In addition, the coefficients of ΔEUITYit×RULEit and ΔDEBTit×RULEit are 19
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significantly positive, as predicted. Column 4 shows the results of regressing future stock returns on both ΔEUITYit and ΔDEBTit. The results are consistent with those in Columns 2 and 3 in that the negative relation of future stock returns with equity and debt financing is weaker in the post-Rule period than in the pre-Rule period. Thus our empirical results in Table 3 support H2.
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5.3. The Relation between Analysts’ Guidance and External Financing Conditional on the Level of
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Conflicts of Interest from Investment Banking
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To enhance the likelihood that our findings of the weaker relation between analysts’ forecasts and recommendations and external financing is attributable to analysts’ conflicts of interest arising from
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investment banking, we estimate regression equation (3) that includes IBit and the interaction terms of IBit with other independent variables. Table 4 reports the results of regressing analysts’ forecasts and
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recommendations on external financing conditional on the level of conflicts of interest related to investment banking.
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Panel A of Table 4 shows the results of estimating regression (3) on net external financing
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(ΔXFINit). The first two columns show that the coefficients of ΔXFINit×IBit and ΔXFINit×IBit×RULEit are insignificant for dependent variables F1ERRORit and F2ERRORit. These results suggest that analysts’
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conflicts of interest related to investment banking have no effect on the relation of analysts’ optimism in short-term earnings forecasts with external financing. On the other hand, the significant coefficients of
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ΔXFINit×RULEit for dependent variables F1ERRORit and F2ERRORit suggest that the relations between analysts’ optimism in short-term earnings forecasts are weaker in the post-Rule period, which likely
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results from reforms unrelated to investment banking ties. In contrast to Columns 1 and 2, Columns 3 and 4 show that the coefficients of IBit and the interactions of IBit with other independent variables are significant for dependent variables LTGit and RECit. As to the variables of our interest, the coefficients of ΔXFINit×IBit are significantly positive and the coefficients of ΔXFINit×IBit×RULEit are significantly negative in the two regressions, consistent with our predictions. These results provide further evidence that the change of the relation between LTGit and RECit and external financing are attributable to analysts’ conflicts of interest from investment banking business. Although these variables are not of primary interest, the coefficients of IBit and IBit×RULEit 20
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suggest that the incremental effects of IBit and IBit×RULEit may be opposite to the incremental effects of ΔXFINit×IBit and ΔXFINit×IBit×RULEit. In other words, one may draw unwarranted conclusions about the effect of investment banking-related conflicts on LTGit and RECit without conditioning on the relation of analyst variables with external financing. The results in Panel A of Table 4 suggest that the changes in the
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relation of LTGit and RECit with external financing is greater for firms with greater analysts’ conflicts of
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interest.
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Panel B of Table 4 reports the results of regression model (3) with both equity financing and debt financing. Since the results in Panel A indicate that analysts’ optimism in short term earnings forecasts
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with external financing is not related to conflicts of interest from investment banking using full sample, we narrow the focus to the period between 4 years pre- and 4 years post-Rule with observations in year
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2002 dropped for dependent variables F1ERRORit and F2ERRORit. Again, the results in Column (1) and (2) show no evidence that analysts’ optimism in short-term forecasts F1ERRORit and F2ERRORi is driven
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by investment banking related conflict of interest. However, these results are consistent with prior
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findings in Cowen, Groyberg and Healy (2006) and Groysberg and Healy (2013). Turning to the results in Columns 3 and 4 for dependent variables LTGit and RECit, we continue
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to find that the change of the relation of LTGit and RECit with equity financing is greater for firms with greater conflicts of interest. Interestingly, the incremental effect of IBit is significant in the relation of
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LTGit with debt financing but not in the relation of RECit with debt financing. The latter result is consistent with the observation that analysts’ stock recommendations are primarily targeted at equity
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investors. Overall, our results show that the change in the relation between analysts’ guidance (mainly in long-term earnings growth forecasts and recommendations) and external financing is greater for firms with greater conflicts from investment banking. 5.4. The Relation between External Financing and Future Stock Returns Conditional on the Level of Conflicts of Interest from Investment Banking We provide further evidence that a weaker relation of external financing and future stock returns are attributable to the Rule. We estimate regression model (4) to investigate whether firms with greater investment banking-related conflicts of interest (captured by the indicator variable IB) experience a 21
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greater change of the relation between external financing activities and future stock returns from the preRule to the post-Rule period. As shown in Table 5, Column 1 reports the result of regressing future stock returns on net external financing (ΔXFINit), analysts’ conflicts of interest (IBit), and the regulation (RULEit). All
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coefficients have the expected signs. Our focus is on the coefficient of ΔXFINit×ΔIBit (-0.115, t = -2.17)
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and the coefficient of ΔXFINit×ΔIBit×RULEit (0.168, t =2.22). These two coefficients are consistent with
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the predictions that investment banking-induced conflicts of interest are associated with a greater negative relation between future stock returns and external financing for firms with greater conflicts of interest, but
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the change of this relation is also greater in the post-Rule period for those firms with greater levels of conflicts of interest.
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We perform similar tests of the change of the coefficients in Columns 2, 3 and 4 for ΔEQUITYit and ΔDEBTit. The coefficients of ΔEQUITYit×IBit and ΔDEBTit×IBit are not significant, but the
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coefficients of ΔEQUITYit×IBit×RULEit are significantly positive, while the coefficients of
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ΔDEBTit×IBit×RULEit are insignificant. The results suggest that the change of the relation between equity financing and future stock returns from the pre-Rule to the post-Rule period is greater for firms with
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greater conflicts of interest. On the other hand, we find that the change of the relation between debt financing and future stock returns from the pre-rule to the post-Rule period is insignificant for firms with
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greater conflicts of interest.
In summary, the results from the tests on investment banking-related conflicts enhance our
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confidence that the change in the relation between external financing (mostly equity financing) and future stock returns in the post-Rule period is attributable to the regulatory reforms. 6. ADDITIONAL ANALYSIS In this section, we examine analysts’ conflicts of interest arising from trading commissions and investigate whether the Rule has changed the relation between external financing and future stock returns that stem from such conflicts. In addition, we examine whether our findings of the change in the relation between external financing and future stock returns can be attributed to alternative factors or other regulatory events. Last, we examine whether our results remain after controlling for shifts in investment 22
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opportunities. 6.1. Analysts’ Conflicts of Interest from Trading/Brokerage Revenue Even though analysts’ conflicts of interest stemming from investment banking business were the primary concern of the regulatory reforms, other potential sources of conflicts of interest are also
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mentioned in the reform package. The most significant one is analysts’ incentives to generate
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brokerage/trading commissions for their employers. Prior studies show that commission business affects
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IPO allocation by the underwriter (Reuter 2006) and that having an all-star analyst of the industry in the IPO is associated with significantly higher first-day returns (Loughran and Ritter 2004). Analysts’
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forecasts and recommendations are more optimistic for analysts associated with brokerage firms (Cowen et al. 2006; Irvine 2004). To test the extent to which the negative relation of external financing activities
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with future stock returns is attributable to analysts’ trading revenue incentives, we create a variable, TRit, to proxy for analysts’ conflicts of interest related to their brokerage/trading commissions. We measure
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this variable by the firm’s share turnover (per share) in the year of financing: greater turnover of shares
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indicates greater trading commissions. Like IBit, TRit is an indicator variable that is set to 1 if the firm’s annual turnover is greater than the median of our sample and to 0 otherwise. If overvaluation around
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financing activities is also attributable to trading-commissions-related incentives, we expect that there is a greater change in the relation of external financing activities with future stock returns for firms with
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greater analysts’ conflicts arising from trading-commisions incentives. Table 6 reports the empirical results related to analysts’ conflicts of interest stemming from
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trading commissions. Panel A of Table 6 reports the empirical results for the sample of observations with analyst following. As a contrast, we report in Panel B of Table 6 the results for the sample of observations without analyst following. As shown in Panel A of Table 6, the coefficients of ΔXFINit×TRit, ΔEQUITYit×TRit, and ΔDEBTit×TRit are all negative and significant at 10% or better (two-tailed) with the exception of ΔDEBTit×TRit in Column (3). These coefficients are consistent with our expectation that analysts’ conflicts of interest stemming from trading commissions at least partially contribute to the negative relation of external financing activities with future stock returns. The coefficients of ΔXFINit×TRit×RULEit, ΔEQUITYit×TRit×RULEit, and ΔDEBTit×TRit×RULEit have the predicted signs but 23
ACCEPTED MANUSCRIPT are only significant for ΔEQUITYit×TRit×RULEit in both Columns 2 and 4. These results suggest that the change in the relation between equity financing and future stock returns from the pre-Rule to the postRule period is greater for firms with greater levels of conflicts of interest related to trading commissions. In contrast, we find that the change in the relation between debt financing and future stock returns from
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the pre-Rule to post-Rule period is insignificant for firms with higher levels of conflicts of interest
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stemming from this source.16 Overall, we find that the influence of analysts’ trading incentives on the
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relation between external financing and future stock returns is attenuated after the implementation of the Rule.
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In Panel B of Table 6, we repeat our estimation of the regression model in Panel A using a sample of firm-year observations with no analyst coverage. Because the objective of the Rule is to address
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analysts’ conflicts of interest, we report these regression results as a contrast to those discussed above. As shown in the table, the coefficients of ΔXFINit×TRit, ΔEQUITYit×TRit, and ΔDEBTit×TRit are all
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insignificant. Furthermore, the coefficients of ΔXFINit×TRit×RULEit, ΔEQUITYit×TRit×RULEit, and
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ΔDEBTit×TRit×RULEit are also insignificant in all equations. These contrasting results enhance our confidence in our findings discussed above.
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6.2. Controlling for Market Timing
Our findings on the change in the relation between external financing and future stock returns
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(H2) has a potential confounding cause related to market timing of financing activities by managers. In order to show that our findings on the regulatory effects are distinct from market timing, we include two
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market timing variables from prior studies, past 24-month stock return and investment sentiment (Change, Dasgupta and Hilary 2006, Baker and Wugler 2006), and run the following regression model (5) SRETit+1= 0 + 1PSTKRTNit + 2SENTMENTit +3RULEit + 4ΔXFINit + 5ΔXFINit×RULEit +it+1,
(5)
Where, PSTKRTN is the past 24-month compound return ended 3 month after fiscal year t.
16
One potential explanation for the insignificant results in explaining the change in the relation of debt financing with future stock returns in the post-Rule period is that we use equity share turnover rather than the trading volume of debt securities.
24
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SEMTIMENT is the past 12month investment sentiment ended 3 month after fiscal year t. We report the results of Model (5) in Table 7. We find that there is a significant coefficient of PSTKRTN and insignificant coefficient of SENTIMENT from Column (1) to Column (4). However, after controlling for the market timing, we continue to find a significant weaker relation between external
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financing (equity or debt) and future stock return in the post-Rule period than in the pre-Rule period.
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6.3. Sarbanes–Oxley Act (SOX) and Accrual Anomalies
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In this subsection, we report the results from additional tests that our findings on the change in the relation between external financing and future stock returns (H2) are not attributable to the effects of
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Sarbanes–Oxley Act (SOX) or the accrual anomalies reported in Sloan (1996) and Richardson et al. (2005). Prior studies find that firms manage accruals before equity financing and that accrual-based
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earnings management declines in the post-SOX period (e.g. Teoh, Welch, and Wong 1998; Cohen, Dey, and Lys 2008). In addition, Cohen and Lys (2006) questions whether the negative relation between
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external financing and future stock returns is separable from the accrual anomalies because the measures
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of accruals using balance-sheet items are likely to be correlated with the measures of financing activities. We examine whether the effects of the Rule on the relation of external financing activities with future
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stock returns remain significant after controlling for the effect of accruals. We compute working capital accruals, ACCRit, and total accruals, T_ACCRit, following Sloan
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(1996) and Richardson et al. (2005), respectively. To provide evidence on whether our prior results are attributable to the effects of accruals, we estimate the following regression model: = 0 + 1RULEit + 2ΔXFINit + 3ΔXFINit×RULEit
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SRETit+1
+ 4ACCRit + 5ACCRit×RULEit + it+1,
(6)
where ACCRit is the accruals estimated from the total accruals or working capital accruals in Sloan (1996). We repeat this analysis also with total accruals, T_ACCRit. Consistent with Cohen and Lys (2006), the correlations between T_ACCRit and ΔXFINit, ΔEQUITYit, and ΔDEBTit are 0.430, 0.245, and 0.360, respectively, all significant at p < 0.001 (untabulated). These correlations are greater in magnitude than the correlations between ACCRit and external financing activities. Furthermore, consistent with prior
25
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findings, both ACCRit and T_ACCRit have significant negative correlations with future stock returns with coefficients of -0.047 and -0.093, respectively. We report the results from the regression model (6) in Table 8. Panel A reports the results on the effect of the Rule on the change in the relation between external financing and future stock returns
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controlling for working capital accruals (ACCRit) or total accruals (T_ACCRit). As shown in columns 1 to
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4, the coefficients of ACCRit and T_ACCRit are negative and significant, consistent with Sloan (1996) and
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Richardson et al. (2005). In addition, the coefficients of the interactions ACCRit×RULE (0.165, t = 2.05) and T_ACCRit×RULE (0.058, t = 1.86) are marginally significant. These positive coefficients are
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consistent with the prediction that the implementation of SOX in 2002 contributed to a weaker relation of future stock returns and accruals because accruals are managed to a lesser extent in the post-SOX period
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(e.g. Cohen, Dey, and Lys 2008). The coefficients of ΔXFINit×RULEit are all positive and significant in both Columns 2 and 4. It follows that, after controlling for accruals, our conclusion of a weaker relation
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between external financing activities and future stock returns in the post-Rule period remains unchanged.
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Panel B of Table 8 reports the results of regressing future stock returns on equity and debt financing controlling for ACCRit or T_ACCRit. As shown in the table, the coefficients of the ACCRit and
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T_ACCRit are significantly negative, while the coefficients of the interaction variables ACCRit×RULE and T_ACCRit×RULE are positive and marginally significant in Column 2 and 4. After controlling for ACCRit
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or T_ACCRit, the coefficients of ΔEQUITYit×RULEit and ΔDEBTit×RULEit are still positive and significant in each estimated equation. The empirical results show that the change of the relation of external
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financing with future stock returns in the post-Rule period is not attributable to the effects of SOX on accrual management or the accrual anomalies reported in Sloan (1996) and Richardson et al. (2005). 6.4. The Relation between External Financing and Future Stock Returns from Changes in Investment Opportunities Our findings on the relation of external financing with future stock returns may be attributable to changes in investment opportunities (Lyandres, Sun, and Zhang 2007; Chen and Zhang 2007). To perform tests on whether our results are attributable to shifts in firms’ investment opportunities in the post-Rule period, we include Tobin’s Q, accounting profitability (return of equity) and the change of profitability in the year 26
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after external financing in the regression of future stock returns and external financing. We find that the profitability and the change of profitability are significant in explaining future stock returns, but our results on the effects of the Rule remain unchanged when we include these variables. 6.5. Robustness Checks
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Prior studies employ analysts’ long-term growth forecast errors to examine the relation of analysts’
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optimism in growth forecast with external financing (Dechow, Hutton, and Sloan 2000; Bradshaw et al.
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2006). As a robustness check, we follow Bradshaw et al. (2006) and compute the long-term growth forecast error (LTGerror) as the realized long-term earnings growth rate minus the forecasted long-term
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growth rate. Realized earnings growth is computed from the slope coefficient of an ordinary least squares regression of the natural logarithm of annual earnings per share on a time trend. We vary the requirement
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of the availability of realized annual earnings per share from a minimum of 3 years to 12 years. We repeat our tests on H1 with LTGerror replacing LTG. The results (untabulated) show that LTG errors have a
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significant negative relation with external financing, consistent with Bradshaw et al. (2006). The results
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are stronger as we increase the number of realized earnings per share in estimating LTGerror. Therefore, our empirical results of analysts’ LTG with external financing are not affected by LTGerror.
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Our measure of analysts’ conflicts of interest at the firm level arising from investment banking (IB) takes into consideration the affiliation of the analysts but also competition to supply investment
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banking services by the analysts’ employers. We repeat our empirical analysis in Table 4 and Table 5 using analysts’ affiliation as an alternative measure of IB (any analyst whose employer has a reputation
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score > 1 is defined as affiliated). This alternative IB measure has a correlation coefficient of 93% with our original IB measure. Our empirical results are qualitatively similar to those reported in Table 4 and Table 5.
In summary, our additional tests and robustness checks suggest that our findings of the change in the relation of analysts’ guidance in earnings forecasts and recommendations with external financing, as well as in the relation between external financing and future stock returns, are attributable to the implementation of the Rule. These results lend further support that the Rule has attenuated the level of analysts’ conflicts of interest in corporate financing activities. 27
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7. CONCLUSIONS Analysts’ incentives to issue and maintain optimistic earnings forecasts and recommendations before corporate financing activities prompted regulatory scrutiny that led to the passage of the NASD Rule 2711 in 2002. The purpose of the Rule was to restore analysts’ independence by isolating analysts from
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pressures to generate investment banking business. In this study, we examine whether Rule 2711
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attenuates analyst’ conflicts of interest in corporate financing activities. To infer the effects of the Rule,
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we investigate the relation between analysts’ guidance in earnings forecasts/recommendations and external financing, and the relation between external financing and future stock returns.
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Our empirical results show that the relation between analysts’ guidance in forecasts and recommendations and external financing and the relation between external financing and future stock
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returns are weaker in the post-Rule than in the pre-Rule period. In addition, using the supply of investment banking services from their employers as our proxy for the firm’s level of potential conflicts
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of interest, we find that the changes in these two relations are greater for firms with greater levels of
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potential conflicts of interest. Further analyses provide evidence that the Rule also reduces the extent of analysts’ conflicts of interest arising from trading commissions. We also perform additional tests to show
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that the effects of the Rule are not attributable to market timing, the changes of accruals due to SOX or changes in investment opportunities.
