Full length articleCEO centrality and stock price crash risk
Introduction
In this study, we extend prior research by examining whether a CEO’s social network has any impact on a firm’s future stock price crash risk. Prior work suggests that bad news hoarding behavior is the most critical factor associated with crash risk (Jin and Myers, 2006). A key assumption in most of these studies is that the CEO exerts a significant control over the dissemination of bad news. For instance, Fang et al. (2020) suggest that managers, having monopoly over firm information, could be significant driver of stock price crash risk. Further, extant studies suggest that compensation, reputation, and career concerns incentivize a manager to delay or conceal price sensitive bad news in hopes of obscuring it with future good news (Ball, 2009, Graham et al., 2005).
Recent prior studies posit that social networks of CEOs provide them with several advantages (Egginton and McCumber, 2019, El-Khatib et al., 2015, Fracassi, 2016, Fracassi and Tate, 2012). First, a CEO’s social networks provide an informational advantage to them that results in lower costs of borrowing with fewer covenant restrictions (Fogel et al., 2018). Second, CEOs’ network connections increase their access to relevant network information, which facilitates innovation by serving to identify, evaluate, and exploit innovative ideas. Third, CEOs’ personal connections provide them with labor market insurance; thereby, enabling investments in risky innovation by mitigating the career concerns intrinsic to such investments (Faleye et al., 2014) and increase their future employment prospects (Liu, 2010, Nguyen, 2012). Since network centrality bestows several advantages to CEOs, they have fewer incentives to destroy their reputation by withholding bad news and causing stock prices of their firms to crash.
Another stream of research suggests that CEOs, who are more central in the network may use their network power to avoid being monitored intensively (Fracassi and Tate, 2012, Nguyen, 2012), resulting in lower quality governance (Nguyen, 2012), and market discipline (El-Khatib et al., 2015). Further, they may pursue riskier strategies, resulting in more volatile stock returns and may lead to failures that need to be covered up (Ferris et al., 2017). More central CEOs are likely to engage in mergers and acquisitions than less central CEOs, and these deals usually cause greater value losses to both acquirers and targets (El-Khatib et al., 2015, Fracassi and Tate, 2012). Further, prior work also suggests that high centrality CEOs are more likely to commit corporate fraud and engage in unethical practices (Brown and Drake, 2014, Cai et al., 2017, Chidambaran et al., 2011, Chiu et al., 2013). Thus, CEOs with high centrality may misuse their influence on other executives in the firm to report unreliable announcements or manipulate accounting practices in order to hoard bad news, leading to a higher probability of stock price crash in the future. Overall, the impact of CEO centrality on stock price crash risk remains an empirical question that has not yet been examined in the literature.
We use 12,540 firm-year observations for S&P1500 firms in the U.S. from 1999 to 2019 to empirically examine the relation between CEO network centrality and stock price crash risk. We follow Egginton and McCumber (2019) and Skousen et al. (2018) to construct measures of the CEO centrality from a vast network of executives and directors. Recent research on social networks suggests that a CEO’s network centrality has significant effects on firm policies (El-Khatib et al., 2015, Fogel et al., 2018, Macaulay et al., 2018). Our results indicate that CEO centrality can effectively reduce future stock price crash risk propensity. Results are consistent across different measures of price crash propensity and alternative specifications of CEO centrality, time-invariant firm-specific factors, and CEO characteristics. Furthermore, our tests reveal that more central CEOs are less likely to exhibit accounting-based manipulative behavior related to earnings management, reducing announcements that break string in earnings, or releasing unexpected earnings announcement, and overinvestments practices. These additional tests are commonly used by others (Al Mamun et al., 2020, Andreou et al., 2017, Francis et al., 2016) to identify the several channels used by CEOs or top executives to conceal bad news from market participants. Collectively, our results support the notion that firms run by more socially connected CEOs experience lower stock price crash risk.
We further argue that if CEO centrality reduces the propensity of crash risk due to a CEO’s social acceptance concern and governance channels, then the disciplining effect of CEO centrality on the probability of future price crash would be more compelling in firms with higher information asymmetry and weak external monitoring. Using subsample analysis, we find the impact of CEO centrality on reducing crash risk remains strong in firms with high opacity and more information asymmetry. Additionally, using analyst coverage and takeover threat, we report that the effect of centrality in crash risk reduction is more pronounced for firms with weaker external monitoring.
