Nothing but good intentions: the search for equity and stock price crash risk

Since the seminal work of Jin and Myers (2006) firm-specific stock price crashes are linked to bad news hoarding by firm managers. Due to incentives such as compensation packages, empire building, and reputation concerns (Ball 2009; Graham et al. 2005), managers have the tendency to hide adverse information from outside investors which leads to bad news being stockpiled within the firm. Once the accumulated bad news reaches a tipping point where it can no longer be contained, stock prices are prone to crash. Given the devastating effects of crash risk on investor welfare, literature in the field of accounting and finance has increasingly turned to understanding the determinants of bad news hoarding behaviour. In this study we examine managers’ intentions to offer equity (hereafter: equity intent) as a potential incentive to hoard bad news. In the case of equity offerings, managers are known to time the market with regard to the current market valuation (Graham and Harvey 2001). More specifically, firm managers seeking equity are incentivised to provide more optimistic information prior to the equity offering to raise more capital, even if this contrasts the firm’s true performance (Lang and Lundholm 2010). Given this evidence, we believe that managers who try to persuade investors to invest in their company are more likely to hoard bad news. However, whether managers’ equity intent serves as a driver for bad news hoarding behaviour as reflected in future stock price crash risk remains an open empirical question. To address this issue, we apply modern techniques of information retrieval to firm disclosures to identify cues revealing managers’ equity intent and quantify its effects on future stock price crash risk.

A prominent example of managerial bad news hoarding with severe effects on investor welfare is the case of Marrone Bio Innovations. Former COO Hector M. Absi Jr. allegedly profited from hiding various sales concessions from independent auditors and outside investors.¹ When the SEC uncovered the alleged fraud in August 2014, the company’s share price plunged by more than 40%. Given the severe effects of opportunistic management behaviour, section 954 of the 2010 Dodd-Frank Act mandates that publicly listed companies adopt clawback provisions that require managers to return part of all benefits they received as the result of misstated accounting numbers. However, Bao et al. (2018) provide empirical evidence that clawback adoptions do not help mitigating crash risk as managers are induced to hide bad news through different channels than manipulated accounting numbers. Since stock price crash risk can neither be mitigated by portfolio diversification (Sunder 2010), literature in the field of accounting and finance has focused on identifying determinants of managerial bad news hoarding to help investors detecting crash prone companies via screening.² Interestingly, we find that, prior to the stock price crash of Marrone Bio Innovations in 2014, the company openly stated in its 10-K filing for the fiscal year 2013 that it was searching for additional external funding (e.g. equity intent) in order to expand its operational business. Considering our opening arguments, the intention to raise equity could have served as an incentive for the management to provide an overly optimistic outlook and hide bad news from investors. In this case, screening companies for managers’ equity intent could have helped investors to better assess firm-specific crash risk and preserve shareholder welfare.

Although firm fundamentals (e.g., leverage ratio, market-book-ratio) help to explain firm financing choices on average, balance sheet items cannot reveal corporate financing intentions. To grasp managers’ equity intent, we build on a concept proposed by Hoberg and Maksimovic (2014) and search for commonly used phrases in the Liquidity and Capital Resources (LIQ + CAP) section, a mandated disclosure of the MD&A section in 10-K files, that managers use to express their equity intent. However, managers’ equity intent is likely to come in shades. The authors suggest that, even if managers do not actively offer equity eventually, the mere intention to do so should be reflected in their choice of words when discussing the capital resources of their firm. Consequently, we follow Hoberg and Maksimovic (2014) to compile a continuous measure of equity intent that allows us to consider early signals that may mark the start of managers’ tendencies to hoard bad news. Specifically, we estimate cosine similarities between vector representations of LIQ + CAP sections in which managers explicitly state that they are issuing equity and all other LIQ + CAP sections in our sample. Instead of using a standard Bag-of-Words (BOW) model that is frequently used in accounting and finance research to estimate document similarities, we construct neural network embeddings of each LIQ + CAP section using the Doc2Vec model developed by Le and Mikolov (2014) that is proven to outperform standard BOW models as it accounts for semantic relationships.