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Our study has implications for regulators in assessing the effects of Rule 2711. Recent research shows the Rule has strengthened the relation of analysts’ recommendations with fundamental valuation
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(Barniv et al. 2009; Chen and Chen 2009) but provides little benefit to investors in terms of more profitable recommendations (Kadan et al. 2009; Guan et al. 2012). Our empirical results demonstrate that the relation between analysts’ guidance embedded in earnings forecasts and recommendations and external financing is weaker in post-Rule period, suggesting that the Rule attenuates analysts’ conflicts of interest in corporate external financing. In addition, our empirical results show that the relation between external financing and future stock returns is weaker in the post-Rule period, suggesting that Rule 2711 improves the alignment of the interests of analysts with those of investors participating in corporate financing activities. 28
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Figure 1. Means of F1ERROR for High and Low External Financing Groups during 1994-2010
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This figure shows the mean of analysts’ consensus forecast errors of one-year-ahead earnings (F1ERROR) in each month during the 1994–2010 period. Forecast errors are defined as the realized annual earnings per share for the coming year minus the corresponding consensus forecasts of this mount, all scaled by the stock price as of the end of the forecast month.
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Figure 2. Means of F2ERROR for High and Low External Financing Groups during 1994-2010
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This figure shows the mean of analysts’ consensus forecast errors of two-year-ahead earnings (F2ERROR) in each month during the 1994–2010 period. Forecast errors are defined as the realized annual earnings per share for the coming year minus the corresponding consensus forecasts of this mount, all scaled by the stock price as of the end of the forecast month.
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ACCEPTED MANUSCRIPT Figure 3. The Means of Analysts’ Forecast of Long-term Earnings Growth (LTG) for High and
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Low External Financing Groups during 1994-2000
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This figure shows the mean of analysts’ consensus forecasts of the long-term earnings growth rates in each month during the 1994–2010 period.
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ACCEPTED MANUSCRIPT Figure 4. The Means of Analysts’ Stock Recommendations for High and Low External Financing
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Groups during 1994-2000
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This figure shows the mean of analysts’ consensus stock recommendations for the high and low external financing groups each month during the 1994–2010 period. Stock recommendation are coded as follows: 1 = Strong Sell; 2 = Sell; 3 = Hold; 4 = Buy; 5 = Strong Buy. The consensus stock recommendation for each company-month equals the mean of the individual analyst recommendation.
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ACCEPTED MANUSCRIPT Table 1 Descriptive Statistics and Pair-wise Correlations of Variables Panel A: Descriptive statistics
M ED PT CE AC
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p50 0.001 0.000 0.000 0.072 0.065 0.060 -0.069 -0.002 -0.008 0.150 3.860 5.000
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p25 -0.041 -0.019 -0.022 0.015 0.016 -0.227 -0.330 -0.025 -0.055 0.110 3.330 2.000
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s.d. 0.183 0.152 0.106 0.159 0.150 0.638 0.589 0.377 0.488 0.097 0.640 6.158
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mean 0.046 0.031 0.015 0.049 0.040 0.155 0.010 -0.081 -0.117 0.175 3.819 6.797
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ΔXFINit ΔEQUITYit ΔDEBTit EARNINGS/ASSETit+1 EARNINGS/ASSETit CRETit+1 SRETit+1 F1EERORit F2ERRORit LTGit RECit #ANALYSTS N
N 65,533 65,533 65,533 65,533 65,404 65,533 65,533 47,782 41,594 38,767 42,211 42,211 65,533
p75 0.07 0.01 0.03 0.13 0.11 0.37 0.21 0.00 0.00 0.214 4.25 9.00
ACCEPTED MANUSCRIPT Panel B: Pearson correlation matrix
ΔXFINit ΔEQUITYit ΔDEBTit EARNINGS/ASSETit+1 EARNINGS/ASSETit CRETit+1 SRETit+1 F1EERORit F2ERRORit LTGit RECit #ANALYSTS
ΔXFINit
ΔEQUITYit ΔDEBTit
1 0.787*** 0.538*** -0.228*** -0.253*** -0.0651*** -0.0642*** -0.0377*** -0.0629*** 0.251*** 0.170*** -0.129***
1 -0.0816*** 1 -0.260*** -0.00795* -0.297*** 0.00213 -0.0417*** -0.0495*** -0.0449*** -0.0429*** -0.0550*** 0.00718 -0.0708*** -0.0114* 0.306*** 0.0414*** 0.149*** 0.0853*** -0.173*** 0.00732
EARNINGS/ EARNINGS/ CRETit+1 ASSETit+1 ASSETit
1 0.805*** -0.0272*** -0.0076 0.284*** 0.250*** -0.180*** 0.0792*** 0.176***
*
1 -0.0322*** -0.0111** 0.159*** 0.162*** -0.218*** 0.0657*** 0.181***
F1EERORit F2ERRORit
LTGit
RECit
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I R
C S
U N
A
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1 0.925*** -0.0129** 0.0486*** -0.0163** -0.0253*** -0.0154**
SRETit+1
1 0.0160*** 1 0.0731*** 0.758*** -0.0171*** -0.0714*** -0.0259*** 0.0133** 0.0176*** 0.0945***
1 -0.103*** -0.0115* 0.0885***
1 0.332*** 1 *** -0.127 -0.0958***
p<0.05, ** p<0.01, *** p<0.001 Panel A reports the descriptive statistics of variables in the empirical analysis. Panel B presents the Pearson correlation coefficients for the main variables. ΔXFIN is the net amount of cash flow received from external financing activities: ΔXFIN = ΔEQUITY + ΔDEBT. ΔEQUITY is net cash received from the sale (and/or repurchase) of common and preferred stock less cash dividends paid (Compustat data item SSTK less data item PRSTKC less data item DV). ΔDEBT represents net cash received from the issuance (and/or repayment) of debt (Compustat data item DLTIS less data item DLTR less data item DLCCH). EARNINGS/ASSET is the ratio of operating income after depreciation to total assets (Compustat data item OIADP divided by data item AT). CRET is annual stock returns measured using compounded buy-hold returns, inclusive of dividends and all other distributions, and are computed for a the 12-month period starting the fourth month after fiscal year t to ensure that all financial statement information is available to the public. SRET is the annual size-adjusted stock return measured using compounded buy-hold returns. F1ERROR is the one-year-ahead earnings forecast error, computed as the realized annual earnings per share for the upcoming year minus the corresponding monthly consensus forecast of annual earnings, scaled by the stock price at the end of the forecast month. F2ERROR is the two-year-ahead earnings forecast error, computed as the realized annual earnings per share for the year after the upcoming year minus the corresponding monthly consensus forecast of annual earnings, scaled by the stock price at the end of the forecast month. LTG is long-term earnings growth forecast, i.e., the corresponding monthly consensus forecast of long-term earnings growth rate. REC is the mean consensus analysts’ stock recommendation rating coded on a 1–5 point scale. We invert the standard coding of stock recommendations so that 1 = strong sell, 2 = sell, 3 = hold, 4 = buy, and 5 = strong buy. #Analysts is the number of financial analysts following the firm in the given year. The analyst variables are all measured four months after the fiscal year t-1.
D E
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ACCEPTED MANUSCRIPT Table 2 Results from Regression of Analysts’ Variable on External Financing Panel A. Results from Regression of Analysts’ Forecasts and Recommendations and external financing (2) F2ERRORit -0.207*** (-7.36)
(3) LTGit 0.198*** (41.02)
(4) RECit 0.710*** (28.54)
RULEit
0.00501 (1.47)
-0.000157 (-0.03)
-0.00892*** (-9.49)
-0.196*** (-31.24)
ΔXFINit × RULEit
0.0410 (1.50)
0.0320 (0.76)
-0.0897*** (-11.21)
-0.217*** (-5.72)
-0.0802*** (-34.20) 47,782 0.001
-0.112*** (-34.20) 41,594 0.004
0.175*** (269.32) 38,767 0.070
3.909*** (813.02) 42,211 0.054
N adj. R2
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CONSTANT
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ΔXFINit
T
(1) F1EERORit -0.104*** (-5.54)
(2) F2ERRORit
0.00436 (1.26)
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ΔEQUITYit
(1) F1EERORit
-0.185*** (-7.04)
(3) LTGit
(4) RECit
-0.000324 (-0.07)
-0.00814*** (-8.52)
-0.196*** (-30.88)
-0.310*** (-8.01)
0.312*** (45.10)
0.833*** (25.88)
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RULEit
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Panel B: Results from Regression of Analysts’ Variable on Equity financing and Debt financing
0.0400 (1.06)
0.0514 (0.92)
-0.0802*** (-6.75)
-0.209*** (-4.13)
ΔDEBTit
0.00103 (0.04)
-0.0704 (-1.72)
0.0790*** (12.03)
0.616*** (14.95)
0.0422 (1.07)
-0.00409 (-0.07)
-0.0685*** (-6.88)
-0.244*** (-4.09)
0.177*** (272.76) 38,767 0.101
3.910*** (806.40) 42,211 0.056
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ΔEQUITYit × RULEit
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ΔDEBTit × RULEit
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-0.0809*** -0.113*** (-34.04) (-33.93) N 47,782 41,594 adj. R2 0.003 0.005 t-statistics in parentheses: * p < 0.05, ** p < 0.01, *** p < 0.001 CONSTANT
Panel A presents the results of regressing analysts’ variable on external financing. Panel B shows the results from regressing analysts’ variable on equity financing and debt financing, ΔXFIN is the net amount of cash flow received from external financing activities: ΔXFIN = ΔEQUITY + ΔDEBT. ΔEQUITY is net cash received from the sale (and/or repurchase) of common and preferred stock less cash dividends paid (Compustat data item SSTK less data item PRSTKC less data item DV). ΔDEBT represents net cash received from the issuance (and/or repayment) of debt (Compustat data item DLTIS less data item DLTR less data item DLCCH). F1ERROR is the one-year-ahead earnings forecast error, computed as the realized annual earnings per share for the upcoming year minus the corresponding monthly consensus forecast of annual earnings, scaled by the stock price at the end of the forecast month. F2ERROR is the two-year-ahead earnings forecast error, computed as the realized annual earnings per share for the year after the upcoming year minus the corresponding monthly consensus forecast of annual earnings, scaled by the stock price at the end of the forecast month. LTG is long-term earnings growth forecast, i.e., the
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corresponding monthly consensus forecast of long-term earnings growth rate. REC is the mean consensus analysts’ stock recommendation rating coded on a 1–5 point scale. We invert the standard coding of stock recommendations so that 1 = strong sell, 2 = sell, 3 = hold, 4 = buy, and 5 = strong buy. The analyst variables are all measured 4 months after the fiscal year end in t–1. RULE is an indicator variable that equals 1 if the observation is from the post-Rule period and 0 otherwise. The t-statistics (in parentheses) are computed using robust standard errors adjusted for clustering by company.
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(2) SRETit+1
(3) SRETit+1
(4) SRETit+1
RULEit
-0.00866 (-1.88)
-0.00324 (-0.71)
0.00233 (0.50)
-0.00826 (-1.79)
ΔXFINit × RULEit
0.166*** (5.70)
ΔEQUITYit
-0.218*** (-9.71)
ΔEQUITYit × RULEit
0.138*** (3.81)
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ΔDEBTit
CR
ΔXFINit
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(1) SRETit+1 -0.265*** (-14.09)
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Table 3 Results from Regression of Future Stock Returns on External Financing
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N adj. R2
0.0171*** (5.07) 65,533 0.002
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0.0239*** (6.98) 65,533 0.005
CONSTANT
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ΔDEBTit × RULEit
-0.241*** (-10.64) 0.154*** (4.25)
-0.299*** (-9.65)
-0.335*** (-10.75)
0.163*** (3.53)
0.193*** (4.15)
0.0121*** (3.55) 65,533 0.002
0.0238*** (6.96) 65,533 0.005
t-statistics in parentheses: * p < 0.05, ** p < 0.01, *** p < 0.001
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This table presents results of regressing future stock returns on external financing. SRET is the annual size-adjusted stock returns measured using compounded buy-hold returns, inclusive of dividends and all other distributions, and are computed for a the 12-month period starting the fourth month after fiscal year t to ensure that all financial statement information is available to the public. ΔXFIN is the net amount of cash flow received from external financing activities: ΔXFIN = ΔEQUITY + ΔDEBT. ΔEQUITY is net cash received from the sale (and/or repurchase) of common and preferred stock less cash dividends paid (Compustat data item SSTK less data item PRSTKC less data item DV). ΔDEBT represents net cash received from the issuance (and/or repayment) of debt (Compustat data item DLTIS less data item DLTR less data item DLCCH). RULE is an indicator variable that equals 1 if the observation is from the post-Rule period, and 0 otherwise. The t-statistics (in parentheses) are computed using robust standard errors adjusted for clustering by company.
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ACCEPTED MANUSCRIPT Table 4 Results from Regression of Analysts’ Variable on External Financing and Level of Conflicts of Interest from Investment Banking
(2) F2ERRORit -0.214*** (-4.03)
(3) LTGit 0.171*** (21.02)
(4) RECit 0.704*** (20.31)
RULEit
0.0290*** (4.49)
0.0357*** (3.69)
-0.0328*** (-19.02)
-0.181*** (-17.68)
ΔXFINit × RULEit
0.0786*** (14.33)
0.0904*** (10.42)
-0.0206*** (-12.48)
-0.0190* (-2.12)
0.0212 (0.47)
-0.0149 (-0.20)
-0.0547*** (-4.21)
-0.151** (-2.70)
IBit × RULEit
-0.0273*** (-3.69)
-0.0311** (-2.76)
0.0112*** (5.20)
-0.101*** (-8.24)
ΔXFINit × IBit
0.0238 (0.61)
0.0818 (1.30)
0.0419*** (3.75)
0.0944* (2.04)
0.0524 (0.57)
-0.0808*** (-4.69)
-0.304*** (-4.16)
-0.174*** (-22.78) 34,435 0.010
0.198*** (151.56) 31,995 0.091
3.926*** (532.16) 40,051 0.077
-0.00856 (-0.16)
CONSTANT
-0.121*** (-24.89) 38,247 0.010
N adj. R2
CR
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ED
ΔXFINit × IBit × RULEit
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IBit
M
ΔXFINit
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(1) F1EERORit -0.0836* (-2.56)
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(2) F2ERRORit 0.1600*** (9.32)
(3) LTGit -0.0329*** (-19.19)
(4) RECit -0.181*** (-17.59)
0.103*** (9.42)
0.114*** (6.47)
-0.0168*** (-10.16)
-0.0129 (-1.43)
-0.0842*** (-7.02)
-0.0765*** (-3.91)
0.00986*** (4.48)
-0.107*** (-8.60)
-0.302** (-3.21)
-0.564*** (-3.69)
0.289*** (25.67)
0.847*** (19.00)
ΔEQUITYit × RULEit
0.196 (1.80)
0.275 (1.51)
-0.0785*** (-4.29)
-0.164* (-2.26)
ΔEQUITYit × IBit
0.198 (1.81)
0.211 (1.48)
0.110*** (6.84)
0.219*** (3.45)
ΔEQUITYit × IBit × RULEit
-0.164 (-1.22)
-0.221 (-1.06)
-0.150*** (-5.87)
-0.535*** (-5.34)
ΔDEBTit
0.231* (2.22)
0.180 (0.93)
0.0429*** (3.70)
0.623*** (10.24)
-0.575* (-2.17)
-0.00831 (-0.48)
-0.185 (-1.93)
-0.223 (-1.03)
0.0279 (1.84)
0.0210 (0.27)
0.257 (1.92)
0.575 (2.14)
-0.0520* (-2.34)
-0.108 (-0.92)
-0.162*** (-16.67) 19,058 0.031
-0.233*** (-14.79) 17,014 0.029
0.199*** (153.78) 31,995 0.124
3.925*** (531.08) 40,051 0.079
-0.322** (-2.65)
ΔDEBTit × IBit
-0.209 (-1.84)
N adj. R2
AC
CONSTANT
CE
ΔDEBTit × IBit × RULEit
PT
ED
ΔDEBTit × RULEit
CR
ΔEQUITYit
US
IBit × RULEit
AN
IBit
M
RULEit
T
(1) F1EERORit 0.125*** (11.96)
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Panel B. Results from Regression of Analysts Variable on Equity Financing, Debt Financing and Level of Conflicts of Interest from Investment Banking
Panel A presents the results of regressing analysts’ variable on external financing and level of conflicts of Interest from investment banking. Panel B shows the results from regressing analysts’ variable on equity, debt financing and level of conflicts of interest from investment banking. ΔXFIN is the net amount of cash flow received from external financing activities: ΔXFIN = ΔEQUITY + ΔDEBT. ΔEQUITY is net cash received from the sale (and/or repurchase) of common and preferred stock less cash dividends paid (Compustat data item SSTK less data item PRSTKC less data item DV). ΔDEBT represents net cash received from the issuance (and/or repayment) of debt (Compustat data item DLTIS less data item DLTR less data item DLCCH). F1ERROR is the one-year-ahead earnings forecast error, computed as the realized annual earnings per share for the upcoming year minus the corresponding monthly consensus forecast of annual earnings, scaled by the stock price at the end of the forecast month. F2ERROR is the two-year-ahead earnings forecast error, computed as the realized annual earnings per share for the year after the upcoming year minus the corresponding monthly consensus forecast of annual earnings, scaled by the stock price at the end of the forecast month. LTG is long-term earnings growth forecast, i.e., the corresponding monthly consensus forecast of long-term earnings growth rate. REC is the mean consensus analysts’ stock recommendation rating coded
43
ACCEPTED MANUSCRIPT
AC
CE
PT
ED
M
AN
US
CR
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on a 1–5 point scale. We invert the standard coding of stock recommendations so that 1 = strong sell, 2 = sell, 3 = hold, 4 = buy, and 5 = strong buy. IB is an indicator variable that is set to 1 if the firm has the sum of reputation score of analysts whose employers are major suppliers of investment banking business (based on Loughran and Ritter 2004) that is above the median of the sample in year t and 0 otherwise. The analyst variables, including IB, are all measured 4 months after the fiscal year end in t–1. RULE is an indicator variable that equals 1 if the observation is from the post-Rule period and 0 otherwise. The t-statistics (in parentheses) are computed using robust standard errors adjusted for clustering by company. Results in Column (1) and (2) are based on observations in 4 years preand 4 years post-Rule period with observations in years in 2002 dropped. Results in Column (4) and (5) are based on available observations in the sample period.
