Essays in corporate governance and capital markets

Despite the best efforts of academics and regulators alike, issues in corporate governance continue to manifest themselves in the worst ways possible. From the destructive fraud at WorldCom to recent frauds involving hedge funds, from here in the United States to the Satyam episodes in India, failures of corporate governance have continued to lead to periodic episodes of fraud on a staggering scale.;This dissertation attempts to understand the mechanisms underlying the relationship between corporate governance and corporate fraud. The first chapter, "Corporate Governance Spillovers," argues that failures of corporate governance at one firm may strengthen incentives for managers at other firms to misbehave when payoffs are based on relative performance evaluation (RPE). I analyze this problem in the context of earnings manipulation using a two-firm dynamic stochastic game where imperfect governance allows managers to manipulate the RPE metric. Weak governance at one firm "spills over" and amplifies the incentive for the competing manager to counterbalance aggressive manipulation with his own manipulation. The model predicts that (i) managers have an incentive both to catch up and stay ahead in relative performance, that (ii) in equilibrium, these two effects feed back into higher manipulation at both firms, so that manipulation is motivated by the fact that "everybody is doing it," that (iii) these feedbacks are strong in industries where the tolerance for relative underperformance is small, and that (iv) industry-average manipulation is increasing in the dispersion of governance.;The second chapter, "Corporate Governance Spillovers: An Empirical Analysis," provides empirical evidence consistent with these implications. Using data on restatements, estimated earnings manipulation, and measures of governance, I find evidence that firms manipulate when lagging in relative performance, and some, albeit weaker, evidence that firms also manipulate when leading in relative performance. I also find that manipulation is clustered in highly competitive industries, where the tolerance for underperformance is small, and that manipulation is sensitive to the governance of a firm's closest competitors. Although the methodology does not permit causal inference, the evidence is consistent with the implication that a few "bad apples" can lead to increased misbehavior at other firms.;The third chapter, "Do Capital Market Frictions Affect Corporate Policies? A Study in S&P 500 Index Addition," studies whether changes in capital market conditions affect managerial behavior and corporate policies. By studying whether capital markets affect managers, the goal of the chapter is to lay the foundation for future work that studies the extent to which capital markets discipline managers. This chapter itself studies investment-cash flow sensitivity, and finds that this sensitivity decreases after S&P 500 index addition. Cash-cash flow sensitivity decreases, but weakly. Given that S&P 500 index inclusion is associated with abnormal returns, a lower cost of capital and improved liquidity, the results suggest that capital market frictions do affect corporate policies. However, the results present a new puzzle in light of the fact that existing theory suggests that these firms should not be sensitive to capital market frictions because they are large, financially healthy firms who are unlikely to be systematically financially constrained. In this sense, the paper finds that capital market frictions matter to firms to whom existing theory predicts it should not matter.;By studying issues in corporate governance and issues in the interactions between corporate policies and capital markets, I hope this dissertation leads to more, exciting future work that will influence how we understand governance and financial markets so that we may, in the future, avoid the frauds and disasters we have seen in this decade.