After the identification of equity intent, we quantify its effect on firm specific future stock price crash risk. We follow the extant literature and analyse the effect of equity intent in conjunction with earnings manipulation—another popular determinant of stock price crash risk related to bad news hoarding (Hutton et al. 2009; Kim et al. 2019). Our results suggest that firms with stronger equity intent are more likely to suffer from stock price crashes in the future. These findings hold for different popular stock price crash risk measures and remain robust after controlling for firms’ earnings manipulation, which is a popular vehicle to hide adverse information as well as an extensive set of control variables. Moreover, the effects have a comparable magnitude like the effect earnings manipulation and textual obfuscation exert on stock price crash risk. To strengthen the case that equity intent is in fact a motive for managers to hoard bad news, we conduct a causal mediation analysis where we use the fraction of negative words in each firm’s MD&A section as a mediator variable. In line with the theory of bad news hoarding, our results show that stronger equity intent incentivises managers to withhold negative information by using less negative language in their MD&A, supporting the view that bad news hoarding serves as an important economic mechanism predicting the likelihood of future price crashes following a sudden release of accumulated negative information.

In additional analyses we examine how managers’ equity intent relates to the usage of earnings manipulation and textual obfuscation. The results show that equity intent reinforces the effects of these two popular vehicles of bad news hoarding. While earnings manipulation and textual obfuscation offer only marginal predictive power for future stock price crash risk for firms with low equity intent, they are strongly significant determinants for future stock price crash risks for high equity intent firms. Furthermore, we conduct a series of analyses to assess the robustness of our main results. Our robustness tests show that equity intent is an early warning indicator for stock price crash risk up to a prediction window of three years while predictive power decreases for wider prediction windows. In the next analysis we evaluate whether equity intent also predicts upward stock price jumps. If equity intent is a motive for bad news hoarding, we should not be able to predict upward stock price jumps in a similar way as stock price crashes. In fact, the results are generally consistent with this notion. We further check whether our findings are driven by model specifications of the applied neural network to estimate the LIQ + CAP embeddings. By exploring an alternative approach to estimate LIQ + CAP embeddings, we find that our main results remain robust for all stock price crash risk measures. Finally, we test the sensitivity of our results by controlling for several additional business risk and textual proxies that are associated with stock price crash risk. Again, our results remain virtually unchanged.

This paper contributes to the literature in the following way: In line with the SEC’s plan to use textual analyses to detect managerial opportunistic behaviour (Eaglesham 2013), we contribute to the literature that uses textual information to complement the prediction of stock price crashes. Consistent with El‐Haj et al. (2019), who state that “mainstream accounting and finance research appears to be behind the curve in terms of computational linguistic sophistication” (p. 266), prior works in the field of stock price crash risk mainly rely on basic content analysis methods, providing evidence that more complex and ambiguous company disclosures obfuscates financial information and thus, facilitates bad news hoarding (Ertugrul et al. 2017; Kim et al. 2019). Instead of identifying a new vehicle that managers use to hide bad news from outside investors, we draw on the bad news hoarding theory of Jin and Myers (2006) which requires the existence of certain incentives that drive managers decision to hoard bad news in the first place. Hence, by raising the question of whether company disclosures contain information about managerial incentives to hide bad news, we add a new perspective on how to use company filings to identify determinants of future crash risk. Furthermore, we argue that, as compared to prior works relying on broad textual characteristics of company files, our approach is superior in detecting managers’ bad news hoarding as it identifies a theoretically grounded incentive to use asymmetric information in efforts to time markets within managers’ capital structure decisions.

The remainder of this paper is structured as follows: Sect. 2 reviews literature in the field of stock price crash risk and provides our research hypothesis. Section 3 describes our data, the crash risk measures, the neural network embeddings we use to identify equity intent and the models to predict future crash risk. In Sect. 4 we present our prediction results before Sect. 5 provides additional analyses and Sect. 6 concludes the paper.

Since Jensen and Meckling (1976) first introduced agency costs, a large stream of literature analyses how linking the performance measurement of managers to certain budgetary or financial targets exacerbates existing conflicts of interests between them and outside investors that incentivise managers to engage in earnings management (Franco-Santos et al. 2012; Jensen 2005). Likewise, since the current market valuation of a firm can influence its managers' strategic capital structure decisions, in theory, managers are incentivised to withhold information that could negatively affect the firms’ market valuation (Alti 2003; Baker and Wurgler 2002; DeAngelo et al. 2010; Graham and Harvey 2001). Unsurprisingly managers that engage in earnings management in this context, also try to maximize their seasoned equity offerings (SEO) proceeds by increasing SEO pricing (Kim and Park 2005) but at the same time experience a declining operating performance as well as a distinctly post-SEO underperformance as the real consequences of their earnings management decisions reach the market (Cohen and Zarowin 2010; DuCharme et al. 2004; Walker and Yost 2008). However, thus far the literature has neglected that managerial opportunistic behaviour may also have much larger implications for investors welfare due to its impact on stock price crash risk. Hence, we contribute to this literature by analysing how a firms equity intent serves as a motive for opportunistic behaviour in the form of bad news hoarding, which leads to stock price crashes.