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ACCEPTED MANUSCRIPT Table 5 Results of Regression of Future Stock Returns on External Financing and Level of Conflicts of Interest from Investment Banking
IBit IBit × RULEit ΔXFINit × IBit ΔXFINit × IBit × RULEit ΔEQUITYit
0.0143 (1.66)
0.00796 (0.93)
0.0104 (1.24) 0.0147 (1.34)
0.0243** (2.81) 0.00242 (0.22)
0.0173* (2.00) 0.00854 (0.76)
-0.301*** (-4.99) 0.201* (2.33) -0.138 (-1.69) 0.134 (1.18) -0.0127 (-1.93) 40,051 0.004
-0.250*** (-4.85) 0.150* (2.00) -0.0975 (-1.33) 0.247* (2.33) -0.314*** (-5.21) 0.211* (2.44) -0.124 (-1.51) 0.126 (1.11) -0.00474 (-0.72) 40,051 0.006
-0.239*** (-4.64) 0.141 (1.89) -0.110 (-1.50) 0.261* (2.46)
AN
ΔEQUITYit × RULEit ΔEQUITYit × IBit
M
ΔEQUITYit × IBit × RULEit ΔDEBTit
ED
ΔDEBTit × RULEit
ΔDEBTit × IBit × RULEit
CE
CONSTANT
PT
ΔDEBTit × IBit
N adj. R2
0.0140 (1.66)
T
ΔXFINit × RULEit
(4) SRETit+1
IP
RULEit
(3) SRETit+1
CR
ΔXFINit
(2) SRETit+1
US
(1) SRETit+1 -0.267*** (-7.09) 0.00770 (0.90) 0.177** (3.20) 0.0159 (1.87) 0.00756 (0.69) -0.115* (-2.17) 0.168* (2.22)
-0.00472 (-0.72) 40,051 0.006
-0.0119 (-1.84) 40,051 0.003
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This table reports results of regressing future stock returns on external financing and level of conflicts of interest from investment banking. SRET is the annual size-adjusted stock returns measured using compounded buy-hold returns, inclusive of dividends and all other distributions, and are computed for a the 12-month period starting the fourth month after fiscal year t to ensure that all financial statement information is available to the public. ΔXFIN is the net amount of cash flow received from external financing activities: ΔXFIN = ΔEQUITY + ΔDEBT. ΔEQUITY is net cash received from the sale (and/or repurchase) of common and preferred stock less cash dividends paid (Compustat data item SSTK less data item PRSTKC less data item DV). ΔDEBT represents net cash received from the issuance (and/or repayment) of debt (Compustat data item DLTIS less data item DLTR less data item DLCCH). RULE is an indicator variable that equals 1 if the observation is from the post-Rule 2711 period, and 0 otherwise. IB is an indicator variable that is set to 1 if the firm has the sum of reputation score of analysts whose employers are major suppliers of investment banking business (based on Loughran and Ritter 2004) that is above the median of the sample in year t and 0 otherwise. The t-statistics are computed using robust standard errors adjusted for clustering by company.
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ACCEPTED MANUSCRIPT Table 6 Results from Regression of Future Stock Returns on External Financing and Level of Conflicts of Interest from Trading Commissions Panel A. Results from Regressions for Observations with Analyst Following
TRit TRit × RULEit ΔXFINit × TRit ΔXFINit × TRit × RULEit ΔEQUITYit
ΔEQUITYit × TRit
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ΔEQUITYit × TRit × RULEit
ΔDEBTit × RULEit
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ΔDEBTit × TRit × RULEit
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ΔDEBTit × TRit
-0.0133 (-1.61) 0.00382 (0.35)
-0.0188* (-2.29) 0.0108 (0.98)
-0.00692 (-0.81) -0.00103 (-0.09)
-0.286*** (-5.10) 0.250** (2.59) -0.144 (-1.86) 0.0717 (0.60) 0.0229*** (4.15) 42,202 0.003
0.0718 (0.79) -0.189 (-1.65) -0.360*** (-3.62) 0.364** (2.84) -0.285*** (-5.10) 0.247* (2.56) -0.166* (-2.15) 0.0886 (0.74) 0.0237*** (4.10) 42,202 0.005
0.0733 (0.81) -0.190 (-1.66) -0.343*** (-3.45) 0.352** (2.75)
0.0184*** (3.46) 42,202 0.005
0.0176** (3.12) 42,202 0.002
p < 0.05, ** p < 0.01, *** p < 0.001
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*
-0.0143 (-1.78)
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ΔDEBTit
N adj. R2
-0.0136 (-1.74)
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ΔEQUITYit × RULEit
CONSTANT
-0.00864 (-1.09)
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ΔXFINit × RULEit
(4) SRETit+1
IP
RULEit
(3) SRETit+1
CR
ΔXFINit
(2) SRETit+1
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(1) SRETit+1 -0.154** (-3.19) -0.00875 (-1.14) 0.0917 (1.27) -0.00198 (-0.24) -0.00627 (-0.58) -0.183** (-3.14) 0.130 (1.53)
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ACCEPTED MANUSCRIPT Panel B. Results from Regressions for Observations without Analyst Following
ΔXFINit × RULEit TRit TRit × RULEit ΔXFINit × TRit ΔXFINit × TRit × RULEit
-0.0253* (-2.30)
-0.0302** (-2.67)
-0.0253* (-2.47) 0.0469 (1.62)
-0.0444*** (-4.56) 0.0396 (1.50)
-0.0234* (-2.27) 0.0439 (1.52)
US
ΔEQUITYit × RULEit
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ΔEQUITYit × TRit ΔEQUITYit × TRit × RULEit
M
ΔDEBTit ΔDEBTit × RULEit
ED
ΔDEBTit × TRit ΔDEBTit × TRit × RULEit
0.0506*** (8.14) 23,087 0.005
CE
PT
CONSTANT
*
-0.0304** (-2.70)
-0.178*** (-3.92) 0.138* (1.99) -0.0457 (-0.77) -0.181 (-1.47)
ΔEQUITYit
N adj. R2
(4) SRETit+1
T
RULEit
(3) SRETit+1
IP
ΔXFINit
(2) SRETit+1
CR
(1) SRETit+1 -0.181*** (-4.78) -0.0278* (-2.45) 0.0731 (1.16) -0.0234* (-2.29) 0.0388 (1.35) -0.0594 (-1.16) -0.0634 (-0.57)
0.0496*** (8.04) 23,087 0.004
-0.154* (-2.53) -0.128 (-1.05) -0.0394 (-0.45) 0.238 (0.94) 0.0438*** (7.06) 23,087 0.002
-0.191*** (-4.17) 0.142* (2.01) -0.0531 (-0.89) -0.166 (-1.34) -0.183** (-2.97) -0.104 (-0.85) -0.0750 (-0.85) 0.263 (1.03) 0.0511*** (8.24) 23,087 0.005
p < 0.05, ** p < 0.01, *** p < 0.001
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Panel A presents results of regressing future stock returns on external financing and level of conflicts of interests from trading revenue for firms with analyst following. Panel B presents results of regressing future stock returns on external financing and level of conflicts of interests from trading revenue for firms without analyst following. SRET is the annual size-adjusted stock returns measured using compounded buy-hold returns, inclusive of dividends and all other distributions, and are computed for a the 12-month period starting the fourth month after fiscal year t to ensure that all financial statement information is available to the public. ΔXFIN is the net amount of cash flow received from external financing activities: ΔXFIN = ΔEQUITY + ΔDEBT. ΔEQUITY is net cash received from the sale (and/or repurchase) of common and preferred stock less cash dividends paid (Compustat data item SSTK less data item PRSTKC less data item DV). ΔDEBT represents net cash received from the issuance (and/or repayment) of debt (Compustat data item DLTIS less data item DLTR less data item DLCCH). RULE is an indicator variable that equals 1 if the observation is from the post-Rule 2711 period, and 0 otherwise. TR is an indicator variable that is set to 1 if the firm’s annual turnover, calculated as the number of shares traded during the year divided by average shares outstanding, is greater than the median of our sample and to 0 otherwise. The t-statistics (in parentheses) are computed using robust standard errors adjusted for clustering by company.
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ACCEPTED MANUSCRIPT Table 7 Results from Regression of Future Stock Returns on External Financing Controlling for Market Timing (1) SRETit+1
(2) SRETit+1
(3) SRETit+1
(4) SRETit+1
-0.0354*** (-8.33)
-0.0404*** (-9.71)
-0.0345*** (-8.13)
SENTMENTit
-0.00702 (-1.08)
-0.00667 (-1.02)
-0.00664 (-1.01)
-0.00676 (-1.04)
ΔXFINit
-0.306*** (-11.07)
RULEit
-0.00530 (-0.74)
ΔXFINit × RULEit
0.306*** (6.21)
0.00316 (0.43)
US
0.000731 (0.10)
CR
IP
T
-0.0347*** (-8.25)
PSTKRTNit
-0.323*** (-9.33)
-0.333*** (-9.60)
0.392*** (5.86)
0.399*** (5.96)
AN
ΔEQUITYit
M
ΔEQUITYit × RULEit
ED
ΔDEBTit
PT
ΔDEBTit × RULEit
0.0202*** (3.93) 29,716 0.009
0.0145** (2.86) 29,716 0.007
AC
N adj. R2
CE
CONSTANT
-0.00371 (-0.50)
-0.271*** (-6.03)
-0.288*** (-6.40)
0.191** (2.58)
0.210** (2.83)
0.0132* (2.54) 29,716 0.006
0.0200*** (3.89) 29,716 0.009
t-statistics in parentheses: * p < 0.05, ** p < 0.01, *** p < 0.001 This table presents results of regressing future stock returns on external financing and proxies for market timing. SRET is the annual size-adjusted stock returns measured using compounded buy-hold returns, inclusive of dividends and all other distributions, and are computed for a the 12-month period starting the fourth month after fiscal year t to ensure that all financial statement information is available to the public. PSTKRTN is the past 24-month compound return ended 3 month after fiscal year t. SENTMENT is the past 12month sentiment index ended 3 month after fiscal year t (Baker and Wugler 2006). ΔXFIN is the net amount of cash flow received from external financing activities: ΔXFIN = ΔEQUITY + ΔDEBT. ΔEQUITY is net cash received from the sale (and/or repurchase) of common and preferred stock less cash dividends paid (Compustat data item SSTK less data item PRSTKC less data item DV). ΔDEBT represents net cash received from the issuance (and/or repayment) of debt (Compustat data item DLTIS less data item DLTR less data item DLCCH). RULE is an indicator variable that equals 1 if the observation is from the post-Rule period, and 0 otherwise. The t-statistics (in parentheses) are computed using robust standard errors adjusted for clustering by company.
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ACCEPTED MANUSCRIPT Table 8 Results from Regression of Future Stock Returns on External Financing and Accurals Panel A. Results from Regression of Future Stock Returns on External Financing and Accruals
-0.360*** (-8.22) 0.0224*** (4.26)
ΔXFINit × RULEit
0.165*** (5.08)
ACCRit × RULEit
0.162* (2.05)
US
RULEit
T
-0.327*** (-8.99)
(3) SRETit+1 -0.110*** (-6.82)
IP
ACCRit
(2) SRETit+1 -0.238*** (-12.18)
CR
ΔXFINit
(1) SRETit+1 -0.194*** (-12.43)
AN
T_ACCRit
0.0272*** (10.36) 55,361 0.006
CONSTANT
ED
N adj. R2
M
T_ACCRit × RULEit
0.0189*** (5.27) 55,361 0.007
AC
CE
PT
t-statistics in parentheses: * p < 0.05, ** p < 0.01, *** p < 0.001
49
-0.226*** (-14.91)
(4) SRETit+1 -0.157*** (-7.70)
-0.00822 (-1.63) 0.152*** (4.57)
-0.244*** (-12.76) 0.0585 (1.86)
0.0304*** (12.00) 64,719 0.009
0.0348*** (9.78) 64,719 0.010
ACCEPTED MANUSCRIPT Panel B. Results from Regression of Future Stock Returns on Equity, Debt Financing and Accruals (2) SRETit+1 -0.210*** (-9.01)
(3) SRETit+1 -0.112*** (-5.97)
(4) SRETit+1 -0.152*** (-6.46)
ΔDEBTit
-0.251*** (-9.60)
-0.317*** (-9.70)
-0.116*** (-4.53)
-0.177*** (-5.50)
ACCRit
-0.329*** (-9.03)
-0.364*** (-8.31)
ΔEQUITYit × RULEit
0.145*** (3.70)
ΔDEBTit × RULEit
0.210*** (3.88)
ACCRit × RULEit
0.166* (2.10)
IP
0.0228*** (4.35)
AN
US
RULEit
CR
ΔEQUITYit
T
(1) SRETit+1 -0.176*** (-9.36)
-0.226*** (-14.77)
M
T_ACCRit
ED
T_ACCRit × RULEit 0.0273*** (10.39) 55,361 0.006
CONSTANT
PT
N adj. R2
0.0187*** (5.21) 55,361 0.007
-0.00817 (-1.62) 0.139*** (3.55) 0.172** (3.26)
-0.244*** (-12.70) 0.0592 (1.85)
0.0306*** (12.08) 64,719 0.009
0.0348*** (9.80) 64,719 0.010
t-statistics in parentheses: * p < 0.05, ** p < 0.01, *** p < 0.001
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Panel A presents results of regressing future stock returns on external financing and accruals. Panel B presents results of regressing future stock returns on equity,and debt financing and accruals. SRET is the annual size-adjusted stock returns measured using compounded buy-hold returns, inclusive of dividends and all other distributions, and are computed for a the 12-month period starting the fourth month after fiscal year t to ensure that all financial statement information is available to the public. ΔXFIN is the net amount of cash flow received from external financing activities: ΔXFIN = ΔEQUITY + ΔDEBT. ΔEQUITY is net cash received from the sale (and/or repurchase) of common and preferred stock less cash dividends paid (Compustat data item SSTK less data item PRSTKC less data item DV). ΔDEBT represents net cash received from the issuance (and/or repayment) of debt (Compustat data item DLTIS less data item DLTR less data item DLCCH). T_ACCR is total accruals defined as the change in noncash assets [(change in Compustat item AT) less the change in Compustat item CHE)] less the change in non-debt liabilities [change in Compustat item LT less the change in COMPUSTAT item DLTT less the change in Compustat item DLC], deflated by average total assets (Compustat item AT). ACCR is the change in current assets (COMPUSTAT item ACT) less the change in cash (COMPUSTAT item CHE) less the change in current liabilities (COMPUSTAT item LCT) plus the change in debt in current liabilities (COMPUSTAT item DLC) less depreciation (COMPUSTAT item DP), deflated by average total assets (Compustat item AT). RULE is an indicator variable that equals 1 if the observation is from the post-Rule period and 0 otherwise. The t-statistics (in parentheses) are computed using robust standard errors adjusted for clustering by company.
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Highlights 1. Propose to test the relation between analysts’ guidance in earnings forecasts and recommendations and corporate external financing, and the relation between external financing and future stock returns
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2. We obtain empirical results from a sample of firms during the 1994–2010 period. We find a positive relation of analysts’ guidance in earnings forecasts and recommendations (especially long-term growth forecast and recommendations) and corporate financing activities, but the relation is weaker in the postRule period than in the pre-Rule period.
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3. We also find a negative relation between corporate external financing and future stock returns, but the relation is weaker in the post-Rule period. Moreover, the changes of these relations after the implementation of the Rule are greater for firms with greater conflicts of interest.
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4. We conclude from these results that Rule 2711 has reduced the extent of analysts’ conflicts of interest in corporate financing activities.
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Peter Chen, Kirill Novoselov, Yihong Wang PII: DOI: Reference:
S0929-1199(17)30075-5 https://doi.org/10.1016/j.jcorpfin.2017.12.020 CORFIN 1328
To appear in:
Journal of Corporate Finance
Received date: Revised date: Accepted date:
2 February 2017 27 October 2017 11 December 2017
Please cite this article as: Peter Chen, Kirill Novoselov, Yihong Wang , Regulatory effects on Analysts' conflicts of interest in corporate financing activities: Evidence from NASD Rule 2711. The address for the corresponding author was captured as affiliation for all authors. Please check if appropriate. Corfin(2017), https://doi.org/10.1016/ j.jcorpfin.2017.12.020
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Regulatory Effects on Analysts’ Conflicts of Interest in Corporate Financing Activities: Evidence from NASD Rule 2711*
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Peter Chen† Hong Kong University of Science and Technology [email protected] Phone: (+852) 2358-7572
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Kirill Novoselov Nazarbayev University [email protected]
This version: Oct. 2017
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Yihong Wang Shanghai University of Finance and Economics [email protected]
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We thank David Burgstahler, Mingyi Hung, Richard Sloan, Shiheng Wang, Wayne Yu, Haifeng You, Guochang Zhang, and workshop participants at the Hong Kong University of Science and Technology and Shanghai University of Finance and Economics. † Corresponding author.
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Regulatory Effects on Analysts’ Conflicts of Interest in Corporate Financing Activities: Evidence from NASD Rule 2711
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Abstract: We investigate the effects of NASD Rule 2711 on analysts’ conflict of interest in corporate financing activities. Specifically, we examine the relations (1) between analysts’ guidance in earnings forecasts and recommendations and corporate external financing and (2) between external financing and future stock returns during the 1994–2010 period. We find a positive relation of analysts’ guidance in earnings forecasts and recommendations (especially long-term growth forecast and recommendations) and corporate financing activities, but the relation is weaker in the post-Rule period than in the pre-Rule period. We also find a negative relation between corporate external financing and future stock returns, but the relation is weaker in the post-Rule period. Moreover, the changes of these relations after the implementation of the Rule are greater for firms with greater conflicts of interest. Our empirical results suggest that Rule 2711 has reduced the extent of analysts’ conflicts of interest in corporate financing activities.
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Keywords: Conflicts of interest; NASD Rule 2711; analysts’ guidance; external financing; stock returns.
