A Critique of the Agency Theory Viewpoint of Stock Price Crash Risk: The Opacity and Overinvestment Channels
| Published date | 01 October 2023 |
| Author | Panayiotis C. Andreou,Neophytos Lambertides,Marina Magidou |
| Date | 01 October 2023 |
| DOI | http://doi.org/10.1111/1467-8551.12693 |
British Journal of Management, Vol. 34, 2158–2185 (2023)
DOI: 10.1111/1467-8551.12693
A Critique ofthe Agency Theory Viewpoint
ofStock Price Crash Risk: The Opacity and
Overinvestment Channels
Panayiotis C. Andreou,1,2 Neophytos Lambertides1
and Marina Magidou3
1Department of Finance, Accounting and Management Science, Cyprus University of Technology, Limassol,
3036, Cyprus, 2Durham University Business School, Durham University, Durham, DH1 3LB, UK, and 3School
of Business and Management, University ofCentral Lancashire, Larnaka, 7080, Cyprus
Corresponding author email: panayiotis.andreou@cut.ac.cy
This study documents a puzzling historical trendin crash risk for US-listed rms: between
1950 and 2019, the rm-year occurrences of idiosyncratic stock price crashes rose from
5.5% to an astonishing 27%. The vastness of the literature notoriously attributes crashes
to agency reasons, i.e. self-interested executives who strategically camouage bad news
via the nancial reporting opacity and overinvestment channels. Nonetheless, we docu-
ment that the opacity– and overinvestment–crashrelations are non-signicant, especially
in the period following the enforcementofthe Sarbanes–OxleyAct. The statistically non-
signicant relations are also witnessed in tests that account for the effect of equity-based
compensation incentivesandcorporategovernance functions. Overall, this studycriticizes
the efcacy of opacity and overinvestment as channels in explaining crash risk. Our con-
clusions offer avenues for future researchto pursue in rationalizing the puzzling surge in
stock price crashes.
Introduction
A stock price crash features a low-probability
event that produces a large, negative outlier in
the distribution of idiosyncratic returns. The
relation between crash risk and its determinants
−more importantly, the underpinning channels
that mediate this relation −has attracted a lot
of attention over the last decade and remains a
burgeoning research area. A voluminousliterature
postulates an agency-driven hoarding of bad news
mechanism, whereby self-interested managers op-
portunistically exploit information asymmetries
to conceal adverse information and engage in
short-sighted price maximization at the expense
of shareholders. This literature theorizes that the
hoarding of bad news is manifested through two
prominent channels, namely nancial reporting
opacity and overinvestment (e.g. Hutton, Marcus
and Tehranian, 2009; Kim, Li and Zhang, 2011a;
Callen and Fang, 2013, 2015b; Andreou et al.,
2016; Kim and Zhang, 2016; Andreou et al., 2017).
Our study provides evidence to suggest that
these two channels play a limited role in explain-
ing stock price crashes. For instance, the incidence
of stock price crashes for the CRSP–Compustat–
Execucomp universe presents an astonishing
increase from 17% in 2009 to 27% rm-year oc-
currences in 2019. Yet, for the same period, we wit-
ness an attenuation of about −19% in the levels of
opacity and −24% in the levels of overinvestment.
This puzzling surge in stock price crashes becomes
more perplexing if one considers that in the last
two decades,there has also been an upsurge ofcor-
porate governance regulations to combat manage-
rial opportunism and protect shareholder welfare
© 2022 The Authors.British Journal of Management published by John Wiley & Sons Ltd on behalf ofBritish Academy
of Management.
This is an open access article under the terms of the Creative Commons Attribution-NonCommercial-NoDerivs Li-
cense, which permits use and distribution in any medium, provided the original work is properly cited, the use is non-
commercial and no modications or adaptations are made.
A critique of the agency theory for crash risk2159
(Bhagat and Bolton, 2013; DeFond and Zhang,
2014; Gayle, Li and Miller, 2022; Wintoki, 2007).1
To date, explanations for idiosyncratic crashes
generally fall in two broad categories: nancial
market explanations and rm-specic explanations.
