Stock Price Response to Non- and Deferred Prosecution Agreements

Wulf Kaal

In response to perceived corporate governance shortcomings in major U.S. corporations, the U.S. Department of Justice, starting in 2002, substantially increased the execution of non- and deferred prosecution agreements (N/DPAs). High profile N/DPAs and plea agreements executed in 2012 and 2014 suggest that the DOJ – not judges or the legislature – through its targeting of certain industries, is effectuating large-scale corporate governance changes. The companies subject to NDPAs are among the largest domestically and worldwide, including Johnson & Johnson, KPMG, HSBC, JPMorgan Chase, Deutsche Bank, ABN Amro Bank, Barclays Bank, Credit Suisse, Fannie Mae, Freddie Mac, General Reinsurance, Lloyds TSB, Metropolitan Life Insurance, UBS, and Wells Fargo. The collective market capitalization of U.S. financial corporations that are subject to NDPAs exceeds $690 billion and exceeds over $20 trillion in assets under management.

The controversy surrounding N/DPAs is bitter and well defined. Because historically corporate governance fell under state law, some scholars question the DOJ’s authority to expand and police corporate governance without a proper mandate. Judge Rakoff critiqued the use of N/DPAs and the DOJ’s focus on corporate prosecutions as morally and technically suspect. Others decry N/DPAs as overly burdensome, the result of significantly unequal bargaining power between the prosecutor and the corporation, subject to prosecutorial abuse, and unsuitable because of the lack of prosecutors’ governance expertise. Despite the broad critique of N/DPAs, consensus exists among scholars that N/DPAs influence corporate governance.

To date, very few studies have empirically assessed the role of N/DPAs in financial markets. The largest study to date, finds evidence that the execution of N/DPAs is associated with significant corporate governance changes in the following categories: (1) Business Changes, (2) Board Changes, (3) Senior Management, (4) Monitoring, (5) Cooperation, (6) Compliance Program, and (7) Waiver of Rights. This is the first study that examines stock price reactions to N/DPAs. This is the first study that examines stock price reactions to N/DPAs. Our hand-selected dataset comprises all institutions that executed N/DPAs from 1993 to 2014 (N=301) and are publicly traded (N=94). While our dataset includes the celebrated N/DPAs in Johnson & Johnson, KPMG, HSBC and AIG and other cases of substantial governance shortcomings, most N/DPAs in our sample received no or very little media and scholarly attention. N/DPAs in our sample are predominantly the result of DOJ investigations after corporate criminal wrongdoing such as kickback schemes (i.e., violations of the FCPA), were identified. N/DPA governance data used in this study was hand-selected and coded by Kaal and Lacine, and expanded for purposes of this study.

We examine investor responses to three events that define N/DPAs and N/DPA mandated governance improvements, specifically, the official DOJ press release announcing the execution of an N/DPA, the date of the start of the term of the N/DPA, and the date of the end of the term of the N/DPA. We document a significant and predictable positive stock price response to the DOJ press release and the start of the N/DPA term. Our tests indicate that the market interprets the three events not in isolation but as sequential and conditional events. We observe no systematic price momentum beyond the three core dates identified in our study, implying that the market is reasonably efficient with respect to information about N/DPAs. Our results are robust to alternative procedures and definitions.

While other interpretations of market responses are certainly possible, we believe most evidence supports the following interpretations: The positive market reaction to announcements of N/DPAs and to N/DPA governance improvements at the beginning of the N/DPA term suggest that the DOJ’s increase in N/DPA executions, starting in 2002, could be justified. The positive market reaction on the date of DOJ announcement of the N/DPA execution and on the date of the beginning of the N/DPA term appears to be the market’s acknowledgement that the execution and effectiveness of an N/DPA is an opportunity for the entity to be better managed, more compliant, with fewer possibilities to incur penalties and overall less litigation, lowering costs and resulting in higher profitability and corresponding increases in market value. In turn, we interpret the negative market reaction at the end of the N/DPA term as the market’s acknowledgment that post N/DPA term expiration suboptimal governance practices are likely to resume and are associated with higher costs and lower market value for the respective entity.

We interpret the positive market reaction at the beginning of the N/DPA term and its negative reaction at the end of the N/DPA term as evidence that governance changes mandated by N/DPAs matter. The market assesses the governance changes during the term of the N/DPA as beneficial for market value because it effectively addresses corporate wrongdoing and the associated negative effects on goodwill and reputation while lowering the likelihood of continuing fines and litigation. We interpret the negative market reaction at the end of the N/DPA term as evidence that investors see the expiration of the N/DPA term and the expiration and following unenforceability of associated governance improvements as a negative event for the respective entity.

Several limitations in this study seem to suggest that additional research may be required to fully investigate the impact of N/DPAs and the associated governance improvements. It is possible that our results are skewed towards N/DPAs that had a relatively low impact on the respective entity. Because of lacking public trading data, we had to remove those firms subject to N/DPAs that were acquired, merged or went bankrupt as a result of the N/DPA execution. N/DPAs that caused mergers etc. have the highest impact on the respective entities. We did not find evidence in our sample that would suggest the timing of N/DPA execution resulted in mitigating the effect of N/DPAs, e.g. by announcing it with other news at the end of the quarter. The findings of this study are based on a small sample size and limited data. As more publicly traded companies are subjected to N/DPAs, we may expand this study with a larger dataset.

The preceding post comes to us from Wulf Kaal, Associate Professor at the University of St. Thomas School of Law. It is based on his recent article with Tim Lacine, Associate Professor at the Minnesota School of Business-Rochester, which is entitled “Stock Price Response to Non- and Deferred Prosecution Agreements” and is available here.