In this regard Jin and Myers (2006) set up a model in which the degree of opaqueness affects the division of risk bearing between firm insiders (managers) and outside investors. Managers’ ambitions to capture parts of the firm’s cash flow is limited by outside investors’ perception of the firm’s cash flow and value. If cash flows exceed investors’ expectations, managers are able to capture a larger fraction of it. Conversely, if managers underperform relative to investors’ expectations, they suffer reduced compensation and might even run the danger to lose their job. Thus, managers are incentivised to overstate financial performance and increase opacity by strategically withholding negative information from outside investors. In this sense, managers’ disclosure preferences are not aligned with those of outside investors (Kothari et al. 2009). However, there is a natural limit to the accumulation of bad news, because the probability that outsider investors grasp the firm’s true value continuously increases the more negative news are accumulated. When further obfuscations become too costly or difficult to maintain, all the negative information are released at once, resulting in the firm’s stock price to crash. Given the subsequent destruction of shareholder welfare, managers’ incentives to engage in bad news hoarding and the underlying mechanisms of this practice have received increasing attention from financial research. Previous literature has already established the positive relation between information asymmetries and stock price crash risk. For instance, incentive-based management compensation, CEO overconfidence (Kim et al. 2016), and overall career concerns (Kothari et al. 2009) provide motives for managers to uphold and expand information asymmetries against outside investors, thus, increasing the risk of a stock price crash (Kim et al. 2011).

In search for other motives for managers to obfuscate corporate disclosure, we turn our focus on corporate financing decisions, more precisely managers’ equity intent. Besides the obvious importance for the continuation and success of a firm’s business activities, financial management decisions are subject to agency conflicts between managers and outside investors, especially in the case of equity financing. While we do not plan to extend the comprehensive literature on choosing the optimal financial strategy, we are interested in the possibilities of opportunistic management behaviour (and its financial consequences) that are associated with managers’ equity intent.

In general, managers should be interested in a successful SEO for at least two reasons. Firstly, their future courses of action inside the firm benefits from higher financial resources. Secondly, they may fear the negative resonance following a disappointing SEO from a career perspective. Conversely, a positive stock performance and a successful equity issuance should enhance their job security and increase their value on the labour market (Chi and Gupta 2009). Consistently, the influential survey of corporate financing decisions by Graham and Harvey (2001) showed that managers proactively chose their equity issuances with regard to the current market valuation of the firm. Since firm outsiders are unable to assess the true value of a firm (given semi-informationally efficient markets), managers are able to exploit these information asymmetries to maximize the corresponding capital inflow. Lang and Lundholm (2010) observe changes in corporate disclosure policies around the period of an SEO. They show that firms seeking for equity tend to provide more detailed and more optimistic disclosure prior to the equity offering, leading to an increase of their stock price prior to the offering announcement. While the increase of the stock price may also be the result of improved economic conditions, Lang and Lundholm (2010) provide evidence, that this effect also holds true for firms without an economic improvement which “hype up” their stock. Interestingly, firms dialling up their disclosure suffer from comparably higher price declines after the actual announcement of the equity offering, indicating a market correction for “hyped up” stocks. Bergmann and Roychowdhury (2008) show that managers strategically adapt the level of disclosure (long-horizon earnings forecasts) to mould investor expectations and foster the firm’s valuation. In the case of high investor sentiment, managers are expected to decrease the level of voluntary disclosure to manage future expectations and maintain optimistic firm valuations. Thus, managers are incentivised to uphold high investor sentiment by concealing negative information in the interest of optimizing their SEO. Due to the limits of bad news accumulation, an opportunistic manager should offer equity when the (positive) difference between outside investors’ assessment and firm’s true value is the highest. In this sense, the search for equity could be interpreted as signal that managers do not expect the market’s perception of the firm’s value to further increase in the near future (Krasker 1986). Following the notion of Bergmann and Roychowdhury (2008), the search for equity would mark the beginning of a decrease in a firm’s disclosure level and the starting point of negative news concealment. Given this evidence, managers who intend to issue equity in the foreseeable future might be more likely to withhold negative news from outside investors to secure a successful SEO and maximize their capital inflow. We thus posit the following hypothesis:

