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Chicanery, Intelligence, And Financial Market Equilibrium

Chicanery, Intelligence, And Financial Market Equilibrium

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Published by Cervino Institute
Subrahmanyam, Avanidhar (2003). “Chicanery, Intelligence, and Financial Market Equilibrium” The Anderson School, University of California, March 31, 2003.

In this paper, we provide perspectives on how disclosure policies and managerial intelligence interact to influence stock prices, firm values, and the liquidity of financial markets. In addition to the natural premise that intelligent managers positively influence firm values, we adopt two alternative perspectives on managerial intelligence. First, intelligent managers, precisely because of their intellect, are likely to be very successful in disseminating misleading impressions of a company’s true value. Second, agents with intelligence have high reservation wages which increases their incentives to overstate firm value. These two features cause the incentive to make misleading disclosures to increase in managerial intelligence. We show that given feedback from stock prices to cash flows, such confounding actions may actually improve ex post firm values. We then show that agents may have inadequate incentives to investigate and acquire information in firms run by disingenuous but intelligent managers. This ensures that firms where managers fudge financial reports can be very liquid with little information asymmetry in financial markets but substantial information asymmetry between management and outside investors.
Subrahmanyam, Avanidhar (2003). “Chicanery, Intelligence, and Financial Market Equilibrium” The Anderson School, University of California, March 31, 2003.

In this paper, we provide perspectives on how disclosure policies and managerial intelligence interact to influence stock prices, firm values, and the liquidity of financial markets. In addition to the natural premise that intelligent managers positively influence firm values, we adopt two alternative perspectives on managerial intelligence. First, intelligent managers, precisely because of their intellect, are likely to be very successful in disseminating misleading impressions of a company’s true value. Second, agents with intelligence have high reservation wages which increases their incentives to overstate firm value. These two features cause the incentive to make misleading disclosures to increase in managerial intelligence. We show that given feedback from stock prices to cash flows, such confounding actions may actually improve ex post firm values. We then show that agents may have inadequate incentives to investigate and acquire information in firms run by disingenuous but intelligent managers. This ensures that firms where managers fudge financial reports can be very liquid with little information asymmetry in financial markets but substantial information asymmetry between management and outside investors.

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Published by: Cervino Institute on Jun 20, 2010
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March 31, 2003
Chicanery, Intelligence, and Financial Market Equilibrium
Avanidhar Subrahmanyam
The Anderson School, University of California at Los Angeles. I thank two referees,Utpal Bhattacharya, Michael Brennan, Kent Daniel, Laura Frieder, Richard Roll, andKaveri Subrahmanyam for stimulating feedback and/or for encouraging me to explorethis topic.
 
Abstract
Chicanery, Intelligence, and Financial Market Equilibrium
In this paper, we provide perspectives on how disclosure policies and managerial in-telligence interact to in
uence stock prices,
rm values, and the liquidity of 
nancialmarkets. In addition to the natural premise that intelligent managers positively in
u-ence
rm values, we adopt two alternative perspectives on managerial intelligence. First,intelligent managers, precisely because of their intellect, are likely to be very successfulin disseminating misleading impressions of a company’s true value. Second, agents withintelligence have high reservation wages which increases their incentives to overstate
rmvalue. These two features cause the incentive to make misleading disclosures to increasein managerial intelligence. We show that given feedback from stock prices to cash
ows,such confounding actions may actually improve ex post
rm values. We then show thatagents may have inadequate incentives to investigate and acquire information in
rmsrun by disingenuous but intelligent managers. This ensures that
rms where managersfudge
nancial reports can be very liquid with little information asymmetry in
nan-cial markets but substantial information asymmetry between management and outsideinvestors.
 
1 Introduction
Recent months have witnessed a spate of revelations about misleading
nancial disclo-sures. The Enron crisis, the WorldCom revelations, and other indications of chicaneryby top management have all added to a concern that investors may lose con
dence in the
nancial markets, which may threaten the viability of such avenues as a source of cap-ital. While prominent
nance academics believe that the bulk of the scienti
c evidencesupports semi-strong e
ciency (Fama, 1998, Schwert, 2003), recent ex post disclosuresof managerial disingenuousness indicate that the information embedded in the
nancialand accounting statements of Enron and WorldCom was not properly interpreted by the
nancial markets. Overall, therefore, it is reasonable to assert that the market for assess-ing the health of companies functioned imperfectly in these and other high pro
le cases.In the Enron case, a speci
c concern has been that the intelligence of management wasused in so ingenious a way that the dishonesty was simply not decipherable by outsideinvestors (see, e.g., Partnoy, 2002).Given the upsurge of cases involving misleading
nancial disclosures and chicanery,an analysis of the incentives for managers to make dishonest disclosures appears to bewarranted.
1
In this paper, we consider theoretical perspectives on how managerial in-telligence interacts with the incentive to disclose information, and, in turn, on how itimpacts
nancial market prices. Our premises and assumptions are motivated not justby economic arguments, but by alluding to literature in psychology and related areas. Inthe context of stock market returns, Brennan (2001) argues that “[While using] radicallydi
ff 
erent behavioral postulates to explain di
ff 
erent phenomena...is the route to explainingasset prices in a statistical sense, it is clearly not a route to understanding them.” Acontrasting argument in the rapidly emerging
eld of behavioral
nance is that usingconcepts from
elds other than economics is important to understand phenomena in
-nancial markets. Our view is consistent with this latter approach; speci
cally, that using
1
In this paper, we interpret “managers” as executives as well as agents with close relationships to the
rm (e.g., accountants hired to audit the company’s statements).
1

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