Byungjin Kwak, Byung T. Ro, and Inho Suk
The composition of top management with general counsel and voluntary information disclosure
Journal of Accounting and Economics | Volume 54, Issue 1 (Aug 2012), 19–41

Many firms have in-house legal counsel or an internal legal department as part of their organizational structure. The chief counsel, called General Counsel (GC) or Chief Legal Officer (CLO), plays important roles as an internal advisory and monitoring mechanism for top management. For many firms, the demand for legal expertise and experience is high and increasing as their business environments become more complex and litigious. Thus, firms often have a GC in top management to take advantage of his (her) legal expertise (43% of our sample firms).

GCs play two basic roles: (a) advising Chief Executive Officers (CEOs) and boards of directors on important business decisions and contracts, regulatory compliances, legal matters, and litigation risk (among others), and (b) monitoring CEOs' unusual behavior against shareholders' interest. The advisory role of GCs varies across firms. While such advisory services may be obtained from external lawyers, CEOs prefer in-house lawyers because these lawyers understand their firms better, are more trustworthy, and serve as an effective vehicle for dealing with outside counsel (the ACCA-Spherion survey, 2001).

GCs' monitoring role is also important. The American Bar Association Task Force on Corporate Responsibility (March 2003) reports that corporate legal counsel is one of the four most important private sector governance mechanisms for public firms, along with boards, audit firms, and shareholders (institutional investors in particular). (Some believe that recent corporate accounting scandals were due partly to the failure of GCs (or in-house counsel) to play an effective role. For example, Bainbridge-Johnson (LawRev 2004) argue that lawyers often act as facilitators of management impropriety.) For corporate information disclosures, this means that GCs help top management make fair and full disclosure on a timely basis, in order to protect shareholders' interest. (The Sarbanes-Oxley Act (SOX) of 2002 emphasizes the importance of in-house counsel as an internal governance mechanism for transparent financial reporting to investors.)

Hypotheses

Despite the key role of GCs for information disclosure, it is not clear in reality whether they serve the interest of top management or shareholders when there is a potential conflict of interest between managers and shareholders. Our study examines whether the presence of a GC in top management is related to the disclosure of management earnings forecasts(MFs). (We focus on MFs, since MFs are perhaps the most common form of firms' voluntary information and are frequently associated with litigation risk, which is related to the role of GCs. Johnson-Nelson-Pritchard (JLEO 2007) find that forecast-related allegations in lawsuits are more common than accounting fraud and insider trading allegations before the Private Security Litigation Reform Act (PSLRA) of 1995 and about equally common even after the PSLRA, despite the safe harbor rule.) If the GC in top management plays an effective role as a voluntary internal governance mechanism on behalf of shareholders, he is likely to help his firm reduce information asymmetry with shareholders and make fair and transparent voluntary disclosures, including MFs. Therefore, our first hypothesis is:

Firms with a general counsel in top management are more likely to provide management earnings forecasts and do so more frequently than other firms.

Prior research shows that managers have legal and reputational incentives to voluntarily preempt effects of bad news MF or negative earnings news, in order to reduce litigation risk (Skinner (JAR 1994), Skinner (JAE 1997)). We argue that such incentives are particularly strong for a GC because minimizing litigation risk is one of his primary duties. Also, he has an incentive to build a good reputation as an effective advisor and monitor and serve his own interest (e.g., compensation, job security, and reputation). Thus, if the likelihood and frequency of MF disclosure are higher for firms with a GC in top management, this tendency should be more pronounced for bad than good news forecasts. Our second hypothesis concerns this proposition:

The likelihood and frequency of bad news forecasts, relative to good news forecasts, is higher for firms with a general counsel in top management than for other firms.

If a GC in top management plays an effective governance role, he will advise top managers to issue fair and credible MFs. Also, he will know that any MF issued opportunistically may not be credible, or may even be misleading, which can trigger lawsuits against the firm. This is particularly true for forward-looking information such as MFs, since they are not formally audited by an external auditor. (Grundfest-Perino (1997) report that about 65% of all alleged corporate fraud cases filed by shareholders during 1996 (one year after the PSLRA) was because of some false or misleading forward-looking information disclosed by firms and that 14% of those cases were involved in forward-looking information only.) For these reasons, we posit that MFs issued by firms with a GC in top management are more accurate and less biased than those issued by other firms. This is consistent with the notion that strong governance can deter or reduce managers' opportunistic disclosure behavior, which in turn reduces the likelihood of shareholder lawsuits and lawsuit damages. Thus our third hypothesis is:

Management earnings forecasts issued by firms with a general counsel in top management are likely to be more accurate and less optimistically biased than forecasts issued by other firms.