In order to test the sensitivity of our results, we conduct several robustness tests. Firstly, because investors that try to hedge against future crash risk might be interested in the persistence with which equity intent signals bad news hoarding, we expand the prediction window of all four crash risk measures. While our baseline analysis employs a 12-month ahead prediction window, managers may accumulate bad news over several years. Thus, we test the relationship between managers’ equity intent and the 24-, 36-, and 48-month ahead stock price crash risk. The results are displayed in Table 6. We find that the coefficients of \({EQUITY\_INTENT}_{it}\) remain statistically significant at least on the 5%-level for all four crash variables when employing a 24-month window, and even remain significant on at least 5% for \(NCSKE{W}_{it+3}\) and \(DUVO{L}_{it+3}\) when employing a 36-month window. Even for a 48-month prediction window, the coefficients of \({EQUITY\_INTENT}_{it}\) remain statistically significant on the 10%-level when predicting \(DUVO{L}_{it+4}\). Consistent with the notion that bad news hoarding becomes more difficult to maintain over the course of time the coefficients and their respective t-values of \({EQUITY\_INTENT}_{it}\) steadily decreases with an increasing prediction window, similar the models’ R-squared. Given the decreasing importance of \(EQUITY\_INTEN{T}_{it}\) over time, our results suggest that investors should screen 10-K filings on a yearly basis to obtain better predictions of future crash risk.

Secondly, we examine the association between managers’ equity intent and upward stock price jumps. Our results generally suggest that managers’ equity intent is associated with increasing bad news hoarding behaviour. While a gradual increase of the stock price as a result of managers “hyping up” the firm’s stock price prior to an SEO seems plausible, sudden upward price jumps seem comparably unlikely, as they would indicate positive market reaction following the revelation of unexpected (good) news. In this case, one would expect that \({EQUITY\_INTENT}_{it}\) is associated with future stock price crashes as a consequence of the sudden release of the accumulated negative information, but should either have no, or a negative correlation with upward stock price jumps. Therefore, we decompose the crash risk measure \(COUN{T}_{it+1}\) into stock price crashes and upward jumps and estimate both proxies separately. Unreported results show that \({EQUITY\_INTENT}_{it}\) is only positively associated with stock price crashes and shows a negative correlation with upward jumps, that is statistically significant only at the 10%-level. Similar to the conception of a placebo test, the theoretical consistency of these results suggest that our inferences are unlikely to be driven by unobservable forces.

Thirdly, we construct an alternative measure for our main variable of interest \({EQUITY\_INTENT}_{it}\). Given the usage of neural networks, we acknowledge that the variable is subject to a large parameter space and uncountable interactions between neurons. While our baseline analysis employs the DM model, we next estimate word embeddings using the DBOW model proposed by Le and Mikolov (2014). The DBOW model is generally considered to be less complex compared to the DM model as it only uses the document matrix to predict a randomly sampled set of consecutive words from a document. For the implementation of the DBOW model, we follow the recommendations of Lau and Baldwin (2016) and estimate 300-dimensional document embeddings in 400 iterations over the whole sample of LIQ + CAP sections.²⁴ Similar to our baseline analysis, we use these document embeddings to estimate an equity intent vector and calculate cosine similarities from each LIQ + CAP embeddings to the equity intent vector to derive \(EQUITY\_INTENT{\_DBOW}_{it}\). Table 7 shows the results of estimating our crash risk measures using \(EQUITY\_INTENT{\_DBOW}_{it}\). The results remain virtually unchanged, indicating that our inferences are not merely driven by model and parameter choices.

Fourthly, we include additional control variables to address concerns of omitted variable bias.²⁵ Specifically, we address concerns that managers’ equity intent is merely a reflection of a firm’s risk profile by controlling for additional variables capturing business risks including a firm’s cash flow volatility \(CFVO{L}_{it}\), sales volatility \(SALESVO{L}_{it}\), earnings volatility \(EARNVO{L}_{it}\) as well as the Herfindahl–Hirschman Index based on 3-digit SIC codes \(HH{I}_{it}\) (Giroud and Mueller 2010; Kim et al. 2019). Since our main variable of interest is based on textual data, we also control for textual proxies that prior works found to be significantly associated with crash risk. These include the modified FOG Index \(MODFO{G}_{it}\) proposed by Kim et al. (2019), managers’ usage of ambiguous language measured by the fraction of weak modal words within the MD&A \(WMO{D}_{it}\) and the natural logarithm of a 10-K’s file size in megabytes \(FILESIZ{E}_{it}\) as in Ertugrul et al. (2017).²⁶ Finally, based on the findings of Wu and Lai (2020), we include two additional measures for firm’s inherent information asymmetry, namely, intangible intensity \(ADJROT{A}_{it}\) as suggested by Clausen and Hirth (2016) as well as a firm’s proprietary costs \(PROP\_COS{T}_{it}\) measured as a firm’s R&D expense scaled by total assets and firm age (\(AG{E}_{it}\)). The results displayed in Table 8 show that the coefficient of \({EQUITY\_INTENT}_{it}\) remains statistically significant for all four crash measures, alleviating concerns of omitted variable bias.²⁷

