The impact of illegal business practice on shareholder returns
Over the past decade the subject of illegal business practices has taken on added importance. Incidents such as the widespread efforts of E.F. Hutton to defraud customers of the use of their money and the efforts of Ivan Boesky and Michael Milken to capitalize on inside information represent just a few of the more notable cases. The academic literature has also begun to take note of the increased coverage of corporate corruption (Horrigan , Gaa and Krinsky , and Lehman ). For the most part, these studies present a conceptual analysis of the moral issues involved. The objective of this study is to determine the quantitative impact of corporate indictments on stockholder returns during the decade of the 1980s.
Recent attempts to quantify the impact of illegal business behavior have generated mixed results. For example, Strachan, Smith, and Beedles  examine the effect on stock returns of a sample of 84 firms charged with illegal activity during the decade of the 1970’s. Criminal indictments were broken into two types: illegal political payoffs and price fixing. Significant negative results were observed only in the case of price fixing. Significant results were also found in a study by Torabzadeh, Davidson, and Assar  who examine the impact of the Levine-Boesky indictments for insider-trading on the stock returns of securities firms.
In 1990, Skantz, Cloninger, and Strickland  examine the effect of price fixing announcements on 41 firms around three different event dates: indictment, plea, and resolution. The study finds significant negative returns around the indictment date. The results surrounding the plea announcement suggest a high level of uncertainty regarding the ultimate disposition of the case. No significant results were reported at the time of resolution.
Gratto, Thatcher, and Thatcher  examine the impact of indictment and resolution announcements upon 78 firms between 1969 and 1984. Their study considers whether the firm was a plaintiff or defendant and whether the firm was an eventual winner or loser. For the indictment date, the excess returns for both the defendants and plaintiffs were found to be negative but not statistically significant. At the resolution date, excess returns for the losing firms were again found to negative but not significant, and positive but not significant for the winning firms. Recently, Reichert, Lockett, and Rao  present preliminary evidence regarding the impact of corporate indictments on stock returns during the 1980s. The purpose of the current study is to extend this work and further investigate the capital market effects of illegal corporate activity.
Theoretical Considerations and Research Hypotheses
Illegal activity may be considered the result of a rational cost/benefit analysis where management implicitly or explicitly weights the associated costs, benefits, and probability of exposure. The costs and benefits can accrue at either the personal or corporate level. In either case, illegal activity constitutes a significant agency problem. For example, the illegal activity may primarily be undertaken for the financial benefit of management without the owner’s knowledge (e.g. kickbacks, bribes, etc.). Although the benefits accrue primarily to management, once the illegal activity is exposed both management and shareholders will likely share the cost in the form of fines and imprisonment, lost customers, increased regulation and restrictive operating sanctions. Thus, an asymmetrical sharing of costs and benefits is likely.
Other situations may arise where management undertakes some type of illegal activity (e.g. price fixing) and the company benefits by either an increased or more stable cash flow. Along these lines, Cloninger [2,3] illustrates how a firm might "hedge" an otherwise legitimate project through the use of illegal business practices, reducing the overall operating risk of the project. Since illegal business practices, at least initially, are concealed from the marketplace, the market perceives a more rapid growth in assets or an increase in equity value attributed to a reduction in risk and/or increased returns. To the extent that hedging legitimate projects with illegal business practices significantly increases expected cash flow returns or reduces systematic risk, the loss of hedging opportunities occasioned by a public indictment may lead to either a reduction in cash flow returns or an increase in systematic risk (or both), and hence, a decline in stock returns.
This raises an important agency issue since the full knowledge of the effects of moral risk-taking on the firm’s observed systematic risk is available only to management. According to Cloninger , it is these managers who likely require a risk premium in the form of higher compensation, bribes, or kickbacks to compensate them for the personal risk associated with their hedging activities. Hence, the majority of benefits associated with corporate risk reduction from illegal activity may possibly accrue to management. That is, managers "expropriate" some portion of the firm’s cash flow stream through a reduction in variability. In other cases, management may "steal" just enough cash flow through kickbacks and added perquisites to offset the reduction in systematic risk, leaving firm value unaffected.
On the other hand, as illustrated by the recent savings and loan debacle, illegal practices may represent more of a speculative than a hedging activity. The speculative activity may actually destabilize earnings and increase a firm’s systematic risk. In this case, public exposure and the subsequent cessation of the activity may result in a change in top management and the introduction of more conservative operating policies and more effective controls. The end result could be a reduction rather than an increase in firm risk. …