Our paper makes several contributions to the current literature. First, we contribute to the stock price crash risk literature by examining the impact of a CEO’s behavioral characteristics on price crashes. Extending prior understanding of a CEO’s traits such as age or gender (Andreou et al., 2017), and managerial power (Al Mamun et al., 2020), our findings indicate that CEO connectedness, through reduction of crash risk, could decrease the propensity of manipulative behavior.
Second, our findings also contribute by showing that CEO social capital, captured through CEO centrality, can be beneficial for firms. As reported in Genicot et al. (2004) and Gompers et al. (2016), social ties are mutually beneficial and offer a channel for two-way information diffusion, especially when the issue of information asymmetry is prevailing (Fracassi, 2016). Furthermore, our findings are consistent with the notion that well-connected CEOs are less likely to use their social power to influence their subordinates in order to conserve their private wealth at the expense of others, as opposed to prior studies that support the argument of CEO entrenchment through social advantages (Chahine et al., 2019, El-Khatib et al., 2015).
Finally, our work is related to Fang et al. (2020) who examine the role played by director social networks in influencing crash risk. They find that the extent of external connections of directors mitigates a firm’s future stock price crash risk. Their findings are consistent with the monitoring view, which suggests that better informed directors reduce the scope for bad news hoarding by managers. We distinguish our work from that of Fang et al. (2020) by studying the role of CEO centrality as opposed to director centrality. A central premise of their work is that CEOs are responsible for bad news hoarding. While we do not disagree with that premise, we suggest that more central CEOs may differ from less central CEOs in terms of their incentives to hoard bad news. Further, our results suggest that the negative association between CEO network centrality and crash risk remains even after controlling for directors’ external social networks.
We structure the rest of the paper as follows. Section 2 discusses the literature review and hypothesis development. Section 3 describes the empirical design, data and provides summary statistics. Section 4 reports our empirical results, followed by additional analyses in Section 5. Section 6 summarizes our findings and concludes.
Section snippets
Literature review and hypotheses development
Recent literature has focused on the determinants and consequences of firm-specific stock price crash (Al Mamun et al., 2020, Andreou et al., 2017, Jin and Myers, 2006). Several studies posit the agency perspective of bad news withholding behavior, which arises when top management acts strategically and delays or conceals sensitive information about a firm’s deteriorating performance. However, when bad news stockpiling reaches a critical level, it becomes impossible for managers to continue
Research design
In this section, we describe the measures of stock price crash risk and CEO centrality, the sample selection procedure, and present descriptive statistics on measures of stock price crash risk, CEO centrality, and control variables.
Baseline results
We report the main results in Column (1) of Table 2 in Panels A and B using pooled ordinary least square (OLS) method with industry and year fixed effects (FE) based on Eq. (4). The coefficient on is negative and statistically significant at the 1% level for both measures of crash risk. Specifically, the coefficient on with (Column (1), Panel A) is −0.0445 (t-statistics = −3.51) and with (Column (1), Panel B) is −0.0288 (t-statistics = −3.58).
Test of bad news hoarding behavior
In this section, we examine the relation between CEO centrality and direct and indirect channels of bad news hoarding. Particularly, our direct tests include sudden release of bad news and break of earnings string and indirect tests comprise of real earnings management, accruals earnings management, and overinvestments.
Conclusion
This paper investigates the impact of a CEO’s social capital, captured by CEO centrality, on the firm’s propensity for future stock price crash risk. More specifically, we examine whether social connectedness of a CEO creates a more transparent information environment, and reduce the bad news accumulation behavior of top management (Kothari et al., 2006), which has been shown to lead to future stock price crashes if not controlled (Andreou et al., 2017, Chowdhury et al., 2020, Kim et al., 2016b
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2022, Journal of Behavioral and Experimental FinanceCitation Excerpt :First, we examine whether monitoring moderates the documented positive association between CITI and LIE. Following the extant literature, we use the Takeover Index (Cain et al., 2017; Krishnamurti et al., 2021) as a proxy for external monitoring. It is our conjecture that the presence of a higher (lower) level of CITI will be more (less) beneficial for firms with weaker (stronger) monitoring.
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For insightful comments, authors thank Muhammad Al Mamun (discussant), Jun Myung Song (discussant), and participants in the 2021 FMCG conference and 33rd Asian Finance Association (Asian FA) Annual Meeting. The authors retain responsibility for any remaining errors.