Contagion of Financial Misconduct: Unethical Institutional Ownership and Aggressive Financial Reporting

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Abstract

This paper contributes to the new stream of literature on contagious unethical corporate behavior. We examine how financial misconduct of institutional investors (i.e. their disciplinary history) affects managerial incentives to engage in aggressive financial reporting practices. Specifically, we conjecture that institutional investors who faced disciplinary actions themselves (i.e. unethical institutional investors) are less likely to provide monitoring and more likely to overlook or even nudge firms towards aggressive financial reporting to boost short-term performance. We find evidence that firms held by unethical institutional investors are more likely to engage in aggressive financial reporting practices, such as earnings management, which results in restatement or receiving accounting and auditing enforcement release (AAER) from the SEC. Next, we show that higher unethical institutional ownership positively affects the stock price crash risk, suggesting that unethical institutional ownership increases a firm’s bad news hoarding behavior. Interestingly, we find evidence of ethical institutional investors impeding firm’s aggressive financial reporting. The results continue to hold after implementing various statistical tests to address potential endogeneity issues (i.e., regression discontinuity analysis, two-stage least squares regression and propensity-score matched methodology). Our study is the first to investigate the implications of institutional investors’ ethics on corporate governance.

Authors

• Babak Mammadov, Clemson University

• Avishek Bhandari, University of Wisconsin- Whitewater

• Blerina Bela Zykaj, Clemson University