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1. INTRODUCTION Sell-side analysts face the dual task of providing independent earnings forecasts/stock recommendations for investors and marketing their employers’ financial services to corporate managers. Analytical valuation models and empirical findings show that analysts are capable of guiding market valuation
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through their earnings forecasts and recommendations (e.g., Miller and Modigliani 1961; Ohlson 1995;
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Lys and Sohn 1990; Womack 1996; Jegadeesh, Kim, Krishche and Lee 2004). Analysts, however, may
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divert their ability to guide market valuation to curry favor with corporate managers in selling overvalued securities. In return for their optimistic guidance, analysts are compensated with commissions on ongoing
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investment banking and brokerage business. Meanwhile, investors who purchase the underwritten securities on analysts’ guidance suffer subsequent losses. Consequently, analysts’ conflicts of interest
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have been under considerable regulatory and academic scrutiny in recent decades. Ever since the collapse of the internet and telecom stocks in the early 2000s, analysts have been
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scrutinized for hyping securities during the boom of financing activities (e.g., Shiller 2000, 2012;
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Groysberg and Healy 2013). Securities and Exchange Commission (SEC) approved NASD Rule 2711 in May 2002 (hereafter, the Rule) that prohibits employers from linking analysts’ compensation to their
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investment banking transactions and prohibits analysts from offering favorable research or a specific rating or price target to a company as consideration or inducement for future business. These prohibitions
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reflect the belief that linking analysts’ pay to their employers’ investment banking business leads analysts to make more optimistic forecasts and recommendations to curry favor with managers.1 Prior studies find
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that analysts’ bias in forecasts and recommendations has decreased and the relation between analysts’ recommendations and fundamental valuation (V/P) has strengthened in the post-Rule period (Barber, Lehavy, McNichols, and Truman 2006; Barniv, Hope, Myring, and Thomas 2009; Chen and Chen 2009; Guan, Lu, and Wong 2012; Kadan, Madureira, Wang and Zach 2009). These studies, however, do not directly examine whether the implementation of the Rule has changed the relation between analysts’ 1
Besides investment banking, other conflicts of interest identified by the regulators are (i) positive research reports to trigger higher trading volumes and in turn generate larger commissions for the analysts’ firms and (ii) ownership of equity by the analyst or the brokerage firm in the companies that the analyst covers. See the SEC Acting Chair Laura Unger’s written testimony before the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, Committee on Financial Services, U.S. House of Representatives on July 31, 2001.
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ACCEPTED MANUSCRIPT optimistic guidance on valuation and corporate financing activities, which was the regulator’s primary concern. In addition, prior studies provide little evidence on whether the Rule has redressed the imbalance in the relation between the interests of analysts and those of investors who purchase the securities underwritten by the analysts’ employers.
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A stream of finance studies documents a negative relation between corporate financing activities
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and future stock returns and suggests that analysts’ optimism around corporate financing events may
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contribute to this negative relation (Loughran and Ritter 2004; Ritter 2003). Building on prior findings on stock returns after various financing activities, Bradshaw, Richardson, and Sloan (2006) construct
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comprehensive measures of corporate financing using statements of cash flow data for the 1971–2000 period and report evidence of systematic negative relations between corporate financing activities (debt or
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equity) and future stock returns. 2 Furthermore, they find that, although analysts’ forecasts and recommendations are too optimistic for firms raising new capital regardless of investment banking ties,
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affiliated analysts are slightly more optimistic than non-affiliated analysts.3 Their findings of the negative
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relation between external financing and future stock returns are consistent with analysts’ conflicts of interest, even though these findings are also consistent with market timing. These relations reported by
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Bradshaw et al. (2006) in the pre-Rule period may have changed, however, if the Rule, implemented in 2002, has attenuated the degree of analysts’ conflicts of interest in corporate financing.
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In this study, we provide evidence on whether Rule 2711 has changed the extent of analysts’ conflicts of interest in corporate financing activities. To infer the effects of the Rule, we investigate (1)
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the relation between analysts’ guidance in earnings forecasts and recommendations and corporate external financing, and (2) the relation between external financing and future stock returns. If the prohibitions stipulated in the Rule have weakened analysts’ incentive to issue overly optimistic guidance in selling new securities, we hypothesize that the relation between analysts’ guidance in earnings forecasts and recommendation ratings and firms’ external financing is weaker in the post-Rule than in the pre-Rule 2
Bradshaw et al. (2006) report an annual return of 15.5%, using a hedge strategy based on net external financing. Bradshaw et al. (2006) find that analysts’ earnings forecasts and recommendation ratings are optimistic following the external financing activity. In this study, we investigate whether analysts’ earnings forecasts and recommendations are too optimistic in the year of external financing. 3
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ACCEPTED MANUSCRIPT period. In addition, if the implementation of the Rule has led to a re-alignment of analysts’ incentives with the interests of investors in the newly issued securities, we hypothesize that the relation between corporate external financing and future stock returns is weaker after the Rule’s implementation. Our sample consists of firm-year observations for the 1994–2010 period. The empirical results
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show a positive relation between analysts’ guidance in earnings forecasts and recommendation ratings
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and external financing, but this relation is weaker in the post-Rule period. Among the four analysts’
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variables in our empirical tests, the effects of the Rule on analysts’ long-term growth forecasts and recommendations are more evident than on one-year and two-year-ahead earnings forecasts. In addition,
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the Rule has a stronger effect on equity financing than on debt financing. Our empirical results also show a negative relation between external financing and future stock returns, but the relation is weaker in the
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post-Rule than in the pre-Rule period.
To enhance the likelihood that these changes in relations are attributable to the implementation of
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the Rule, we partition the sample into two groups based on the firm’s level of conflicts of interest. We use
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the supply of investment banking services from the analysts’ employers as a proxy for the firm’s potential conflicts of interest. We find that the changes in the relation between analysts’ guidance and external
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financing and in the relation between external financing and future stock returns from the pre-Rule to the post-Rule period are greater for firms with greater conflicts of interest. These empirical results provide
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further evidence that the reforms implemented by the Rule have attenuated analysts’ conflicts of interest in corporate financing activities.
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We acknowledge that our inferences on the effects of the Rule are subject to limitations. In particular, we cannot rule out the possibility that the changes in the relations we document are attributable to concurrent regulatory events such as the passage of the Sarbanes–Oxley Act (SOX) in 2002 and changes in investment opportunities. In additional analyses, we perform several tests and robustness checks to enhance our confidence that our results are attributable to the Rule and are not driven by alternative explanations. First, we perform similar analyses on whether Rule 2711 has attenuated the analysts’ conflicts of interest arising from trading commissions because this was also a part of the regulatory reform. Using the firm’s share turnover (per share) in the year of external financing as a proxy 3
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for potential conflicts from trading commissions, we find effects of the Rule similar to those of the investment banking. Interestingly, we find no such effect of the Rule for a sample of firm-year observations with no analyst following. We also perform empirical tests to show that our results on the change in the relation between
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external financing and future stock returns (H2) are not attributable to market timing and the passage of
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SOX. With respect to marketing timing, we find our result remains unaffected after controlling for market
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timing variables, past 24 month stock returns, and investment sentiment (Chang, et al. 2006; Baker and Wugler 2006). Prior studies report evidence that firms manage accruals before equity financing, but
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accrual-based earnings management declines because of strengthened regulatory oversight on financial reporting in the post-SOX period (e.g. Teoh, Welch, and Wong 1998; Cohen, Dey, and Lys 2008). We
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include measures of accruals in our regression of future stock return on external financing. Our results on the relation between external financing and future stock returns attributable to analysts’ conflicts of
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interest are unaffected after controlling for the effect of accruals. By conducting these tests, we also rule
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out the possibility that the change of the above-mentioned negative relation is attributable to the accrual anomalies (Sloan 1996; Richardson et al. 2005; Cohen and Lys 2006). In addition, we perform tests to
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show that our results are not attributable to changes in the firm’s investment opportunity set in the postRule period (Lyandres, Sun, and Zhang 2007; Chen and Zhang 2007). Specifically, we include both
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accounting profitability (return of equity) and the change in profitability after external financing in the regression of future stock returns and external financing. Our results on the effects of the Rule remain
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unchanged by including these variables. In addition to the above tests, we perform several robustness checks. We repeat our analysis with observations within ±4 years around the implementation of the Rule and obtain even stronger results on the effects of the Rule. We use affiliated analysts as the alternative measure of analysts’ conflicts of interest and obtain qualitatively similar results. Our study makes several contributions. First, by focusing on the role of analysts in corporate financing activities, we provide new empirical evidence on the effects of Rule 2711. Our empirical results on the changes in the relation between analysts’ guidance in earnings forecasts and recommendations and 4
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external financing as well as the relation between external financing and future stock returns in the postRule period provide further evidence to differentiate the role of analysts’ conflicts of interest versus market timing in corporate financing activities. Although prior studies show that analysts have changed their assignments of Buy and Sell recommendations toward more objective valuations, these studies do
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not show whether the Rule has resulted in the change of analysts’ guidance to market overvalued new
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issuances, as targeted by the Rule. Unlike Bradshaw et al (2006) and consistent with Kadan et al. (2009)
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and Guan et al. (2012), we find that analysts’ conflicts of interest, controlling for external financing, are associated with more optimistic guidance in pre-Rule period. Unlike Kadan et al. (2009) and Guan et al.
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(2012), we provide direct evidence on whether the change of the Rule has changed the relation of analysts’ guidance and financing activities as well as on the relation between future stock return and financing
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activities in the post-Rule period. Our empirical results contribute to those based on the change of the relation of analysts’ recommendation with fundamental valuation (V/P) in prior studies (Barniv et al.
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2009; Chen and Chen 2009; Groysberg et al. 2011).
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Second, for regulators, our empirical results on the change in the relation of external financing and future stock returns suggest that Rule 2711 redresses the misalignment between the interests of
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analysts and those of investors in the underwritten securities. Several studies find that the Rule has resulted in unintended consequences, such as loss of pay and funding to analysts and reduced analysts’
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coverage, and conclude that the reforms provide little benefit to investors based on the accuracy of analysts’ forecasts and the profitability of analysts’ recommendations (Kadan et al. 2009; Guan et al.
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2012; Groysberg and Healy 2013). By providing evidence on the Rule’s intended purpose, our empirical results help regulators assess the economic consequences of the Rule. The results also have implications for studies on the wealth transfers among ongoing investors and new investors as a result of financing activities (e.g., Sloan and You 2015). To the extent that misaligned incentives of analysts, managers, and other market participants result in wealth transfers via financing transactions, the regulators must remain vigilant. Third, our study enhances our understanding of the role of analysts in guiding market valuation. Our empirical results show that conflicts of interest that compel analysts to guide optimistic valuation are 5
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more evident in long-term growth forecasts and recommendations than in short-term earnings forecasts. These results suggest that using short-term earnings forecast errors to infer analysts’ conflicts of interest may lead to unwarranted conclusions (Guan et al 2012, Cowen et al. 2006). Our results complement prior findings on the relation of long-term growth forecasts and recommendations with future stock returns
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(Dechow and Sloan 1997; Dechow et al. 2000; Bradshaw 2004; Jegadeesh et al. 2004; Purnanandam and
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Swaminathan 2004). Additionally, our empirical results show that analysts’ forecasts and
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recommendations have a stronger relation with equity financing than with debt financing, consistent with the greater impact of analysts’ guidance on equity valuation than on debt valuation.
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The rest of the paper is organized as follows. Section II discusses the related literature and develops our research hypotheses. Section III lays out the research design, while Section IV describes
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measurement of variables and the sample. Section V presents the main empirical results. Section VI presents the results from tests of alternative explanations and robustness checks. Section VII concludes
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the paper.
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2. RELATED LITERATURE AND HYPOTHESIS DEVELOPMENT 2.1. Analysts’ Conflicts of Interest and Corporate External Financing
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Valuation models show that security valuation requires forecasts of earnings and earnings growth (Miller and Modigliani 1961; Ohlson 1995). Financial analysts are specialists in forecasting earnings and making
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stock recommendations. To develop an informational edge, they collect and process various industry- and firm-specific information. A large body of empirical evidence shows that analysts’ forecasts of earnings
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serve as a better proxy for market expectation than time-series models (Fried and Givoly 1982; O’Brien 1988), that analysts’ forecasts of earnings and earnings growth serve as key valuation metrics in explaining stock price (Frankel and Lee 1998; Liu, Nissim, and Thomas 2002), and that changes of analysts’ forecasts and their recommendation ratings are associated with predictable stock returns (Lys and Sohn 1990; Womack 1996; Barber et al. 2003). Both valuation theories and empirical studies support the notion that financial analysts guide market valuation through their forecasts and recommendations. Sell-side analysts also perform a valuable role in selling new securities and making a liquid market for their clients (e.g. Womack 1996; Groysberg and Healy 2013). Analysts’ ability to guide 6
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market valuation, however, may be diverted to curry favor with corporate managers by issuing optimistic guidance on newly issued securities. In return, issuers compensate analysts and their employers with commissions on current and future investment banking business. Besides their access to corporate managers, analysts have a natural advantage over other market participants in generating future
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investment banking business because in forecasting earnings and earnings growth, analysts are able to
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anticipate the firm’s future demand for external financing. 4 Linking analysts’ compensation to investment
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banking business strengthens their incentives to divert effort from generating objective forecasts and valuation to the marketing of overvalued securities. However, analysts’ conflicts of interest during
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financing activities benefit analysts or their corporate clients at the expense of investors who purchase the newly issued securities.5 This wealth transfer was a major concern that led to regulatory reforms in the
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Rule.
Valuation models discussed above have implications for the different types of earnings forecasts
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and recommendations that analysts issue to guide valuation. Because the value of a firm is the capitalized
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stream of its expected future earnings, analysts’ optimism in their long-term growth guidance has a multiplier effect on valuation that is much greater than a similar level of optimism in short-term earnings
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forecasts would have.6 Analysts’ stock recommendations signal their private valuation relative to current market valuation. A Buy or Strong Buy rating indicates the analyst’s valuation that is higher than current
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market valuation and vice versa for a Sell or Strong Sell rating. Accordingly, analysts’ recommendations influence market valuation through more direct guidance of investors’ trading than earnings forecasts.
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Therefore, we expect that analysts’ guidance of market valuation during external financing activities is more effective through stock recommendations and long-term earnings growth forecasts than through 4
The valuation models in Miller and Modigliani (1961) show various links between the forecast of earnings and the forecast of external financing, given the firm’s investment policy. 5 Consistent with investment banking-related incentives, Groysberg et al. (2011) find that at leading investment banks, the average sell-side analyst compensation increased dramatically during the 1990s, leading to a peak of around $1.11 million in 2000 and then declined by 44% between 2003 and 2005 after the implementation of Rule 2711. These changes are largely driven by bonus awards related to investment banking. During the same period, the percentage of Strong Buy or Buy recommendations increases from 45% to 70% in 2000 while the percentage of Sell recommendations drops from 9.7% to 1.4%. 6 Analysts are also more constrained in issuing optimistic short-term earnings forecasts because of reputation concerns as well as the availability of other information such as management forecasts and earnings reports (Cowen et al. 2006).
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short-term earnings forecasts. Analysts’ guidance in earnings forecasts and recommendations may vary with the type of securities to be issued. Unlike equity holders, who have a residual claim on the firm, debtholders do not participate in the success or the upside potential of the firm beyond the promised claim in the debt
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contract. On the other hand, debtholders share the downside risk if the firm’s future cash flows cannot
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meet its debt obligations. Therefore, the valuation of equity (debt) has a convex (concave) relation with
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analysts’ optimisms in earnings and earnings growth forecasts as well as recommendations (Black and Scholes 1973; Zhang 2000). This implies that, to the extent that analysts guide overvaluation before
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external financing to curry favor with managers, analysts’ guidance in earnings forecasts and recommendations has a stronger relation with equity issuance than with debt financing.
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Prior research reports mixed evidence on whether investment banking affects the quality of analysts’ forecasts and recommendation ratings. Affiliated analysts are slower to downgrade from Buy
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and Hold recommendations and faster to upgrade from Hold, suggesting that investment banking ties
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increase analysts’ reluctance to reveal negative opinions about the firms they cover (Lin and McNichols 1998; O’Brien, McNichol and Lin 2005). Cowen, Groysberg, and Healy (2006) examine how the level of
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optimism in analyst forecasts and recommendations varies with the types of their employer for the 1996– 2002 period and report that analysts whose employers have significant underwriting and trading activities
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actually make less optimistic forecasts and recommendations than those at brokerage houses without underwriting. Cowen et al. attribute these results to reputation as the primary cause of reduced optimism
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of large underwriters. However, these authors’ evidence on analysts’ forecasts and recommendations is not conditional on corporate financing activities. While analysts’ affiliations likely reflect conflicts of interest arising from recent investment banking ties, unaffiliated analysts may also have incentives to issue favorable research reports to induce future investment banking business and to stay on friendly terms with managers, who serve as a valuable source of information (Mayew 2008). While prior studies measure conflicts of interest at the analyst level, in this study we measure conflicts of interest around financing activities at the firm level. Specifically, we use the supply of investment banking services from the analysts’ employers as a proxy for the level of 8
ACCEPTED MANUSCRIPT potential conflicts of interest.7 Our reasoning is that a greater supply of investment banking services to the firm leads to greater pressure for analysts to curry favor with managers in their competition for ongoing financing opportunities. Therefore, our measure of the conflicts of interest at the firm level captures the intensity of analysts’ competition for the firm’s current and future investment banking business, not just
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the analysts’ affiliation.
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The regulator’s primary concern is that linking analysts’ compensation to investment banking
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business motivates analysts to attract and retain investment banking clients for their employer and as a consequence makes analysts accountable to investment banks for their earnings forecasts and
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recommendation ratings. 8 Our first research question is whether the Rule has changed the relation between analysts’ guidance in earnings forecasts and recommendations and external financing. Several
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recent studies find that analysts’ bias in forecasts and recommendations is smaller and the relation of analysts’ recommendations with fundamental valuation (V/P) is stronger in the post-Rule than in the pre-
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Rule period, consistent with improved analysts’ independence (e.g., Barber, et al. 2006; Barniv et al.
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2009; Chen and Chen 2009; Guan et al. 2012). These studies, however, do not directly examine whether the Rule has changed the relation between analysts’ forecasts and recommendations to guide market
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valuation and specific corporate financing activities. If the implementation of the Rule has attenuated the extent of analysts’ conflicts of interest associated with financing activities, we expect the relation of
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analysts’ guidance in earnings forecasts and recommendations with future external financing to be weaker in the post-regulation period.
H1:
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The above discussion leads to our first hypothesis: The relation between analysts’ guidance in earnings forecasts and recommendations and future external financing is weaker in the post-Rule than in the pre-Rule period.
7
The supply is computed as the sum of reputation score of the analysts’ employers in Loughran and Ritter (2004). Underwriters with a rank of 8 to 9 are the prestigious national underwriters. Those with a rank of 5 to 7.9 are considered to be quality regional underwriters. Underwriters with a rank of 0 to 4.9 are associated with penny stocks. The reputation rank is based on the underwriter’s position as lead underwriter or syndicated underwriter in the tombstone announcements of the IPOs (Carter and Manaster 1990; Loughran and Ritter 2004). 8 SEC Acting Chairman Laura Unger’s testimony before the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, Committee on Financial Services, U.S. House of Representatives on July 31, 2001. Available at http://www.sec.gov/news/testimony/073101ortslu.htm.
