1. Corporate Scandals and Household Stock Market Participation Mariassunta Giannetti, Stockholm School of Economics, CEPR Tracy Yue Wang, University of Minnesota

2. The Idea  Effect of fraud on market participation and spillover effect on firms Corporate frauds may decrease demand for equity and households’ willingness to (directly or indirectly) participate in the stock market; Through this channel, fraud may generate large indirect value losses by increasing the cost of capital for other firms (i.e., firms with no revealed fraud).  Households are important yet relatively vulnerable participants in the stock market. Low household participation rate (Guiso & Sodini 2013) Incentive to participate is sensitive to past stock market experience and the level of trust Corporate frauds likely have a large negative impact on household participation 2

3. Empirical Design  Corporate frauds → household participation → firms’ cost of capital, valuation, liquidity...  Identify variation in households’ exposure to fraud Likely larger exposure to frauds in firms located in the same state. Local bias in households’ investment  Grinblatt & Keloharju 2001, Ivkovic & Weisbenner 2005, Seashole & Zhu 2010. Local news coverage, personal connections,… 3

4. Empirical Design  Causal impact of fraud on household participation The sudden demise of Arthur Andersen as an exogenous shock to fraud revelation; Exogenous variation in households’ life-time experience of corporate fraud.  Spillover effect on firms with no revealed fraud Geographic spillover through local demand for equity vs. Information spillover in an industry 4

5. Main Results  Corporate frauds in a state significantly reduce equity holdings and stock market participation of households in that state. The impact of fraud is causal.  Significant spillover effect of fraud: other firms headquartered in states hit by corporate scandals experience Decline in # of shareholders (particularly retail shareholders) Increase in cost of capital Decrease in valuation and liquidity 5

6. Relation to Fraud Literature  Most work focus on consequences to shareholder value of the fraud-committing firms: loss of firm value, cost of equity, cost of debt…  Limited work on spillover effects Information spillover among industry peers: Gleason, Jenkins, and Johnson (2008), Goldman, Peyer, & Stefanescu (2012).  We document a distinct and potentially more pernicious spillover effect through the demand for equity by local households. 6

7. Relation to Participation Literature  Effect of past stock market experiences (Malmendier and Nagel 2011) More recent stock market returns have larger effects; Younger households’ participation is more affected by past experiences. We find that corporate scandals have more lasting effects than general stock market experiences, affecting older households more.  Effect of trust (Guiso, Sapienza, & Zingales 2008) Trust that is rooted in cultural origin; Less financially-literate households are more influenced by trust. We find that corporate scandals tend to affect households who are more likely to be in the market in the absence of frauds. 7

8. Data on Households  Panel Study of Income Dynamics (PSID) State of residence Infor. on equity holdings: 1984, 1989, 1994, 1999, 2001, 2003, 2005, 2007, 2009 “Equity Participation” =1 if hold stocks in public firms, mutual funds, or investment trusts in a given year  Exclude equity holdings in retirement accounts  “Equity Participation_IRA”  Participation rate: 22% (w/o IRA), 30% (w/ IRA) Equity value, net equity purchase, equity-wealth ratio Household characteristics: family income, wealth, number of family members, age, years of schooling, marital status 8

9. Data on Corporate Fraud  Federal Securities Regulation (FSR) database (by Karpoff, Lee, and Martin) Enforcement actions by SEC and DOJ: 1980-2009. Select 711 cases involving 702 US publicly traded issuers with charged securities fraud under the Securities Act or the Exchange Act. Time of fraud revelation  Headquarter state infor. from COMPUSTAT and hand collection Covers 47 out of (50 states + DC) Variation in fraud revelation across states over time 9

10. Data on Corporate Fraud  “Fraud in State”: cumulative fraud revelation intensity in the past 4 years in a state Fraud revelation intensity = # of revealed frauds divided by total # of public firms in a state; Mean: 1.02%, S.D.: 2.31%  Alternative measures: “Fraud in State 2”: larger weights for frauds in larger firms; “Fraud in State 3”: larger weights for frauds with more negative market reaction upon detection; “Fraud in State 4”: larger weights for frauds in firms with more retail shareholders. 10

11. Data on State Conditions  State economic conditions could be the omitted variables Economic condition affects fraud revelation (Povel et al. 2007, Wang et al. 2010); May affect households’ stock market participation too.  Bereau of Economic Analysis (BEA) State GDP growth, employment growth, population, total personal income (and growth), per capital personal income (and growth)  State stock market condition Buy-and-hold VW return of stocks in the state 11

12. Empirical Model 12  Participation(ijt): equity participation, log(equity value), log(net equity purchase), equity-wealth ratio  X(ijt): time-varying controls for the households and the states  Fixed effects: household, state, year Year : absorb national changes in demand for equity ; State : absorb average differences in fraud revelation and participation across states; Household: absorb any unobservable household characteristics that affect participation.

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15. Identification Strategy 1  A shock to fraud revelation due to the sudden demise of Arthur Andersen (AA) The probability of fraud detection increases for AA clients relative to other firms during 2002-2004 (Dyck, Morse, Zingales 2013); The effect of the shock is different across states, depending on the fraction of firms in a state that were AA clients in 2001-2002 (“AA Shock”), which should be exogenous to our question. Use “AA Shock” as the instrument for “Fraud in State” 15

16. 16 Validity of the Instrument Exclusion Restriction (before 2001)

17. Identification Strategy 1 17

18. Identification Strategy 2  Households living in the same state at a point of time may have different corporate fraud experiences Differences in household age Some households have moved across states Variation across households’ experiences due to age and moving is exogenous to our question. Allow us to absorb any state level shocks by including state-year fixed effects. 18

19. Identification Strategy 2  Use the methodology in Malmendier & Nagel (2011): 19

20. Identification Strategy 2 20 c

21. Which Households are More Affected? 21

22. Spillover Effects on Local Firms  Corporate frauds in a state have long-lasting negative impact on equity holdings of local households  Households are more likely to invest in local stocks. Local bias implies segmentation in the supply of capital by geographic areas.  Frauds could lead to a lasting decrease in demand for all local stocks.  The decrease in demand could generate economic costs on local firms that are not involved in fraud. 22

23. Change in Shareholder Base 23

24. Cost of Capital 24

25. IV Estimation  Use “AA Shock” to instrument for “Fraud in State”  Also examine valuation and liquidity 25

26. Conclusion  Corporate fraud has a long-lasting negative impact on households’ incentive to participate in the stock market.  The decrease in households’ demand for equity due to fraud generates significant costs on local firms that are not even involved in fraud. 26