The focus of nancial market explanations,as por-
trayed in Hong and Stein (2003), is on the in-
vestor’s perspective. In a nutshell, they theorize
that in the presence of short-sale constraints faced
by at least some investors, disagreements among
investors over a rm’s fundamental value lead to
higher crash risk. This rigorous theory has never-
theless received limited attention in the literature
(e.g. Chang et al., 2022; Lobo et al., 2020).
The strand of the literature using rm-specic
explanations primarily builds upon the agency
models of Jin and Myers (2006) and Benmelech,
Kandel and Veronesi (2010), which, respectively,
theorize opacity and overinvestmentas the channels
that managers strategically exploit to camouage
bad news.2
In terms of the opacity channel, Jin andMy-
ers (2006) argue that information asymmetries,
compounded by investors’ incompletely secured
property rights, enable managers to accumulate
bad news. Financial reporting opacity offers man-
agers opportunities to disguise bad news through
earnings management manipulations. The more
opaque the rm, the greater the amount of hidden,
rm-specic bad news that may arrive at a given
time. While managers have incentives to stockpile
adverse economic fundamental information about
the rm, their capacity to conceal bad news is not
unlimited; when the accumulated negative infor-
mation crosses a tipping point, adverse informa-
tion comes out all at once, which leads to a stock
price crash.
1These include the Regulation Fair Disclosure of 2000,
the Sarbanes–Oxley Act of 2002, the Dodd–Frank Act of
2010 and the Corporate Governance Reform and Trans-
parency Act of 2017.
2He and Ren (2022) suggest that default risk is related
to bad news hoarding and propose it as a separate chan-
nel that explains crash risk. In the same spirit, Andreou,
Andreou and Lambertides (2021) provide evidence sup-
porting a positive distress–crash risk relation, which is
consistent with an agency explanation for the impact of
the probability of default on crashes. While our focus is
on the relation between opacity, overinvestment and fu-
ture crashes,our regression analysis explicitly controls for
potential confounding effects associated with a rm’s de-
fault risk.
In terms of the overinvestment channel, Ben-
melech, Kandel and Veronesi (2010) argue that
CEOs exploit information asymmetries to mani-
fest self-interested behaviour by persistently hid-
ing bad news through overinvestment. Specically,
when the growth rate of investment opportuni-
ties starts to decline, concerns abouttheir personal
wealth can incentivize CEOs to conceal adverse
outcomes from shareholders. Likewise, Bleck and
Liu (2007) argue that managers in more opaque
nancial markets are able to keep unprotable
projects by hiding their poor performance with
the aim of realizing greater compensation. Ergo,
CEOs do not reveal adverse fundamental infor-
mation in a timely fashion to retain investor ex-
pectations and, by extension, the level of stock
price. The overinvestment-related bad news hoard-
ing continues until the rm’s managers lose the
ability or incentive to conceal it any more. The ac-
cumulated bad news is then released all atonce, re-
sulting in a stock price crash.
The studies focusing on rm-specic explana-
tions have clearly lionized the crash risk litera-
ture. To demonstrate this, we have conducted a
qualitative meta-analysis of 94 papers published
since 2009 in prestigious journals (for details,
see the Internet Appendix), which merely demon-
strates the over-reliance of the extant literature on
agency theory. Figure 1 illustrates the cloud of key-
words that these papers quote on their rst page.
The most frequently used keywords are ‘corpo-
rate governance’, ‘information asymmetry’, ‘earn-
ings management’, ‘managerial opportunism’, ‘in-
formation environment’, and so on, all of which
underlie important aspects of agency theory per-
taining to opacity.Further, Figure 2 illustrates that
about 90% of these papers explore agency theory
in their investigations. Specically, 66% of them
motivate their investigation through opacity, 3%
through overinvestment and 11% simultaneously
rely on both opacity and overinvestment.3Also,
another 11% justify their ndings through a gen-
eral agency-related context, without specifying the
channel. Interestingly, about 85% of these 94 pa-
pers havebeen published since 2016 using data that
3The increased interest of researchers in stock price
crashes in the last two decades might be attributed to the
wide coverage of corporate scandals, such as Enron’s col-
lapse in 2001. It is highly likely that such scandals com-
ing to light steered the attention of the literature towards
rm-specic explanations, particularly the opacity chan-
nel, which involves earnings managementpractices.
© 2022 The Authors.British Journal ofManagement published by JohnWiley & Sons Ltd on behalfof British
Academy of Management.
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