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2.2. Corporate External Financing and Future Stock Returns Prior studies in finance report a negative relation between corporate external financing activities and future stock returns. In particular, future stock returns are consistently low in the periods following initial public offerings (Ritter 1991; Dechow et al. 2000), seasoned equity offerings (Loughran and Ritter 1997),
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debt offerings (Spiess and Affleck-Graves 1999), and bank borrowing (Billett, Flannery, and Garfinkel
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2006). In contrast, stock repurchases are associated with high future stock returns. These results suggest
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that corporate managers are able to time the market by selling overvalued and repurchasing undervalued securities (Baker and Wurlger 2006). Corporate managers may have an advantage over other market
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participants in arbitraging the mispriced securities; however, regulators and researchers want to know whether analysts’ conflicts of interest in marketing the newly issued securities contribute to overvaluation
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and thus explain the negative relation between external financing and future stock returns. Dechow, Hutton, and Sloan (2000) report evidence that analysts’ long-term earnings growth
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forecasts at initial public offerings are overly optimistic, especially among affiliated analysts. Dechow et
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al. also show that such optimistic forecasts are reflected in stock prices. Bradshaw et al. (2006) find that analysts’ forecasts and stock recommendations are overly optimistic following corporate financing
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activities. Bradshaw et al. attribute the negative relation between external financing and future stock returns to mispricing and propose a number of potential causes, including analysts’ conflicts of interest
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and managers’ market timing.
Our second research question is whether Rule 2711 has led to a weaker relation of external
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financing with future stock returns in the post-Rule period. Two streams of theoretical studies are relevant to our research question. First, the theory of collusion in organizations (e.g., Kofman and Lawarrée 1993) shows that one way to reduce collusion between the analysts (“the supervisors”) and corporate managers (“the agents”) is to reduce the supervisors’ stake in the agents (Tirole 1986; 2006). By delinking the analysts’ compensation from investment banking, the regulator intended to redress the balance between the interests of analysts and those of investors. Second, the theory of incentives in multi-task settings (Holmström and Milgrom 1991; Feltham and Xie 1994) suggests that analysts would allocate more effort to independent and objective valuation if the regulations were to weaken their incentives to induce 10
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investment banking business by guiding overvaluation. Several studies investigate whether Rule 2711 changes the accuracy of earnings forecasts and profitability of analysts’ recommendations (Barber et al. 2006; Kadan et al. 2009; Ertimur et al. 2007; Guan et al. 2012). The evidence in these studies suggests that the Rule has not benefited investors based
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on the profitability of analysts’ recommendations. In contrast, we investigate whether the Rule has led to
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a change in the relation between external financing and future stock returns to infer the efficacy of the
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reform in mitigating the adverse consequences of misaligned interests of analysts and those of investors trading in the newly issued securities. If the negative relation between external financing and future stock
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returns were attributable to analysts’ conflicts of interest in the pre-Rule period, we expect a weaker relation between external financing and future stock returns following the implementation of the Rule. On
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the other hand, if the negative relation between external financing and future stock returns were only attributable to market timing by managers, we should not find any evidence that the relation is weaker
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because the Rule does not constrain managers’ freedom to time the market in external financing activities.
H2:
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This leads to our second hypothesis stated as follows: The relation between external financing and future stock returns is weaker in the post-Rule than
3. RESEARCH DESIGN
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in pre-Rule period.
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Our hypothesis H1 states that the relation of analysts’ guidance in earnings forecasts and recommendation ratings with future external financing is weaker in the post-Rule period. Following Bradshaw et al. (2006),
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we employ four analyst variables to represent analysts’ guidance: one-year and two-year-ahead earnings forecasts, the long-term growth forecast, and the recommendation rating.9 To test H1, we estimate the regression of analysts’ variables following the release of financial statements of year t–1 on external financing in year t: Analysts’ Variableit = α0 + α1RULEit + α2ΔXFINit + α3ΔXFINit × RULEit + it.
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(1)
We do not examine the analyst’s target price due to data availability. Because analysts’ forecasts of target prices on IBES only become available in 1999, the number of observations with target price in the pre-Rule period is not sufficient large (less than 3,000) to perform tests comparable with those in our main empirical analyses.
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Our dependent variables are four analyst variables: F1ERROR, F2ERROR, LTG, and REC. F1RRORit (F2ERRORit) is the analysts’ one-year-ahead (two-year-ahead) earnings forecast error, i.e., realized earnings per share minus consensus forecasted earnings per share, scaled by stock price at the month of forecast; LTGit is the analysts’ forecast of long-term growth; 10 and RECit is the analysts’ mean
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recommendation rating. RULEit equals 1 if the observation is in the post-Rule (i.e., post-2001) period, and
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0 otherwise. ΔXFINit is net external financing of firm i in year t. To capture the analysts’ guidance for
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firms with external financing in year t, analysts’ earnings forecasts and recommendation ratings are based on the fourth month after the fiscal year end of t-1 because most firms have released their financial results
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by this time, hence analysts shift to earnings forecasts in year t and anticipate their clients’ external financing activities in year t.11 Prior studies find a positive relation between analysts’ optimistic guidance
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and external financing. We, therefore, predict the coefficient α2 to be negative for F1RRORit and F2ERRORit and positive for LTGit and RECit. Our primary interest, however, is in the coefficient α3,
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which we predict to be positive for F1RRORit and F2ERRORit and negative for LTGit and RECit.
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Following Bradshaw et al. (2006), we separate net external financing into net debt financing (ΔDEBTit) and net equity financing (ΔEQUITYit) to examine whether the relation of analysts’ guidance
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with equity issuance is different from the relation with debt issuance. Our earlier discussion predicts the relation to be stronger for equity financing than for debt financing.
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To test H2, which posits that the relation between external financing and future stock returns is
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We use analysts’ long term earnings growth forecast (LTG) rather than long-term earnings growth forecast error for two reasons. First, as a key valuation metric (e.g., PEG ratio), the role of analysts’ long-term growth forecast in guiding valuation is of interest by itself. Unlike one-year ahead and two-year ahead earnings forecasts, long-term growth forecast does not have a specific horizon of the forecasted growth (see Miller and Modigliani 1961), which complicates the meaning and measurement error in the long-term growth forecast error. Second, because our research focus is on the effect of the Rule rather than the relation of LTG with external financing, the use of LTG allows us to infer more directly the effect of the Rule. Nevertheless, we perform sensitivity analyses with long-term earnings growth forecast errors following Bradshaw et al. (2006). Our conclusions are not affected by using this alternative measure. 11 Bradshaw et al (2006) measure analyst variables at the 4th month following the fiscal year end of the external financing t. In other words, our analyst variables are measured one year ahead of those in Bradshaw et al. Since analysts’ conflicts of interest in guiding overvaluation before external financing can lead to their commitment to maintain the optimistic guidance even after external financing, the relation of analyst variables with external financing activities may persist in the months following external financing, as reported in Bradshaw et al. (2006). Furthermore, In Panel E of Figure 2 of Bradshaw et al. (2006), analysts’ recommendation ratings for the highest external financing decile peak around month –8, consistent with analysts’ optimistic guidance in the year of external financing.
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weaker in the post-Rule period, we estimate the following regression model: SRETit+1 = 0 + 1RULEit + 2ΔXFINit + 3ΔXFINit × RULEit + it+1,
(2)
where SRETit+1 is the size-adjusted stock returns of firm i in year t+1. Following Bradshaw et al. (2006), we accumulate the 12-month stock return, starting the fourth month after fiscal year t to ensure that all
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financial statement information is available to the public. We expect 2 and 3 to be negative and positive
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respectively.
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Given the regulator’s concern about analysts’ conflicts of interest related to investment banking and the prohibition of linking analysts’ pay with investment banking business in the Rule, we expect that
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firms with greater potential conflicts of interest should experience a greater change in the relation of analysts’ guidance in earnings forecasts and recommendations with external financing. To provide further
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evidence on the effect of the Rule on analysts’ conflicts of interest related to investment banking, we
Analysts’ Variableit
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estimate the following regression model:
= α0 + α1RULEit + α2ΔXFINit + α3ΔXFINit × RULEit+ α4IBit (3)
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+ α5RULEit × IBit + α6ΔXFINit × IBit + α7ΔXFINit × RULEit × IBit + it,
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where IBit is an indicator variable that is set to 1 if the firm has an IB score higher than the sample median in year t and to zero otherwise. The IB score is computed as the sum of underwriter reputation scores
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(Loughran and Ritter 2004) for the employers of the analysts who have issued recommendations for firm i in the fourth month after fiscal year t–1. The interaction variables, RULEit × IBit, ΔXFINit × IBit, and
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ΔXFINit × RULEit × IBit, are included to capture the incremental effects of IBit on RULEit, ΔXFINit, and ΔXFINit × RULEit in explaining the analysts’ variables. Other variables are defined as those in regression model (1). If investment banking-related conflicts of interest led analysts’ overly optimistic guidance in pre-Rule period, we expect the coefficients α6 to be significant with the same signs as α2 for the respective analyst variables. In addition, if investment banking-related conflicts are attenuated by the Rule, we expect coefficients α7 to be significant with the same signs as α3. Similarly, if the negative relation between external financing and future stock returns is attributable to analysts’ conflicts of interest related to investment banking, we expect that firms with 13
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higher levels of conflicts of interest should experience a larger change in the relation between external financing and future stock returns from the pre-Rule to the post-Rule period. To provide further evidence on whether the change of the relation between external financing and future stock returns is attributable to investment banking-related analysts’ conflicts, we estimate the following regression model, which
= 0 + 1RULEit + 2ΔXFINit + 3ΔXFINit × RULEit + 4IBit
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SRETit+1
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includes IBit:
(4)
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+ 5RULEit × IBit + 6ΔXFINit × IBit + 7ΔXFINit × RULEit × IBit + it+1,
where IBit is the indicator variable as defined above. The interaction variables, RULEit × IBit,
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ΔXFINit × IBit, ΔXFINit × RULEit × IBit, are included to capture the incremental effects of IBit on RULEit, ΔXFINit, and ΔXFINit × RULEit in explaining future stock returns. If the negative relation of external
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financing with future stock returns is attributable to analysts’ conflicts of interest arising from investment
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banking business, we expect 6 to be negative and 7 to be positive. 4. SAMPLE SECTION AND DESCRIPTIVE STATISTICS
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4.1. Variable Definition and Data Sources
We obtain one- and two-year-ahead earnings forecasts, long-term earnings growth forecasts, and stock
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recommendations from the I/B/E/S/ summary statistics files. We define year t as the year in which
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corporate external financing is measured. To measure the analyst variables before corporate financing activities, we obtain the mean consensus analysts’ forecasts and recommendation ratings in the 4th month
variables:
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after the fiscal year t–1. The following description provides the details of the measurement of our analyst
F1ERRORit: one-year-ahead earnings forecast error, computed as the realized annual earnings per share for the upcoming year minus the corresponding monthly consensus forecast of annual earnings, scaled by the stock price at the end of the forecast month. F2ERRORit: two-year-ahead earnings forecast error, computed as the realized annual earnings per share for the year after the upcoming year minus the corresponding monthly consensus forecast of annual earnings, scaled by the stock price at the end of the forecast month.
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LTGit: Long-term earnings growth forecast, i.e., the corresponding monthly consensus forecast of the long-term earnings growth rate. RECit: The mean consensus analysts’ stock recommendation rating coded on a 1–5 point scale.12 We invert the standard coding of stock recommendations so that 1 = strong sell, 2 = sell, 3 = hold,
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4 = buy, and 5 = strong buy.
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RULEit: an indicator variable that equals 1 if the observation is from post-Rule period (year greater than
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2001) and zero otherwise.13
Our measure of analysts’ conflicts of interest from investment banking, IBit, the indicator variable
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of investment banking-related conflicts, is constructed based on reputation scores of the employers of the firm’s analysts. Specifically, IBit is set to 1 if the firm has an IB score higher than the sample median in
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year t and to zero otherwise. We obtain the name of the analyst’s employer from the I/B/E/S detailed files. The IB scores are reputation scores computed as the sum of underwriter prestige rankings from Loughran
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and Ritter (2004) for the employers of the analysts who have issued recommendations for firm i in the
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fourth month after fiscal year t–1.14
Following Bradshaw et al. (2006), we measure the net amount of cash received from external
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financing activities (ΔXFINit) as:
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ΔXFINit = ΔEQUITYit + ΔDEBTit,
where ΔEQUITYit represents net cash received from the sale (and/or repurchase) of common and preferred
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stock less cash dividends paid (Compustat data item SSTK less data item PRSTKC less data item DV) and ΔDEBTit represents net cash received from the issuance (and/or repayment) of debt (Compustat data item DLTIS less data item DLTR less data item DLCCH). We require that all of these data items be
12
Following prior studies, we use the mean (instead of median) consensus recommendations because of the greater variation of means rating across companies. 13 Even though NASD Rule 2711 was passed in May, analysts might have anticipated the Rule in the month prior to its passage. For this reason, we consider year 2002 to be within the post-Rule period. However, our empirical results are not affected by excluding this year from the post-Rule period. 14 As a robustness check, we also performed our analysis using affiliation with an investment bank as our proxy for analysts’ conflicts of interest. The dummy variable using affiliation has 93% correlation coefficient with our IB in the full sample. We obtain qualitatively similar empirical results using this alternative measure.
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fiscal year. All results reported in the tables are based on size-adjusted returns.
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4.2. Sample Selection and Descriptive Statistics
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We collect and merge the data from the Compustat annual files, the CRSP monthly returns files, and the I/B/E/S summary files. Our sample consists of all firm-years with sufficient data during the period from
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1994 to 2010. The number of years is approximately balanced around the passage of the Rule in 2002. The number of observations in our empirical tests investigating the relation between analysts’ forecasts
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and recommendations and external financing (H1) ranges from 38,767 (LTGit) to 47,782 (F1ERRORit) due to data availability. The number of observations in empirical tests on the relation between external
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financing and future stock returns (H2) is 65,533, and the number is 40,051 if the investment banking-
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related conflicts of interest variable, IBit, is introduced into the regression model. Table 1 reports the descriptive statistics of the external financing and analyst variables and pair-
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wise correlations for the full sample. The mean values of ΔXFINit, ΔEQUITYit, and ΔDEBTit are 0.046, 0031, and 0.015 respectively, indicating an overall tendency of raising additional external capital. The
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median values of these financing variables are close to zero, however, implying that the positive means are driven by the right tail of the distribution. Equity financing has a larger variation (standard
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deviation = 0.152) than debt financing (standard deviation = 0.106). The mean value of F1ERRORit and F2ERRORit are -0.081 and -0.117, respectively, indicating analysts’ optimism in earnings forecasts before external financing. These forecast errors are more than twice the forecast errors at the year-end of financing activity, as reported in Bradshaw et al. (2006). The mean of LTG is 17.483 and the mean recommendation rating is 3.819. The average number of analysts
15
By drawing a random sample, Bradshaw et al. (2006) verify that ΔEQUITYit mostly reflects initial public offerings (IPO) and seasoned equity offerings (SEO), while ΔDEBTit includes convertible debt, subordinated debt, notes payables, debentures, and capitalized lease obligations.
16
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following a firm is 6.797. Panel B of Table 1 reports the pair-wise Pearson correlations between external financing and analyst variables. Note first that there is a negative correlation between ΔEQUITYit and ΔDEBTit (correlation coefficient = -0.082 significant at p < 0.001), suggesting that a few firms engage refinancing by issuing equity to repurchase debt or by issuing debt to repurchase equity. Note also that the
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correlation between ΔXFINit and ΔEQUITYit is greater (correlation coefficient = 0.787) than the
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correlation between ΔXFINit and ΔDEBTit (correlation coefficient = 0.538). In addition, equity financing
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(ΔEQUITYit) is negatively associated with firm profitability in the year of financing and in the year prior to financing activity, but there is little evidence that the same relation holds for debt financing (ΔDEBTit).
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With respect to the correlation with analysts’ optimism, equity financing (ΔEQUITYit) has a higher correlation with analysts’ one-year-ahead and two-year-ahead earnings forecast errors (F1ERRORit,
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F2ERRORit), long-term earnings growth forecasts (LTGit), and recommendation ratings (RECit) than debt financing. These results suggest that analysts’ guidance on overvaluation is more oriented to investors in
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the equity market than to those in the debt market.
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Consistent with prior research, the correlations between each of the financing variables and cumulated future stock returns or size-adjusted future stock returns are all negative and significant.
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Interestingly, net external financing (ΔXFINit) has larger negative correlation coefficients with future stock returns (CRET or SRET) than with either equity financing (ΔEQUITYit) or debt financing (ΔDEBTit).
(2006).
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This result is indicative of refinancing activities and is consistent with similar findings in Bradshaw et al.
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Before performing empirical tests, we partition our annual samples into the high and low external financing groups and plot the monthly means of analyst forecast errors, F1ERRORit, F2ERRORit, LTGit, and RECit over our sample period. Consistent with analysts’ optimism, Figure 1 shows that the values of F1ERRORit are negative, with the magnitude increasing steadily in the years leading to the peak of the dot-com bubble around 2000, followed by a reversal with decreasing forecast errors. In addition, the values of F1ERRORit are more negative (i.e., analysts are more optimistic) for the high external financing group than for the low external financing group and the gap between the two has narrowed in the postRule period. Figure 2 shows a similar pattern for F2ERRORit. 17
ACCEPTED MANUSCRIPT Figure 3 shows the means of analysts’ long-term forecasts of earnings growth (LTGit). For both high and low financing groups, LTGit shows an ascending trend in the years leading to 2000 followed by a dramatic drop in 2002. The gap in mean LTGit between the high-financing group and the low-financing group becomes smaller in the post-Rule period. Figure 4 shows annual analyst recommendation ratings
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over the sample period for high and low external financing groups. The mean recommendation ratings
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show an ascending trend up to year 2000 for both groups and then a dramatic drop in 2002, consistent
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with results reported in prior studies (Barber et al. 2006; Chen and Chen 2009). The plot further shows that, although analyst recommendations for the high-financing group are higher than those for the low-
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financing group, the gap between the two narrows in the post-Rule period. Consistent with prior findings (Bradshaw et al. 2006), analysts’ forecasts and recommendations are strongly related to external
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financing. Our following empirical analysis employs multiple regressions to examine the effects of Rule 2711 on these relations.
