CFA Institute Journal ReviewMay 2017Volume 47Issue 5
Corporate Scandals and Household Stock Market Participation (Digest Summary)
MariassuntaGiannettiTracy YueWangJournal of Finance
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Corporate fraud reduces participation in the stock market, particularly for households in
the place where the fraud occurs. Individual households with a high degree of lifetime
experience of corporate scandals reduce their equity holdings. Given the critical
importance of positive returns on equities for meeting such goals as education and
retirement, corporate fraud has a negative effect on households’ financial
How Is This Research Useful to Practitioners?
The authors find that local equity fraud reduces local household participation in equity
markets even when the household does not hold stock in the fraudulent company. They use two
primary tests to determine whether their results are influenced by the US state’s
economic condition. The first test studies the demise of Arthur Andersen, formerly one of
the “Big Five” accounting firms, in 2002. When Arthur Andersen ceased to exist,
clients that were based in many states were forced to find new auditors. When a company
switches auditors, the probability that fraud will be exposed is usually higher. The authors
show that in the Arthur Andersen case, a rise of one standard deviation in fraud revelation
increases the probability that a household will exit the stock market by 7%.
In the second test, the authors explore same-state variations in household experience with
fraud. The results show that individuals in a state reduce not only their investments in the
stocks of corporations in that state but also their stock market investments overall. The
authors attribute this behavior to a rational belief that fraud could be equally present
across states and in other firms. Using the second test, they find that a rise of one
standard deviation in a household’s lifetime exposure to local fraud reduces that
household’s probability of holding stocks by 4% and its ratio of equity to total
wealth by 10%.
Although households reallocate their equity positions to such fixed-income securities as
bonds and insurance policies, the decline in equities is not dependent on household risk
tolerance or actual financial loss. The authors provide evidence that it could be
attributable to a decline in trust after feeling cheated and betrayed. Households with
high-status individuals reduce their equity positions the most because they have the most to
lose; the betrayal costs are high. In particular, college-educated households drive the
observed decline. The authors demonstrate that this lack of confidence has a lasting impact
on household investing patterns rather than a fleeting effect.
How Did the Authors Conduct This Research?
Using the Federal Securities Regulation (FSR) database, the authors study intentional and
material financial misconduct that directly affects shareholder wealth and find 704
enforcement actions involving 695 US companies between 1980 and 2009. They observe
households located in the same state where the fraud occurs because these households may be
more aware of the fraud. Household demographics are from the Panel Study of Income Dynamics
and show that 31% of households participate in the stock market outside of IRAs. The authors
use information from a large discount broker to determine which common stocks households
hold and sell.
Their results represent the lower range of negative outcomes, because households may have
experienced fraud from out-of-state firms as well.
The authors contribute to the financial literature by studying the relationships between
trust and economic transactions and between the cumulative lifetime experience of corporate
fraud and the demand for equities. Their findings can help corporate executives, insurance
companies, financial planners, and portfolio managers understand the effects of widely
publicized corporate fraud on shareholder value, shareholder concerns, and investing
The authors’ behavioral finance research shows the impact of corporate fraud on
household investing behaviors. Their findings serve as a reminder to portfolio managers that
revelations of corporate fraud may lead their clients to make decisions that are not in
their own best interests.