If the forecasts issued by firms with a GC in top management are more credible (i.e., less biased and more accurate), the market will perceive them to be of high quality. Therefore, the stock price reaction per unit of MF news is likely to be stronger for such firms than for other firms. This is consistent with the notion that strong governance increases the credibility of forecasts and induces stronger stock price reaction to a given level of news in MF. This is our fourth hypothesis:

The stock price reaction to management earnings forecast disclosure is stronger for firms with a general counsel in top management than for other firms.

Frequency of management earnings forecasts (MFs)

The tables report the multivariate regression results for H1–H4. (For brevity, the results for the control variables included are not reported here (and hereafter). The original models include control variables such as board independence (OUTBOD), CEO duality (CEOCOB), insider ownership (INSDOWN), institutional ownership (INSTOWN), firm size (LSZ), book-to-market ratio of equity (LMB), change in return on asset (CROA), earnings volatility (EVOL), return volatility (RVOL), new share issuance (ISSUE), and analyst following (NAF).)

1: Management Earnings Forecast (MF) likelihoods (MFD)
Any Bad news Good news Good/bad news
Intercept –3.99*** –4.93*** –3.73*** –1.23
General Counsel (GC) 0.33*** 0.41*** 0.13*** 0.17***
PrLitig –0.10** -0.01 –0.29*** 0.15***
GC×PrLitig 0.61*** –0.15** 0.32**
Controls Yes Yes Yes Yes
#obs 20,478 20,478 20.478 7,903
Pseudo R2 23% 24% 21% 20%
One, two, and three stars mark statistical significance at the 10%, 5%, and 1% level, respectively.

Table 1 shows the results for MF likelihood from logistic regressions (models 1-4) and MF frequency from Poisson regressions (models 5-8), after adjusting two-way (firm and year) cluster-robust standard errors. The results in column 1 are for H1, the case in which the likelihood of MF disclosure (MFD) is the choice variable and the variable of interest is GC. The estimated coefficient on GC is significant with the predicted (positive) sign (0.33), suggesting that GC firms are more likely to issue MFs than non-GC firms. This supports H1. The marginal effect of GC is 0.24, indicating that the probability of a firm issuing an MF is 24% higher for GC firms than for non-GC firms. Columns 2 and 3 report results from separate analyses for the likelihood of good and bad news MF issuance. While the estimated coefficients on GC are positive for both bad (column 2) and good (column 3) news, it is much larger for bad news. Results for the direct comparison between bad news and good news MF likelihood (using the sample only with good and bad news MF years) show that the coefficient on GC is significantly positive (column 4), indicating that the positive impact of GCs in top management on MF likelihood is stronger for bad than good news forecasts. This supports H2. The interaction variable GC×PrLitig is also significantly positive (column 4), indicating that the positive role of GCs on the likelihood of bad relative to good news MFs increases with ex ante litigation risk.

Test results for MF bias and accuracy

H3 concerns the bias in and the accuracy of MFs. Table 2 reports the OLS regression results. The results for MF bias (columns 1-2) show that the coefficients on GC are significantly negative (–0.0012), indicating that MFs issued by GC firms are less optimistic (more conservative) than those issued by non-GC firms. The coefficient on PrLitig is negative and significant in both columns, indicating that the optimistic bias in MFs decreases in ex ante litigation risk. The coefficient on GC×PrLitig is significantly negative in column 2, suggesting that the negative impact of GCs in top management on forecast bias is more apparent when litigation risk is high.

2: Management Earnings Forecast (MF) bias and accuracy
MF Bias (MFB)×100 MF Error (MFE)×100
Intercept 0.29 0.29 0.28 0.28
General Counsel (GC) –0.12*** –0.12*** –0.18*** –0.18***
PrLitig –0.15*** –0.10*** –0.19*** –0.12***
GC×PrLitig –0.08*** –0.10***
Controls Yes Yes Yes Yes
# of obs. 7,924 7,924 7,924 7,924
Pseudo R2 0.29 0.31 0.22 0.26
One, two, and three stars mark statistical significance at the 10%, 5%, and 1% level, respectively.