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5. EMPIRICAL RESULTS
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5.1. The Effect of the Rule on the Relation between Analysts’ Guidance and External Financing In this section, we present results on the effect of the Rule on the relation between analysts’ guidance in
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earnings forecasts and recommendations and corporate external financing. Table 2 reports the results of regression model (1). Panel A of Table 2 presents the results of regressing analyst variables on net
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external financing (ΔXFINit). Columns 1, 2, 3, and 4 show that the coefficients of ΔXFINit are -0.104 (t = -5.54), -0.207 (-7.36), 0.198 (41.02), and 0.710 (29.54), respectively, for analyst variables
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F1EERORit, F2ERRORit, LTGit, and RECit. These coefficients are consistent with prior findings that there is a positive relation of analysts’ optimism in forecasts and recommendations with external financing. Examining the coefficients of RULEit across the four analyst variables, these coefficients are consistent with the patterns in Figure 1 and significant except for F2ERRORit. They are consistent with the Rule having the effect of reducing analysts’ optimism. The coefficients of ΔXFINit×RULE it for the four analyst variables are insignificant for F1ERRORit and F2ERRORit and are significant for LTGit and RECit. The latter two coefficients suggest that the relations of LTGit and RECit, respectively, with external financing are weaker in the post-Rule period. In addition, the difference in the effect of the Rule on the short-term 18
ACCEPTED MANUSCRIPT earnings forecast errors is consistent with our expectation that analysts’ guidance has a stronger effect on valuation through LTGit and RECit than through short-term earnings forecasts. Previously Figure 1 and Figure 2 show that the effect of Rule is more evident in the relations of F1ERRORit and F2ERRORit with external financing in the years close to 2002. Therefore, we perform
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additional analyses by restricting our sample to ±4 years around the Rule (untabulated). Our results show
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that the coefficient of ΔXFINit×RULEit is significant for F1ERRORit (0.073, t = 2.05) but not for
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F2ERRORit (0.061, t = 1.12). Overall, our results show that the relation of analysts’ optimism in forecasts and recommendations with external financing is weaker in the post-Rule period and thus support H1.
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Panel B of Table 2 reports the results of regressing analyst variables on equity financing and debt financing. The results in the Panel B show that relations of the four analyst variables with equity
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financing are significant but neither F1EERORit nor F2ERRORit has any relation with debt financing. In addition, the effect of the regulatory reform is significant for LTGit and RECit but not for short-term
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analysts’ forecasts, consistent with findings in Panel A. However, if we focus on the ±4 years around the
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Rule, the coefficient of ΔEQUITYit×RULEit is significant for F1ERRORit (1.38, t = 2.69) while the coefficient of ΔDEBTit×RULEit is not (-0.01, t = –0.03). None of these two coefficients is significant for
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analysts’ variable F2ERRORit. Overall, our results in Table 2 show that the relation between analysts’ guidance (especially long-term growth forecasts and recommendations) and external financing is weaker
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in the post-Rule period, supporting H1.
5.2. The Effect of the Rule on the Relation between External Financing and Future Stock Returns
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Table 3 reports the results on whether the Rule has changed the relation between external financing and future stock returns. Column 1 shows the result of regressing future stock returns on net external financing. The coefficient of ΔXFINit is –0.265 (t = –14.09), consistent with the negative relation reported in Bradshaw et al. (2006). The coefficient of ΔXFINit×RULEit is 0.166 (t = 5.70) as predicted, suggesting that the negative relation of external financing with future stock returns is weaker in the postRule period. Columns 2 and 3 show the separate results of regressing future stock returns on equity financing and debt financing, respectively. The coefficients of ΔEUITYit and ΔDEBTit are both significantly negative. In addition, the coefficients of ΔEUITYit×RULEit and ΔDEBTit×RULEit are 19
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significantly positive, as predicted. Column 4 shows the results of regressing future stock returns on both ΔEUITYit and ΔDEBTit. The results are consistent with those in Columns 2 and 3 in that the negative relation of future stock returns with equity and debt financing is weaker in the post-Rule period than in the pre-Rule period. Thus our empirical results in Table 3 support H2.
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5.3. The Relation between Analysts’ Guidance and External Financing Conditional on the Level of
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Conflicts of Interest from Investment Banking
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To enhance the likelihood that our findings of the weaker relation between analysts’ forecasts and recommendations and external financing is attributable to analysts’ conflicts of interest arising from
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investment banking, we estimate regression equation (3) that includes IBit and the interaction terms of IBit with other independent variables. Table 4 reports the results of regressing analysts’ forecasts and
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recommendations on external financing conditional on the level of conflicts of interest related to investment banking.
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Panel A of Table 4 shows the results of estimating regression (3) on net external financing
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(ΔXFINit). The first two columns show that the coefficients of ΔXFINit×IBit and ΔXFINit×IBit×RULEit are insignificant for dependent variables F1ERRORit and F2ERRORit. These results suggest that analysts’
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conflicts of interest related to investment banking have no effect on the relation of analysts’ optimism in short-term earnings forecasts with external financing. On the other hand, the significant coefficients of
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ΔXFINit×RULEit for dependent variables F1ERRORit and F2ERRORit suggest that the relations between analysts’ optimism in short-term earnings forecasts are weaker in the post-Rule period, which likely
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results from reforms unrelated to investment banking ties. In contrast to Columns 1 and 2, Columns 3 and 4 show that the coefficients of IBit and the interactions of IBit with other independent variables are significant for dependent variables LTGit and RECit. As to the variables of our interest, the coefficients of ΔXFINit×IBit are significantly positive and the coefficients of ΔXFINit×IBit×RULEit are significantly negative in the two regressions, consistent with our predictions. These results provide further evidence that the change of the relation between LTGit and RECit and external financing are attributable to analysts’ conflicts of interest from investment banking business. Although these variables are not of primary interest, the coefficients of IBit and IBit×RULEit 20
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suggest that the incremental effects of IBit and IBit×RULEit may be opposite to the incremental effects of ΔXFINit×IBit and ΔXFINit×IBit×RULEit. In other words, one may draw unwarranted conclusions about the effect of investment banking-related conflicts on LTGit and RECit without conditioning on the relation of analyst variables with external financing. The results in Panel A of Table 4 suggest that the changes in the
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relation of LTGit and RECit with external financing is greater for firms with greater analysts’ conflicts of
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interest.
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Panel B of Table 4 reports the results of regression model (3) with both equity financing and debt financing. Since the results in Panel A indicate that analysts’ optimism in short term earnings forecasts
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with external financing is not related to conflicts of interest from investment banking using full sample, we narrow the focus to the period between 4 years pre- and 4 years post-Rule with observations in year
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2002 dropped for dependent variables F1ERRORit and F2ERRORit. Again, the results in Column (1) and (2) show no evidence that analysts’ optimism in short-term forecasts F1ERRORit and F2ERRORi is driven
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by investment banking related conflict of interest. However, these results are consistent with prior
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findings in Cowen, Groyberg and Healy (2006) and Groysberg and Healy (2013). Turning to the results in Columns 3 and 4 for dependent variables LTGit and RECit, we continue
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to find that the change of the relation of LTGit and RECit with equity financing is greater for firms with greater conflicts of interest. Interestingly, the incremental effect of IBit is significant in the relation of
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LTGit with debt financing but not in the relation of RECit with debt financing. The latter result is consistent with the observation that analysts’ stock recommendations are primarily targeted at equity
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investors. Overall, our results show that the change in the relation between analysts’ guidance (mainly in long-term earnings growth forecasts and recommendations) and external financing is greater for firms with greater conflicts from investment banking. 5.4. The Relation between External Financing and Future Stock Returns Conditional on the Level of Conflicts of Interest from Investment Banking We provide further evidence that a weaker relation of external financing and future stock returns are attributable to the Rule. We estimate regression model (4) to investigate whether firms with greater investment banking-related conflicts of interest (captured by the indicator variable IB) experience a 21
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greater change of the relation between external financing activities and future stock returns from the preRule to the post-Rule period. As shown in Table 5, Column 1 reports the result of regressing future stock returns on net external financing (ΔXFINit), analysts’ conflicts of interest (IBit), and the regulation (RULEit). All
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coefficients have the expected signs. Our focus is on the coefficient of ΔXFINit×ΔIBit (-0.115, t = -2.17)
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and the coefficient of ΔXFINit×ΔIBit×RULEit (0.168, t =2.22). These two coefficients are consistent with
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the predictions that investment banking-induced conflicts of interest are associated with a greater negative relation between future stock returns and external financing for firms with greater conflicts of interest, but
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the change of this relation is also greater in the post-Rule period for those firms with greater levels of conflicts of interest.
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We perform similar tests of the change of the coefficients in Columns 2, 3 and 4 for ΔEQUITYit and ΔDEBTit. The coefficients of ΔEQUITYit×IBit and ΔDEBTit×IBit are not significant, but the
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coefficients of ΔEQUITYit×IBit×RULEit are significantly positive, while the coefficients of
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ΔDEBTit×IBit×RULEit are insignificant. The results suggest that the change of the relation between equity financing and future stock returns from the pre-Rule to the post-Rule period is greater for firms with
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greater conflicts of interest. On the other hand, we find that the change of the relation between debt financing and future stock returns from the pre-rule to the post-Rule period is insignificant for firms with
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greater conflicts of interest.
In summary, the results from the tests on investment banking-related conflicts enhance our
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confidence that the change in the relation between external financing (mostly equity financing) and future stock returns in the post-Rule period is attributable to the regulatory reforms. 6. ADDITIONAL ANALYSIS In this section, we examine analysts’ conflicts of interest arising from trading commissions and investigate whether the Rule has changed the relation between external financing and future stock returns that stem from such conflicts. In addition, we examine whether our findings of the change in the relation between external financing and future stock returns can be attributed to alternative factors or other regulatory events. Last, we examine whether our results remain after controlling for shifts in investment 22
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opportunities. 6.1. Analysts’ Conflicts of Interest from Trading/Brokerage Revenue Even though analysts’ conflicts of interest stemming from investment banking business were the primary concern of the regulatory reforms, other potential sources of conflicts of interest are also
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mentioned in the reform package. The most significant one is analysts’ incentives to generate
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brokerage/trading commissions for their employers. Prior studies show that commission business affects
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IPO allocation by the underwriter (Reuter 2006) and that having an all-star analyst of the industry in the IPO is associated with significantly higher first-day returns (Loughran and Ritter 2004). Analysts’
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forecasts and recommendations are more optimistic for analysts associated with brokerage firms (Cowen et al. 2006; Irvine 2004). To test the extent to which the negative relation of external financing activities
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with future stock returns is attributable to analysts’ trading revenue incentives, we create a variable, TRit, to proxy for analysts’ conflicts of interest related to their brokerage/trading commissions. We measure
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this variable by the firm’s share turnover (per share) in the year of financing: greater turnover of shares
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indicates greater trading commissions. Like IBit, TRit is an indicator variable that is set to 1 if the firm’s annual turnover is greater than the median of our sample and to 0 otherwise. If overvaluation around
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financing activities is also attributable to trading-commissions-related incentives, we expect that there is a greater change in the relation of external financing activities with future stock returns for firms with
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greater analysts’ conflicts arising from trading-commisions incentives. Table 6 reports the empirical results related to analysts’ conflicts of interest stemming from
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trading commissions. Panel A of Table 6 reports the empirical results for the sample of observations with analyst following. As a contrast, we report in Panel B of Table 6 the results for the sample of observations without analyst following. As shown in Panel A of Table 6, the coefficients of ΔXFINit×TRit, ΔEQUITYit×TRit, and ΔDEBTit×TRit are all negative and significant at 10% or better (two-tailed) with the exception of ΔDEBTit×TRit in Column (3). These coefficients are consistent with our expectation that analysts’ conflicts of interest stemming from trading commissions at least partially contribute to the negative relation of external financing activities with future stock returns. The coefficients of ΔXFINit×TRit×RULEit, ΔEQUITYit×TRit×RULEit, and ΔDEBTit×TRit×RULEit have the predicted signs but 23
ACCEPTED MANUSCRIPT are only significant for ΔEQUITYit×TRit×RULEit in both Columns 2 and 4. These results suggest that the change in the relation between equity financing and future stock returns from the pre-Rule to the postRule period is greater for firms with greater levels of conflicts of interest related to trading commissions. In contrast, we find that the change in the relation between debt financing and future stock returns from
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the pre-Rule to post-Rule period is insignificant for firms with higher levels of conflicts of interest
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stemming from this source.16 Overall, we find that the influence of analysts’ trading incentives on the
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relation between external financing and future stock returns is attenuated after the implementation of the Rule.
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In Panel B of Table 6, we repeat our estimation of the regression model in Panel A using a sample of firm-year observations with no analyst coverage. Because the objective of the Rule is to address
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analysts’ conflicts of interest, we report these regression results as a contrast to those discussed above. As shown in the table, the coefficients of ΔXFINit×TRit, ΔEQUITYit×TRit, and ΔDEBTit×TRit are all
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insignificant. Furthermore, the coefficients of ΔXFINit×TRit×RULEit, ΔEQUITYit×TRit×RULEit, and
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ΔDEBTit×TRit×RULEit are also insignificant in all equations. These contrasting results enhance our confidence in our findings discussed above.
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6.2. Controlling for Market Timing
Our findings on the change in the relation between external financing and future stock returns
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(H2) has a potential confounding cause related to market timing of financing activities by managers. In order to show that our findings on the regulatory effects are distinct from market timing, we include two
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market timing variables from prior studies, past 24-month stock return and investment sentiment (Change, Dasgupta and Hilary 2006, Baker and Wugler 2006), and run the following regression model (5) SRETit+1= 0 + 1PSTKRTNit + 2SENTMENTit +3RULEit + 4ΔXFINit + 5ΔXFINit×RULEit +it+1,
(5)
Where, PSTKRTN is the past 24-month compound return ended 3 month after fiscal year t.
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One potential explanation for the insignificant results in explaining the change in the relation of debt financing with future stock returns in the post-Rule period is that we use equity share turnover rather than the trading volume of debt securities.
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SEMTIMENT is the past 12month investment sentiment ended 3 month after fiscal year t. We report the results of Model (5) in Table 7. We find that there is a significant coefficient of PSTKRTN and insignificant coefficient of SENTIMENT from Column (1) to Column (4). However, after controlling for the market timing, we continue to find a significant weaker relation between external
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financing (equity or debt) and future stock return in the post-Rule period than in the pre-Rule period.
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6.3. Sarbanes–Oxley Act (SOX) and Accrual Anomalies
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In this subsection, we report the results from additional tests that our findings on the change in the relation between external financing and future stock returns (H2) are not attributable to the effects of
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Sarbanes–Oxley Act (SOX) or the accrual anomalies reported in Sloan (1996) and Richardson et al. (2005). Prior studies find that firms manage accruals before equity financing and that accrual-based
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earnings management declines in the post-SOX period (e.g. Teoh, Welch, and Wong 1998; Cohen, Dey, and Lys 2008). In addition, Cohen and Lys (2006) questions whether the negative relation between
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external financing and future stock returns is separable from the accrual anomalies because the measures
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of accruals using balance-sheet items are likely to be correlated with the measures of financing activities. We examine whether the effects of the Rule on the relation of external financing activities with future
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stock returns remain significant after controlling for the effect of accruals. We compute working capital accruals, ACCRit, and total accruals, T_ACCRit, following Sloan
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(1996) and Richardson et al. (2005), respectively. To provide evidence on whether our prior results are attributable to the effects of accruals, we estimate the following regression model: = 0 + 1RULEit + 2ΔXFINit + 3ΔXFINit×RULEit
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SRETit+1
+ 4ACCRit + 5ACCRit×RULEit + it+1,
(6)
where ACCRit is the accruals estimated from the total accruals or working capital accruals in Sloan (1996). We repeat this analysis also with total accruals, T_ACCRit. Consistent with Cohen and Lys (2006), the correlations between T_ACCRit and ΔXFINit, ΔEQUITYit, and ΔDEBTit are 0.430, 0.245, and 0.360, respectively, all significant at p < 0.001 (untabulated). These correlations are greater in magnitude than the correlations between ACCRit and external financing activities. Furthermore, consistent with prior
25
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findings, both ACCRit and T_ACCRit have significant negative correlations with future stock returns with coefficients of -0.047 and -0.093, respectively. We report the results from the regression model (6) in Table 8. Panel A reports the results on the effect of the Rule on the change in the relation between external financing and future stock returns
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controlling for working capital accruals (ACCRit) or total accruals (T_ACCRit). As shown in columns 1 to
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4, the coefficients of ACCRit and T_ACCRit are negative and significant, consistent with Sloan (1996) and
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Richardson et al. (2005). In addition, the coefficients of the interactions ACCRit×RULE (0.165, t = 2.05) and T_ACCRit×RULE (0.058, t = 1.86) are marginally significant. These positive coefficients are
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consistent with the prediction that the implementation of SOX in 2002 contributed to a weaker relation of future stock returns and accruals because accruals are managed to a lesser extent in the post-SOX period
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(e.g. Cohen, Dey, and Lys 2008). The coefficients of ΔXFINit×RULEit are all positive and significant in both Columns 2 and 4. It follows that, after controlling for accruals, our conclusion of a weaker relation
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between external financing activities and future stock returns in the post-Rule period remains unchanged.
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Panel B of Table 8 reports the results of regressing future stock returns on equity and debt financing controlling for ACCRit or T_ACCRit. As shown in the table, the coefficients of the ACCRit and
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T_ACCRit are significantly negative, while the coefficients of the interaction variables ACCRit×RULE and T_ACCRit×RULE are positive and marginally significant in Column 2 and 4. After controlling for ACCRit
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or T_ACCRit, the coefficients of ΔEQUITYit×RULEit and ΔDEBTit×RULEit are still positive and significant in each estimated equation. The empirical results show that the change of the relation of external
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financing with future stock returns in the post-Rule period is not attributable to the effects of SOX on accrual management or the accrual anomalies reported in Sloan (1996) and Richardson et al. (2005). 6.4. The Relation between External Financing and Future Stock Returns from Changes in Investment Opportunities Our findings on the relation of external financing with future stock returns may be attributable to changes in investment opportunities (Lyandres, Sun, and Zhang 2007; Chen and Zhang 2007). To perform tests on whether our results are attributable to shifts in firms’ investment opportunities in the post-Rule period, we include Tobin’s Q, accounting profitability (return of equity) and the change of profitability in the year 26
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after external financing in the regression of future stock returns and external financing. We find that the profitability and the change of profitability are significant in explaining future stock returns, but our results on the effects of the Rule remain unchanged when we include these variables. 6.5. Robustness Checks
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Prior studies employ analysts’ long-term growth forecast errors to examine the relation of analysts’
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optimism in growth forecast with external financing (Dechow, Hutton, and Sloan 2000; Bradshaw et al.