Finally, we test whether earnings manipulation, a common vehicle managers use to hoard bad news (Hutton et al. 2009), serves as another mediator for the effect of equity intent on stock price crash risks. Specifically, one could argue that managers do not only block negative news flow but also engage in more aggressive earnings management to obfuscate financial disclosures. Therefore, in Table 9, we use \(OPAQU{E}_{it}\) as a mediator variable for \(EQUITY\_INTEN{T}_{it}\). “Step 1” of the mediation analysis shows that higher equity intent is associated with higher levels of earnings management, suggesting that managers who search for equity are more likely to engage in earnings management. Similarly, the results of “Step 2” and “Step 3” of the mediation analysis are largely consistent with our baseline analysis, indicating that earnings management serves as a significant mediator for effects of managers’ equity intent on future crash risk. In summary, the above analyses suggest robustness of our finding that managers equity intent incentivises managers to hoard bad news and hence, increases firm-specific crash risk.

Previous research has established the notion that managers are incentivised to strategically withhold negative information from outside investors in order to maximize their own capture of the firm’s cash flows (Jin and Myers 2006; Kothari et al. 2009). Since the accumulation of bad news is limited when further obfuscations become too costly or difficult to maintain, all negative information is released at once, resulting in the firm’s stock price to crash. Given the subsequent destruction of shareholder welfare, the motives for managers to conduct this behaviour has received increasing attention from financial research literature. While incentive-based management compensation, CEO overconfidence (Kim et al. 2016), and overall career concerns (Kothari et al. 2009) have already been identified as motives to obfuscate corporate disclosure, we turn our focus on corporate financing decisions, thus drawing the connection to arguably one of the most important areas of corporate decision making. Capital structure decisions, especially in the case of equity financing. are known for providing agency conflicts between managers and outside investors, which should incentivise managers to obfuscate corporate disclosure.

Further extending the analysis of drivers of bad news hoarding behaviour, we analyse whether the intention to issue equity incentivises managers to strategically withhold negative information to maximize corresponding capital inflow and strengthen their position of power inside the firm. We examine the role of managers’ intentions within the capital structure decisions in shaping firm-specific stock price crash risks, by analysing how managers express the financing needs of their firms in the LIQ + CAP sections of their MD&A. Using neural network embeddings of the LIQ + CAP sections, we identify different degrees of equity intent. Differences in the management’s inclination to raise more equity may lead to different levels of bad news hoarding which in turn may impact firm-specific stock price crash risks. We expect that managers expressing equity intent in the firms’ disclosures are more prone to bad news hoarding behaviour which helps to predict future stock price crash risk of firms. In fact, we find that a firm’s current equity intent has strong predictive power for firm-specific stock price crash risk in \(t+1\). As a central motive for bad news hoarding, equity intent exerts comparable effects on crash risk as other popular obfuscation vehicles. By conducting a mediation analysis, we find that stronger equity intent affects future stock price crash risk through the channel of bad news hoarding. Consistent with this notion, we find that managers’ equity intent incentivises managers to obfuscate financial disclosure by manipulating earnings and writing overly complex reports. Moreover, our results remain robust for wider prediction windows up to three years, alternative measures of equity intent as well as for a diverse set of additional factors that potentially influence stock price crash risk.

This paper contributes to the stock price crash risk literature by describing the mechanisms between management intentions in capital structure decisions and future stock price crash risks. As financing decisions present one of the most essential business activities, our results apply relevance for both investors and a broad scope of corporate decision makers. In addition, our approach fits in with current SEC efforts to use data analytics to uncover EPS manipulation as part of their current policy agenda requiring stronger corporate disclosures to better protect investors.²⁸ In contrast to the rather basic textual information complementing prediction models applied in previous research, our approach holds additional prediction power for stock price crashes as it is sensitive towards various textual cues in management statements within firm disclosures indicative for bad news hoarding. More general, it enables to gauge management intentions from written statements and therefore provides an interesting venue for future research analysing the effects of opportunistic management behaviour on financial market outcomes. For example, using our method to identify managers’ intentions with regards to capital structure decisions, future research may provide a deeper analysis of how manager time the release of good news prior to raising capital (Lang and Lundholm 2010). While this paper suggests that using information retrieval techniques that go beyond simple summarization techniques such as word counts and readability measures, future works may further explore textual cues of bad news hoarding by applying more sophisticated approaches such as named entity recognition techniques, topic models, or word embeddings.