The regression results for MF accuracy are shown in columns 3-4. The estimated coefficients on GC are significantly negative. Thus, absolute MF errors are reliably lower on average and thus MFs are more accurate for GC firms than for non-GC firms. The coefficient on PrLitig is significantly negative in both columns, indicating that MF accuracy is increasing in ex ante litigation risk. The coefficient on GC×PrLitig is significantly negative (column 4). Thus, the impact of GC on reducing MF errors becomes more pronounced as litigation risk increases. Together, the results in panel B are consistent with H3.

Test results for market reaction

H4 posits that the stock price reaction to MF surprise is stronger for GC firms than for other firms. Table 3 reports the OLS regression results. The estimated coefficients on MFSUR (MF surprise) are significantly positive, consistent with prior evidence (e.g., Skinner (JAR 1994); Kasznik-Lev (RAS 1995); Kothari-Shu-Wysocki (JAR 2009)). The coefficient on GC×MFSUR is also significantly positive (column 1), indicating that the price reaction to per unit of MF news is stronger for GC firms than for non-GC firms. This supports H4.

3: Stock market reaction to Management Earnings Forecast (MF)
Intercept –0.04*** –0.03*** –0.03***
MFSUR 0.69*** 0.50*** 0.44***
GC×MFSUR 0.35*** 0.33*** 0.54***
PrLitig×MFSUR –0.65*** –0.89***
GC×PrLitig×MFSUR 0.65**
GC 0.00 0.00 0.00
PrLitig –0.01** –0.005 –0.004
GC×PrLitig 0.002 0.003
Controls Yes Yes Yes
# of obs. 7,802 7,802 7,802
Adj. R2 0.0611 0.0655 0.0679
One, two, and three stars mark statistical significance at the 10%, 5%, and 1% level, respectively.

However, the equity market appears to be concerned about litigation risk. The coefficients on PrLitig×MFSUR are negative (columns 2 and 3), suggesting that litigation risk weakens the price reaction to MF surprise. The coefficient on GC×PrLitig×MFSUR is significantly positive (0.654), suggesting that the positive role of GCs in strengthening the price reaction to MF surprise is more apparent when litigation risk is high. It is interesting that the coefficient on PrLitig×MFSUR is more negative (–0.885) in column 3 than in column 2. Thus, the weaker price reaction related to PrLitig (i.e., the negative price reaction captured by PrLitig×MFSUR in column 2) is more apparent for non-GC firms (β3) but is greatly mitigated for GC firms (β3 + β4 =  – 0.23). Thus, while the market appears to be concerned about firms' litigation risk involving MF disclosure, this concern is greatly alleviated if firms have a GC in top management. We interpret these results, along with the results for MF accuracy and bias, as evidence that the market appreciates the role of GCs in helping their firms issue high-quality forecasts and reduce litigation risk.

Summary and conclusions

Our results show that the likelihood and frequency of MF disclosure are higher for firms with a GC in top management (GC firms) than for other (non-GC) firms, suggesting that GC firms more likely issue MFs, particularly bad news MFs. The forecasts issued by these firms are less optimistic and more accurate than those issued by non-GC firms. The price reaction to MF news is stronger for GC firms than for non-GC firms. Together, the results suggest that GCs as a voluntary internal advisory/governing mechanism play an important role for their firms in making fair MF disclosure. They also suggest that the equity market recognizes the role of GCs for MF disclosures.


13-genji
Unknown: Section from `Tale of Genji Painting Scroll (E-maki)'. Japan, Heian Period, 12th Century.. Empress Akiko and her lady-in-waiting Murasaki Shikibu know the ins and outs of court life. There was no Hollywood or Bollywood in 12th-Century Japan, but she writes an absorbing account of the court rituals—both the hidden and the open. Her Tale of Genji, considered world's first novel, is an intriguing and absorbing read even today. Her Tale of Genji was a frequent source of inspiration for the art of E-maki, picture scrolls. Only some sections of this one survive in the Tokugawa Art Museum and Gotoh Museum in Japan, but they are enough to illustrate the vibrant colors, expressive details, and cultural significance of the E-maki art. They resemble an illustrative comic book novel—possibly a predecessor of Manga.