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2006). As a robustness check, we follow Bradshaw et al. (2006) and compute the long-term growth forecast error (LTGerror) as the realized long-term earnings growth rate minus the forecasted long-term
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growth rate. Realized earnings growth is computed from the slope coefficient of an ordinary least squares regression of the natural logarithm of annual earnings per share on a time trend. We vary the requirement
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of the availability of realized annual earnings per share from a minimum of 3 years to 12 years. We repeat our tests on H1 with LTGerror replacing LTG. The results (untabulated) show that LTG errors have a
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significant negative relation with external financing, consistent with Bradshaw et al. (2006). The results
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are stronger as we increase the number of realized earnings per share in estimating LTGerror. Therefore, our empirical results of analysts’ LTG with external financing are not affected by LTGerror.
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Our measure of analysts’ conflicts of interest at the firm level arising from investment banking (IB) takes into consideration the affiliation of the analysts but also competition to supply investment
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banking services by the analysts’ employers. We repeat our empirical analysis in Table 4 and Table 5 using analysts’ affiliation as an alternative measure of IB (any analyst whose employer has a reputation
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score > 1 is defined as affiliated). This alternative IB measure has a correlation coefficient of 93% with our original IB measure. Our empirical results are qualitatively similar to those reported in Table 4 and Table 5.
In summary, our additional tests and robustness checks suggest that our findings of the change in the relation of analysts’ guidance in earnings forecasts and recommendations with external financing, as well as in the relation between external financing and future stock returns, are attributable to the implementation of the Rule. These results lend further support that the Rule has attenuated the level of analysts’ conflicts of interest in corporate financing activities. 27
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7. CONCLUSIONS Analysts’ incentives to issue and maintain optimistic earnings forecasts and recommendations before corporate financing activities prompted regulatory scrutiny that led to the passage of the NASD Rule 2711 in 2002. The purpose of the Rule was to restore analysts’ independence by isolating analysts from
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pressures to generate investment banking business. In this study, we examine whether Rule 2711
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attenuates analyst’ conflicts of interest in corporate financing activities. To infer the effects of the Rule,
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we investigate the relation between analysts’ guidance in earnings forecasts/recommendations and external financing, and the relation between external financing and future stock returns.
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Our empirical results show that the relation between analysts’ guidance in forecasts and recommendations and external financing and the relation between external financing and future stock
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returns are weaker in the post-Rule than in the pre-Rule period. In addition, using the supply of investment banking services from their employers as our proxy for the firm’s level of potential conflicts
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of interest, we find that the changes in these two relations are greater for firms with greater levels of
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potential conflicts of interest. Further analyses provide evidence that the Rule also reduces the extent of analysts’ conflicts of interest arising from trading commissions. We also perform additional tests to show
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that the effects of the Rule are not attributable to market timing, the changes of accruals due to SOX or changes in investment opportunities.
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Our study has implications for regulators in assessing the effects of Rule 2711. Recent research shows the Rule has strengthened the relation of analysts’ recommendations with fundamental valuation
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(Barniv et al. 2009; Chen and Chen 2009) but provides little benefit to investors in terms of more profitable recommendations (Kadan et al. 2009; Guan et al. 2012). Our empirical results demonstrate that the relation between analysts’ guidance embedded in earnings forecasts and recommendations and external financing is weaker in post-Rule period, suggesting that the Rule attenuates analysts’ conflicts of interest in corporate external financing. In addition, our empirical results show that the relation between external financing and future stock returns is weaker in the post-Rule period, suggesting that Rule 2711 improves the alignment of the interests of analysts with those of investors participating in corporate financing activities. 28
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Figure 1. Means of F1ERROR for High and Low External Financing Groups during 1994-2010
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This figure shows the mean of analysts’ consensus forecast errors of one-year-ahead earnings (F1ERROR) in each month during the 1994–2010 period. Forecast errors are defined as the realized annual earnings per share for the coming year minus the corresponding consensus forecasts of this mount, all scaled by the stock price as of the end of the forecast month.
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Figure 2. Means of F2ERROR for High and Low External Financing Groups during 1994-2010
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This figure shows the mean of analysts’ consensus forecast errors of two-year-ahead earnings (F2ERROR) in each month during the 1994–2010 period. Forecast errors are defined as the realized annual earnings per share for the coming year minus the corresponding consensus forecasts of this mount, all scaled by the stock price as of the end of the forecast month.
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ACCEPTED MANUSCRIPT Figure 3. The Means of Analysts’ Forecast of Long-term Earnings Growth (LTG) for High and
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Low External Financing Groups during 1994-2000
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This figure shows the mean of analysts’ consensus forecasts of the long-term earnings growth rates in each month during the 1994–2010 period.
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ACCEPTED MANUSCRIPT Figure 4. The Means of Analysts’ Stock Recommendations for High and Low External Financing
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Groups during 1994-2000
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This figure shows the mean of analysts’ consensus stock recommendations for the high and low external financing groups each month during the 1994–2010 period. Stock recommendation are coded as follows: 1 = Strong Sell; 2 = Sell; 3 = Hold; 4 = Buy; 5 = Strong Buy. The consensus stock recommendation for each company-month equals the mean of the individual analyst recommendation.
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ACCEPTED MANUSCRIPT Table 1 Descriptive Statistics and Pair-wise Correlations of Variables Panel A: Descriptive statistics
M ED PT CE AC
37
p50 0.001 0.000 0.000 0.072 0.065 0.060 -0.069 -0.002 -0.008 0.150 3.860 5.000
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p25 -0.041 -0.019 -0.022 0.015 0.016 -0.227 -0.330 -0.025 -0.055 0.110 3.330 2.000
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s.d. 0.183 0.152 0.106 0.159 0.150 0.638 0.589 0.377 0.488 0.097 0.640 6.158
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mean 0.046 0.031 0.015 0.049 0.040 0.155 0.010 -0.081 -0.117 0.175 3.819 6.797
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ΔXFINit ΔEQUITYit ΔDEBTit EARNINGS/ASSETit+1 EARNINGS/ASSETit CRETit+1 SRETit+1 F1EERORit F2ERRORit LTGit RECit #ANALYSTS N
N 65,533 65,533 65,533 65,533 65,404 65,533 65,533 47,782 41,594 38,767 42,211 42,211 65,533
p75 0.07 0.01 0.03 0.13 0.11 0.37 0.21 0.00 0.00 0.214 4.25 9.00
ACCEPTED MANUSCRIPT Panel B: Pearson correlation matrix
ΔXFINit ΔEQUITYit ΔDEBTit EARNINGS/ASSETit+1 EARNINGS/ASSETit CRETit+1 SRETit+1 F1EERORit F2ERRORit LTGit RECit #ANALYSTS
ΔXFINit
ΔEQUITYit ΔDEBTit
1 0.787*** 0.538*** -0.228*** -0.253*** -0.0651*** -0.0642*** -0.0377*** -0.0629*** 0.251*** 0.170*** -0.129***
1 -0.0816*** 1 -0.260*** -0.00795* -0.297*** 0.00213 -0.0417*** -0.0495*** -0.0449*** -0.0429*** -0.0550*** 0.00718 -0.0708*** -0.0114* 0.306*** 0.0414*** 0.149*** 0.0853*** -0.173*** 0.00732
EARNINGS/ EARNINGS/ CRETit+1 ASSETit+1 ASSETit
1 0.805*** -0.0272*** -0.0076 0.284*** 0.250*** -0.180*** 0.0792*** 0.176***
*
1 -0.0322*** -0.0111** 0.159*** 0.162*** -0.218*** 0.0657*** 0.181***
F1EERORit F2ERRORit
LTGit
RECit
T P
I R
C S
U N
A
M
1 0.925*** -0.0129** 0.0486*** -0.0163** -0.0253*** -0.0154**
SRETit+1
1 0.0160*** 1 0.0731*** 0.758*** -0.0171*** -0.0714*** -0.0259*** 0.0133** 0.0176*** 0.0945***
1 -0.103*** -0.0115* 0.0885***
1 0.332*** 1 *** -0.127 -0.0958***
p<0.05, ** p<0.01, *** p<0.001 Panel A reports the descriptive statistics of variables in the empirical analysis. Panel B presents the Pearson correlation coefficients for the main variables. ΔXFIN is the net amount of cash flow received from external financing activities: ΔXFIN = ΔEQUITY + ΔDEBT. ΔEQUITY is net cash received from the sale (and/or repurchase) of common and preferred stock less cash dividends paid (Compustat data item SSTK less data item PRSTKC less data item DV). ΔDEBT represents net cash received from the issuance (and/or repayment) of debt (Compustat data item DLTIS less data item DLTR less data item DLCCH). EARNINGS/ASSET is the ratio of operating income after depreciation to total assets (Compustat data item OIADP divided by data item AT). CRET is annual stock returns measured using compounded buy-hold returns, inclusive of dividends and all other distributions, and are computed for a the 12-month period starting the fourth month after fiscal year t to ensure that all financial statement information is available to the public. SRET is the annual size-adjusted stock return measured using compounded buy-hold returns. F1ERROR is the one-year-ahead earnings forecast error, computed as the realized annual earnings per share for the upcoming year minus the corresponding monthly consensus forecast of annual earnings, scaled by the stock price at the end of the forecast month. F2ERROR is the two-year-ahead earnings forecast error, computed as the realized annual earnings per share for the year after the upcoming year minus the corresponding monthly consensus forecast of annual earnings, scaled by the stock price at the end of the forecast month. LTG is long-term earnings growth forecast, i.e., the corresponding monthly consensus forecast of long-term earnings growth rate. REC is the mean consensus analysts’ stock recommendation rating coded on a 1–5 point scale. We invert the standard coding of stock recommendations so that 1 = strong sell, 2 = sell, 3 = hold, 4 = buy, and 5 = strong buy. #Analysts is the number of financial analysts following the firm in the given year. The analyst variables are all measured four months after the fiscal year t-1.
D E
T P
E C
C A
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ACCEPTED MANUSCRIPT Table 2 Results from Regression of Analysts’ Variable on External Financing Panel A. Results from Regression of Analysts’ Forecasts and Recommendations and external financing (2) F2ERRORit -0.207*** (-7.36)
(3) LTGit 0.198*** (41.02)
(4) RECit 0.710*** (28.54)
RULEit
0.00501 (1.47)
-0.000157 (-0.03)
-0.00892*** (-9.49)
-0.196*** (-31.24)
ΔXFINit × RULEit
0.0410 (1.50)
0.0320 (0.76)
-0.0897*** (-11.21)
-0.217*** (-5.72)
-0.0802*** (-34.20) 47,782 0.001
-0.112*** (-34.20) 41,594 0.004
0.175*** (269.32) 38,767 0.070
3.909*** (813.02) 42,211 0.054
N adj. R2
IP
CONSTANT
CR
ΔXFINit
T
(1) F1EERORit -0.104*** (-5.54)
(2) F2ERRORit
0.00436 (1.26)
AN
ΔEQUITYit
(1) F1EERORit
-0.185*** (-7.04)
(3) LTGit
(4) RECit
-0.000324 (-0.07)
-0.00814*** (-8.52)
-0.196*** (-30.88)
-0.310*** (-8.01)
0.312*** (45.10)
0.833*** (25.88)
M
RULEit
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Panel B: Results from Regression of Analysts’ Variable on Equity financing and Debt financing
0.0400 (1.06)
0.0514 (0.92)
-0.0802*** (-6.75)
-0.209*** (-4.13)
ΔDEBTit
0.00103 (0.04)
-0.0704 (-1.72)
0.0790*** (12.03)
0.616*** (14.95)
0.0422 (1.07)
-0.00409 (-0.07)
-0.0685*** (-6.88)
-0.244*** (-4.09)
0.177*** (272.76) 38,767 0.101
3.910*** (806.40) 42,211 0.056
PT
ED
ΔEQUITYit × RULEit
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ΔDEBTit × RULEit
AC
-0.0809*** -0.113*** (-34.04) (-33.93) N 47,782 41,594 adj. R2 0.003 0.005 t-statistics in parentheses: * p < 0.05, ** p < 0.01, *** p < 0.001 CONSTANT
Panel A presents the results of regressing analysts’ variable on external financing. Panel B shows the results from regressing analysts’ variable on equity financing and debt financing, ΔXFIN is the net amount of cash flow received from external financing activities: ΔXFIN = ΔEQUITY + ΔDEBT. ΔEQUITY is net cash received from the sale (and/or repurchase) of common and preferred stock less cash dividends paid (Compustat data item SSTK less data item PRSTKC less data item DV). ΔDEBT represents net cash received from the issuance (and/or repayment) of debt (Compustat data item DLTIS less data item DLTR less data item DLCCH). F1ERROR is the one-year-ahead earnings forecast error, computed as the realized annual earnings per share for the upcoming year minus the corresponding monthly consensus forecast of annual earnings, scaled by the stock price at the end of the forecast month. F2ERROR is the two-year-ahead earnings forecast error, computed as the realized annual earnings per share for the year after the upcoming year minus the corresponding monthly consensus forecast of annual earnings, scaled by the stock price at the end of the forecast month. LTG is long-term earnings growth forecast, i.e., the
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corresponding monthly consensus forecast of long-term earnings growth rate. REC is the mean consensus analysts’ stock recommendation rating coded on a 1–5 point scale. We invert the standard coding of stock recommendations so that 1 = strong sell, 2 = sell, 3 = hold, 4 = buy, and 5 = strong buy. The analyst variables are all measured 4 months after the fiscal year end in t–1. RULE is an indicator variable that equals 1 if the observation is from the post-Rule period and 0 otherwise. The t-statistics (in parentheses) are computed using robust standard errors adjusted for clustering by company.
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(2) SRETit+1
(3) SRETit+1
(4) SRETit+1
RULEit
-0.00866 (-1.88)
-0.00324 (-0.71)
0.00233 (0.50)
-0.00826 (-1.79)
ΔXFINit × RULEit
0.166*** (5.70)
ΔEQUITYit
-0.218*** (-9.71)
ΔEQUITYit × RULEit
0.138*** (3.81)
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ΔDEBTit
CR
ΔXFINit
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(1) SRETit+1 -0.265*** (-14.09)
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Table 3 Results from Regression of Future Stock Returns on External Financing
ED
N adj. R2
0.0171*** (5.07) 65,533 0.002
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0.0239*** (6.98) 65,533 0.005
CONSTANT
AN
ΔDEBTit × RULEit
-0.241*** (-10.64) 0.154*** (4.25)
-0.299*** (-9.65)
-0.335*** (-10.75)
0.163*** (3.53)
0.193*** (4.15)
0.0121*** (3.55) 65,533 0.002
0.0238*** (6.96) 65,533 0.005
t-statistics in parentheses: * p < 0.05, ** p < 0.01, *** p < 0.001
AC
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This table presents results of regressing future stock returns on external financing. SRET is the annual size-adjusted stock returns measured using compounded buy-hold returns, inclusive of dividends and all other distributions, and are computed for a the 12-month period starting the fourth month after fiscal year t to ensure that all financial statement information is available to the public. ΔXFIN is the net amount of cash flow received from external financing activities: ΔXFIN = ΔEQUITY + ΔDEBT. ΔEQUITY is net cash received from the sale (and/or repurchase) of common and preferred stock less cash dividends paid (Compustat data item SSTK less data item PRSTKC less data item DV). ΔDEBT represents net cash received from the issuance (and/or repayment) of debt (Compustat data item DLTIS less data item DLTR less data item DLCCH). RULE is an indicator variable that equals 1 if the observation is from the post-Rule period, and 0 otherwise. The t-statistics (in parentheses) are computed using robust standard errors adjusted for clustering by company.
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ACCEPTED MANUSCRIPT Table 4 Results from Regression of Analysts’ Variable on External Financing and Level of Conflicts of Interest from Investment Banking
(2) F2ERRORit -0.214*** (-4.03)
(3) LTGit 0.171*** (21.02)
(4) RECit 0.704*** (20.31)
RULEit
0.0290*** (4.49)
0.0357*** (3.69)
-0.0328*** (-19.02)
-0.181*** (-17.68)
ΔXFINit × RULEit
0.0786*** (14.33)
0.0904*** (10.42)
-0.0206*** (-12.48)
-0.0190* (-2.12)
0.0212 (0.47)
-0.0149 (-0.20)
-0.0547*** (-4.21)
-0.151** (-2.70)
IBit × RULEit
-0.0273*** (-3.69)
-0.0311** (-2.76)
0.0112*** (5.20)
-0.101*** (-8.24)
ΔXFINit × IBit
0.0238 (0.61)
0.0818 (1.30)
0.0419*** (3.75)
0.0944* (2.04)
0.0524 (0.57)
-0.0808*** (-4.69)
-0.304*** (-4.16)
-0.174*** (-22.78) 34,435 0.010
0.198*** (151.56) 31,995 0.091
3.926*** (532.16) 40,051 0.077
-0.00856 (-0.16)
CONSTANT
-0.121*** (-24.89) 38,247 0.010
N adj. R2
CR
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ΔXFINit × IBit × RULEit
AN
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M
ΔXFINit
T
(1) F1EERORit -0.0836* (-2.56)
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Panel A: Results from Regression of Analysts Variable on External Financing and Level of Conflicts from Investment Banking
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t-statistics in parentheses: * p < 0.05, ** p < 0.01, *** p < 0.001
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(2) F2ERRORit 0.1600*** (9.32)
(3) LTGit -0.0329*** (-19.19)
(4) RECit -0.181*** (-17.59)
0.103*** (9.42)
0.114*** (6.47)
-0.0168*** (-10.16)
-0.0129 (-1.43)
-0.0842*** (-7.02)
-0.0765*** (-3.91)
0.00986*** (4.48)
-0.107*** (-8.60)
-0.302** (-3.21)
-0.564*** (-3.69)
0.289*** (25.67)
0.847*** (19.00)
ΔEQUITYit × RULEit
0.196 (1.80)
0.275 (1.51)
-0.0785*** (-4.29)
-0.164* (-2.26)
ΔEQUITYit × IBit
0.198 (1.81)
0.211 (1.48)
0.110*** (6.84)
0.219*** (3.45)
ΔEQUITYit × IBit × RULEit
-0.164 (-1.22)
-0.221 (-1.06)
-0.150*** (-5.87)
-0.535*** (-5.34)
ΔDEBTit
0.231* (2.22)
0.180 (0.93)
0.0429*** (3.70)
0.623*** (10.24)
-0.575* (-2.17)
-0.00831 (-0.48)
-0.185 (-1.93)
-0.223 (-1.03)
0.0279 (1.84)
0.0210 (0.27)
0.257 (1.92)
0.575 (2.14)
-0.0520* (-2.34)
-0.108 (-0.92)
-0.162*** (-16.67) 19,058 0.031
-0.233*** (-14.79) 17,014 0.029
0.199*** (153.78) 31,995 0.124
3.925*** (531.08) 40,051 0.079
-0.322** (-2.65)
ΔDEBTit × IBit
-0.209 (-1.84)
N adj. R2
AC
CONSTANT
CE
ΔDEBTit × IBit × RULEit
PT
ED
ΔDEBTit × RULEit
CR
ΔEQUITYit
US
IBit × RULEit
AN
IBit
M
RULEit
T
(1) F1EERORit 0.125*** (11.96)
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Panel B. Results from Regression of Analysts Variable on Equity Financing, Debt Financing and Level of Conflicts of Interest from Investment Banking
Panel A presents the results of regressing analysts’ variable on external financing and level of conflicts of Interest from investment banking. Panel B shows the results from regressing analysts’ variable on equity, debt financing and level of conflicts of interest from investment banking. ΔXFIN is the net amount of cash flow received from external financing activities: ΔXFIN = ΔEQUITY + ΔDEBT. ΔEQUITY is net cash received from the sale (and/or repurchase) of common and preferred stock less cash dividends paid (Compustat data item SSTK less data item PRSTKC less data item DV). ΔDEBT represents net cash received from the issuance (and/or repayment) of debt (Compustat data item DLTIS less data item DLTR less data item DLCCH). F1ERROR is the one-year-ahead earnings forecast error, computed as the realized annual earnings per share for the upcoming year minus the corresponding monthly consensus forecast of annual earnings, scaled by the stock price at the end of the forecast month. F2ERROR is the two-year-ahead earnings forecast error, computed as the realized annual earnings per share for the year after the upcoming year minus the corresponding monthly consensus forecast of annual earnings, scaled by the stock price at the end of the forecast month. LTG is long-term earnings growth forecast, i.e., the corresponding monthly consensus forecast of long-term earnings growth rate. REC is the mean consensus analysts’ stock recommendation rating coded
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on a 1–5 point scale. We invert the standard coding of stock recommendations so that 1 = strong sell, 2 = sell, 3 = hold, 4 = buy, and 5 = strong buy. IB is an indicator variable that is set to 1 if the firm has the sum of reputation score of analysts whose employers are major suppliers of investment banking business (based on Loughran and Ritter 2004) that is above the median of the sample in year t and 0 otherwise. The analyst variables, including IB, are all measured 4 months after the fiscal year end in t–1. RULE is an indicator variable that equals 1 if the observation is from the post-Rule period and 0 otherwise. The t-statistics (in parentheses) are computed using robust standard errors adjusted for clustering by company. Results in Column (1) and (2) are based on observations in 4 years preand 4 years post-Rule period with observations in years in 2002 dropped. Results in Column (4) and (5) are based on available observations in the sample period.
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ACCEPTED MANUSCRIPT Table 5 Results of Regression of Future Stock Returns on External Financing and Level of Conflicts of Interest from Investment Banking
IBit IBit × RULEit ΔXFINit × IBit ΔXFINit × IBit × RULEit ΔEQUITYit
0.0143 (1.66)
0.00796 (0.93)
0.0104 (1.24) 0.0147 (1.34)
0.0243** (2.81) 0.00242 (0.22)
0.0173* (2.00) 0.00854 (0.76)
-0.301*** (-4.99) 0.201* (2.33) -0.138 (-1.69) 0.134 (1.18) -0.0127 (-1.93) 40,051 0.004
-0.250*** (-4.85) 0.150* (2.00) -0.0975 (-1.33) 0.247* (2.33) -0.314*** (-5.21) 0.211* (2.44) -0.124 (-1.51) 0.126 (1.11) -0.00474 (-0.72) 40,051 0.006
-0.239*** (-4.64) 0.141 (1.89) -0.110 (-1.50) 0.261* (2.46)
AN
ΔEQUITYit × RULEit ΔEQUITYit × IBit
M
ΔEQUITYit × IBit × RULEit ΔDEBTit
ED
ΔDEBTit × RULEit
ΔDEBTit × IBit × RULEit
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CONSTANT
PT
ΔDEBTit × IBit
N adj. R2
0.0140 (1.66)
T
ΔXFINit × RULEit
(4) SRETit+1
IP
RULEit
(3) SRETit+1
CR
ΔXFINit
(2) SRETit+1
US
(1) SRETit+1 -0.267*** (-7.09) 0.00770 (0.90) 0.177** (3.20) 0.0159 (1.87) 0.00756 (0.69) -0.115* (-2.17) 0.168* (2.22)
-0.00472 (-0.72) 40,051 0.006
-0.0119 (-1.84) 40,051 0.003
AC
This table reports results of regressing future stock returns on external financing and level of conflicts of interest from investment banking. SRET is the annual size-adjusted stock returns measured using compounded buy-hold returns, inclusive of dividends and all other distributions, and are computed for a the 12-month period starting the fourth month after fiscal year t to ensure that all financial statement information is available to the public. ΔXFIN is the net amount of cash flow received from external financing activities: ΔXFIN = ΔEQUITY + ΔDEBT. ΔEQUITY is net cash received from the sale (and/or repurchase) of common and preferred stock less cash dividends paid (Compustat data item SSTK less data item PRSTKC less data item DV). ΔDEBT represents net cash received from the issuance (and/or repayment) of debt (Compustat data item DLTIS less data item DLTR less data item DLCCH). RULE is an indicator variable that equals 1 if the observation is from the post-Rule 2711 period, and 0 otherwise. IB is an indicator variable that is set to 1 if the firm has the sum of reputation score of analysts whose employers are major suppliers of investment banking business (based on Loughran and Ritter 2004) that is above the median of the sample in year t and 0 otherwise. The t-statistics are computed using robust standard errors adjusted for clustering by company.
45
ACCEPTED MANUSCRIPT Table 6 Results from Regression of Future Stock Returns on External Financing and Level of Conflicts of Interest from Trading Commissions Panel A. Results from Regressions for Observations with Analyst Following
TRit TRit × RULEit ΔXFINit × TRit ΔXFINit × TRit × RULEit ΔEQUITYit
ΔEQUITYit × TRit
M
ΔEQUITYit × TRit × RULEit
ΔDEBTit × RULEit
CE
ΔDEBTit × TRit × RULEit
PT
ΔDEBTit × TRit
-0.0133 (-1.61) 0.00382 (0.35)
-0.0188* (-2.29) 0.0108 (0.98)
-0.00692 (-0.81) -0.00103 (-0.09)
-0.286*** (-5.10) 0.250** (2.59) -0.144 (-1.86) 0.0717 (0.60) 0.0229*** (4.15) 42,202 0.003
0.0718 (0.79) -0.189 (-1.65) -0.360*** (-3.62) 0.364** (2.84) -0.285*** (-5.10) 0.247* (2.56) -0.166* (-2.15) 0.0886 (0.74) 0.0237*** (4.10) 42,202 0.005
0.0733 (0.81) -0.190 (-1.66) -0.343*** (-3.45) 0.352** (2.75)
0.0184*** (3.46) 42,202 0.005
0.0176** (3.12) 42,202 0.002
p < 0.05, ** p < 0.01, *** p < 0.001
AC
*
-0.0143 (-1.78)
ED
ΔDEBTit
N adj. R2
-0.0136 (-1.74)
AN
ΔEQUITYit × RULEit
CONSTANT
-0.00864 (-1.09)
T
ΔXFINit × RULEit
(4) SRETit+1
IP
RULEit
(3) SRETit+1
CR
ΔXFINit
(2) SRETit+1
US
(1) SRETit+1 -0.154** (-3.19) -0.00875 (-1.14) 0.0917 (1.27) -0.00198 (-0.24) -0.00627 (-0.58) -0.183** (-3.14) 0.130 (1.53)
46
ACCEPTED MANUSCRIPT Panel B. Results from Regressions for Observations without Analyst Following
ΔXFINit × RULEit TRit TRit × RULEit ΔXFINit × TRit ΔXFINit × TRit × RULEit
-0.0253* (-2.30)
-0.0302** (-2.67)
-0.0253* (-2.47) 0.0469 (1.62)
-0.0444*** (-4.56) 0.0396 (1.50)
-0.0234* (-2.27) 0.0439 (1.52)
US
ΔEQUITYit × RULEit
AN
ΔEQUITYit × TRit ΔEQUITYit × TRit × RULEit
M
ΔDEBTit ΔDEBTit × RULEit
ED
ΔDEBTit × TRit ΔDEBTit × TRit × RULEit
0.0506*** (8.14) 23,087 0.005
CE
PT
CONSTANT
*
-0.0304** (-2.70)
-0.178*** (-3.92) 0.138* (1.99) -0.0457 (-0.77) -0.181 (-1.47)
ΔEQUITYit
N adj. R2
(4) SRETit+1
T
RULEit
(3) SRETit+1
IP
ΔXFINit
(2) SRETit+1
CR
(1) SRETit+1 -0.181*** (-4.78) -0.0278* (-2.45) 0.0731 (1.16) -0.0234* (-2.29) 0.0388 (1.35) -0.0594 (-1.16) -0.0634 (-0.57)
0.0496*** (8.04) 23,087 0.004
-0.154* (-2.53) -0.128 (-1.05) -0.0394 (-0.45) 0.238 (0.94) 0.0438*** (7.06) 23,087 0.002
-0.191*** (-4.17) 0.142* (2.01) -0.0531 (-0.89) -0.166 (-1.34) -0.183** (-2.97) -0.104 (-0.85) -0.0750 (-0.85) 0.263 (1.03) 0.0511*** (8.24) 23,087 0.005
p < 0.05, ** p < 0.01, *** p < 0.001
AC
Panel A presents results of regressing future stock returns on external financing and level of conflicts of interests from trading revenue for firms with analyst following. Panel B presents results of regressing future stock returns on external financing and level of conflicts of interests from trading revenue for firms without analyst following. SRET is the annual size-adjusted stock returns measured using compounded buy-hold returns, inclusive of dividends and all other distributions, and are computed for a the 12-month period starting the fourth month after fiscal year t to ensure that all financial statement information is available to the public. ΔXFIN is the net amount of cash flow received from external financing activities: ΔXFIN = ΔEQUITY + ΔDEBT. ΔEQUITY is net cash received from the sale (and/or repurchase) of common and preferred stock less cash dividends paid (Compustat data item SSTK less data item PRSTKC less data item DV). ΔDEBT represents net cash received from the issuance (and/or repayment) of debt (Compustat data item DLTIS less data item DLTR less data item DLCCH). RULE is an indicator variable that equals 1 if the observation is from the post-Rule 2711 period, and 0 otherwise. TR is an indicator variable that is set to 1 if the firm’s annual turnover, calculated as the number of shares traded during the year divided by average shares outstanding, is greater than the median of our sample and to 0 otherwise. The t-statistics (in parentheses) are computed using robust standard errors adjusted for clustering by company.
47
ACCEPTED MANUSCRIPT Table 7 Results from Regression of Future Stock Returns on External Financing Controlling for Market Timing (1) SRETit+1
(2) SRETit+1
(3) SRETit+1
(4) SRETit+1
-0.0354*** (-8.33)
-0.0404*** (-9.71)
-0.0345*** (-8.13)
SENTMENTit
-0.00702 (-1.08)
-0.00667 (-1.02)
-0.00664 (-1.01)
-0.00676 (-1.04)
ΔXFINit
-0.306*** (-11.07)
RULEit
-0.00530 (-0.74)
ΔXFINit × RULEit
0.306*** (6.21)
0.00316 (0.43)
US
0.000731 (0.10)
CR
IP
T
-0.0347*** (-8.25)
PSTKRTNit
-0.323*** (-9.33)
-0.333*** (-9.60)
0.392*** (5.86)
0.399*** (5.96)
AN
ΔEQUITYit
M
ΔEQUITYit × RULEit
ED
ΔDEBTit
PT
ΔDEBTit × RULEit
0.0202*** (3.93) 29,716 0.009
0.0145** (2.86) 29,716 0.007
AC
N adj. R2
CE
CONSTANT
-0.00371 (-0.50)
-0.271*** (-6.03)
-0.288*** (-6.40)
0.191** (2.58)
0.210** (2.83)
0.0132* (2.54) 29,716 0.006
0.0200*** (3.89) 29,716 0.009
t-statistics in parentheses: * p < 0.05, ** p < 0.01, *** p < 0.001 This table presents results of regressing future stock returns on external financing and proxies for market timing. SRET is the annual size-adjusted stock returns measured using compounded buy-hold returns, inclusive of dividends and all other distributions, and are computed for a the 12-month period starting the fourth month after fiscal year t to ensure that all financial statement information is available to the public. PSTKRTN is the past 24-month compound return ended 3 month after fiscal year t. SENTMENT is the past 12month sentiment index ended 3 month after fiscal year t (Baker and Wugler 2006). ΔXFIN is the net amount of cash flow received from external financing activities: ΔXFIN = ΔEQUITY + ΔDEBT. ΔEQUITY is net cash received from the sale (and/or repurchase) of common and preferred stock less cash dividends paid (Compustat data item SSTK less data item PRSTKC less data item DV). ΔDEBT represents net cash received from the issuance (and/or repayment) of debt (Compustat data item DLTIS less data item DLTR less data item DLCCH). RULE is an indicator variable that equals 1 if the observation is from the post-Rule period, and 0 otherwise. The t-statistics (in parentheses) are computed using robust standard errors adjusted for clustering by company.
48
ACCEPTED MANUSCRIPT Table 8 Results from Regression of Future Stock Returns on External Financing and Accurals Panel A. Results from Regression of Future Stock Returns on External Financing and Accruals
-0.360*** (-8.22) 0.0224*** (4.26)
ΔXFINit × RULEit
0.165*** (5.08)
ACCRit × RULEit
0.162* (2.05)
US
RULEit
T
-0.327*** (-8.99)
(3) SRETit+1 -0.110*** (-6.82)
IP
ACCRit
(2) SRETit+1 -0.238*** (-12.18)
CR
ΔXFINit
(1) SRETit+1 -0.194*** (-12.43)
AN
T_ACCRit
0.0272*** (10.36) 55,361 0.006
CONSTANT
ED
N adj. R2
M
T_ACCRit × RULEit
0.0189*** (5.27) 55,361 0.007
AC
CE
PT
t-statistics in parentheses: * p < 0.05, ** p < 0.01, *** p < 0.001
49
-0.226*** (-14.91)
(4) SRETit+1 -0.157*** (-7.70)
-0.00822 (-1.63) 0.152*** (4.57)
-0.244*** (-12.76) 0.0585 (1.86)
0.0304*** (12.00) 64,719 0.009
0.0348*** (9.78) 64,719 0.010
ACCEPTED MANUSCRIPT Panel B. Results from Regression of Future Stock Returns on Equity, Debt Financing and Accruals (2) SRETit+1 -0.210*** (-9.01)
(3) SRETit+1 -0.112*** (-5.97)
(4) SRETit+1 -0.152*** (-6.46)
ΔDEBTit
-0.251*** (-9.60)
-0.317*** (-9.70)
-0.116*** (-4.53)
-0.177*** (-5.50)
ACCRit
-0.329*** (-9.03)
-0.364*** (-8.31)
ΔEQUITYit × RULEit
0.145*** (3.70)
ΔDEBTit × RULEit
0.210*** (3.88)
ACCRit × RULEit
0.166* (2.10)
IP
0.0228*** (4.35)
AN
US
RULEit
CR
ΔEQUITYit
T
(1) SRETit+1 -0.176*** (-9.36)
-0.226*** (-14.77)
M
T_ACCRit
ED
T_ACCRit × RULEit 0.0273*** (10.39) 55,361 0.006
CONSTANT
PT
N adj. R2
0.0187*** (5.21) 55,361 0.007
-0.00817 (-1.62) 0.139*** (3.55) 0.172** (3.26)
-0.244*** (-12.70) 0.0592 (1.85)
0.0306*** (12.08) 64,719 0.009
0.0348*** (9.80) 64,719 0.010
t-statistics in parentheses: * p < 0.05, ** p < 0.01, *** p < 0.001
AC
CE
Panel A presents results of regressing future stock returns on external financing and accruals. Panel B presents results of regressing future stock returns on equity,and debt financing and accruals. SRET is the annual size-adjusted stock returns measured using compounded buy-hold returns, inclusive of dividends and all other distributions, and are computed for a the 12-month period starting the fourth month after fiscal year t to ensure that all financial statement information is available to the public. ΔXFIN is the net amount of cash flow received from external financing activities: ΔXFIN = ΔEQUITY + ΔDEBT. ΔEQUITY is net cash received from the sale (and/or repurchase) of common and preferred stock less cash dividends paid (Compustat data item SSTK less data item PRSTKC less data item DV). ΔDEBT represents net cash received from the issuance (and/or repayment) of debt (Compustat data item DLTIS less data item DLTR less data item DLCCH). T_ACCR is total accruals defined as the change in noncash assets [(change in Compustat item AT) less the change in Compustat item CHE)] less the change in non-debt liabilities [change in Compustat item LT less the change in COMPUSTAT item DLTT less the change in Compustat item DLC], deflated by average total assets (Compustat item AT). ACCR is the change in current assets (COMPUSTAT item ACT) less the change in cash (COMPUSTAT item CHE) less the change in current liabilities (COMPUSTAT item LCT) plus the change in debt in current liabilities (COMPUSTAT item DLC) less depreciation (COMPUSTAT item DP), deflated by average total assets (Compustat item AT). RULE is an indicator variable that equals 1 if the observation is from the post-Rule period and 0 otherwise. The t-statistics (in parentheses) are computed using robust standard errors adjusted for clustering by company.
50
ACCEPTED MANUSCRIPT
Highlights 1. Propose to test the relation between analysts’ guidance in earnings forecasts and recommendations and corporate external financing, and the relation between external financing and future stock returns
T
2. We obtain empirical results from a sample of firms during the 1994–2010 period. We find a positive relation of analysts’ guidance in earnings forecasts and recommendations (especially long-term growth forecast and recommendations) and corporate financing activities, but the relation is weaker in the postRule period than in the pre-Rule period.
CR
IP
3. We also find a negative relation between corporate external financing and future stock returns, but the relation is weaker in the post-Rule period. Moreover, the changes of these relations after the implementation of the Rule are greater for firms with greater conflicts of interest.
AC
CE
PT
ED
M
AN
US
4. We conclude from these results that Rule 2711 has reduced the extent of analysts’ conflicts of interest in corporate financing activities.
51