How Adverse Selection and Agency Problems can Effect the Investors Reaction

Abstract Adverse Selection and agency problems are the major areas of Concern for both, the investors, and the corporate governance. Companys good corporate structure can have a positive impact On investors. Our study, with the support of previous studies, tries to prove that the investors are also concerned about the adverse Section and agency problems. This study lacks evidences from the previous researchers regarding the relationship between investors reaction and adverse selection and agency problems. Even then it is a good attempt to study the behavior of investors towards investing in the company where the problems of adverse selection and agency problems are present. Key Words: Investors Reaction, Adverse Selection, Agency Problems, Corporate Governance

Introduction: This paper describes the reactions of the investors to the corporate governance issues with an emphasis on the situation of agency problems and adverse selection. This paper adds to the existing literature of how investor reacts to different corporate governance issues. The idea is that how adverse selection and agency problems can directly or indirectly affect the investors thinking. Corporate governance has an influence on the investors reaction .Many corporate governance issues like board size, outside directors, CEO tenure and other such issues have the impact on investors reaction. Investors can react differently to the situations. Agency problems and adverse selection problems can have a major impact on these situations. Normally agency problems occur when there is a conflict between the board of governance and investors. Adverse Selection problems may also have an impact on the investors reaction. In situation where adverse selection occurs there can be bad relation between the board of governance and investors. This type of situation can occur when the board governors or management try to conceal the information. This may create the bad impression in the investors and they may hesitate to invest.

There has been very limited research on this area. Especially, research is incomplete on the area regarding the investors reaction to the corporate governance issues. Some researchers have done work the investors reaction to the corporate governance issues, but they have not taken into the account the Importance of the agency problems and adverse selection problems .Adverse selection and agency problems have been linked with the stock market ownership ,but it has not been emphasized as a variable that reflects investors reaction. This study is very important because adverse selection and agency problems are the concerned topics for investors and the board of governors. The major focus of the study is to check how investors reaction varies in different corporate governance issues in the presence of problems of agency problems and adverse selection. Since both the agency problems and adverse selection are ignored in the previous studies , therefore this research focuses on these issues. The importance of the topic can be raised by the point that good corporate governance can ultimately reduce the agency problem and adverse section issues. If company has strong governance structure and has better flow of information than it can avoid adverse section problems. This study is also important to find out whether the investors are worried about adverse section problems or not. Previous studies have been done in developing the relations of the corporate governance, agency problems and adverse selection with the investors reaction.Haung and Tompkins in 2010 suggested the model in which they showed the how investors react to different corporate governance issues .Their study has a very important implications .However, they did not check the impact of agency problems and adverse selection issues. This study specifically focuses on these two issues .Both agency problems and adverse selection can have an indirect impact on investors reaction. In the environment where these two problems will exit, there will be a week and ineffective corporate structure and this possibly will affect the investors mind. On the other hand, having strong corporate structure can eliminate the adverse selection and agency problems and this will have a positive impact on investors selection. Research Theory and design: There has been a very limited research on this issue. Huang and Tomkins (2010) discussed that the investor can react positively to the different corporate governance issues like CEO owner ship. While, investors can react negatively, to the presence of outside directors.Thier study also suggested that the strong corporate governance can reduce the agency problems and adverse selection issues.

Becker and Irani (2007) presented that relationship between corporate governance and perceived asymmetric information. It also investigates that how the investors perceive the different matters related to the corporate governance. Becker and Irani also examine the association of between adverse selection issues and good corporate governance. They also found that good corporate governance characteristics can have a better influence on both the company and the investors. Booth et al (1996) examined the relationship between agency problems and effective corporate governance. They argued that regulating the corporate governance may not reduce agency problems. Their study also discussed the degree to which regulations can decrease the impact of managerial decisions on shareholder wealth, effective Monitoring by outside board members, inside director stock ownership, and CEO/ Chair separation turn out to be less significant in scheming agency conflicts. Kim and Purnanandam (2006) explained the investors reaction to SEOs with proxies for adverse selection and agency problems. This paper attempts to assess the, adverse selection problems, and agency problems in explaining investor reaction to SEOs and to separate their joint effects. According to Kim and Purnanandam, investors react negatively when corporate governance sell their share thorough SEO.Investors reaction is slightly positive to managerial equity stakes, because this can reduce the agency problems. According to them Investors react negatively to SEO because of adverse selection problems. Solvin et all (2000) argued that adverse selection problems arise when managers are aware of the shareholders from the outside. They also suggested that adverse section problem is likely to emerge in the case of seasoned equity offerings than right offerings. They also suggested that investors infer to adverse selection problems.

Ness et all (2001) gave five components of measuring adverse selection. They tried to identify the utility of the adverse selection models in measuring information problems, the link between adverse selection mechanism and measures of information asymmetries. They also suggested that the adverse selection models are linked to stock volatility and the existence of knowledgeable traders. Barclay and Hendershott (2004) linked adverse selection with the different trading hours .They argued that the there will be more adverse selection problems during the trading hours than after the trading hours. Sandas (1999) argued that the adverse selection problems can be created by the presences of traders those have the information. He also analyzed how adverse selection can affect the liquidity market. Hellmann and Stieglitz (1998) also discussed
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the impact of adverse section on investors reaction. They analyzed that the investor will invest less if there is the adverse selection issues. Garleanu and Pederson (2003) said in their paper that adverse section can contribute to the trading decisions .They also showed that the adverse selection have the effect on the required returns. Model: Reaction of the investor has been taken as the dependant variable in this model. Corporate governance issues are taken as the independent variables. These corporate issues are chairmans duality, CEO ownership, and presence of outside directors, Director and CEO tenure and Board size. This model has been taken from the paper from the Huang and Tompkins (2010) model which discussed the relation between the corporate governance and investors reaction .They didnt address this relation in means of adverse selection and agency problems. This paper provides two additional variables in this model. These models are agency problems and adverse selection .According to this paper the independent variables that are chairmans duality, CEO ownership, and presence of outside directors, Director and CEO tenure and Board size can create the adverse selection and agency problems which indirectly can influence the investors reaction. Huang and Tompkins (2010) found in their study that Investors react more positively to seasoned equity offerings by firms which have stronger corporate governance mechanism that can ultimately decrease adverse selection or agency problems. Various corporate governance mechanisms which are taken as an independent variable can be used to solve the adverse selection and agency problems. Becker and Irani (2008) argument also support this model that the adverse selection problems have indirect impact on the investors reaction. Booth et all (2001) study also justifies the relationship of corporate governance mechanism and agency problems, and than the impact of this relation on the investors reaction. They argued that role of corporate governance is important in making agency problems. Denis et all (1995) also gave in their study that different corporate governance issues can create agency problems which affect the investors reaction.

CEO Ownership

Chairman s Duality Director and CEO s Tenure Presence of outside Directors Board Size

Adverse Selection Investors Reaction Agency Problems

Figure: Showing the relations showing the impact of Corporate Governance Mechanism on Investor reaction

Hypotheses Development: H1: There is a positive relation ship between CEO owner ship and adverse selection problem. CEO owner ship is very much concerned issue and it is one of the corporate governance mechanisms it can be the reason of the adverse selection problem. H2: There is a positive relation between CEO and Director Tenure and, adverse selection and agency problems. H3: There is a negative relation between Presence of outside directors, and agency problems and adverse selection. H4: There is a positive relation between Board assize and Chairmans Duality, and adverse selection and agency problems. H5: There is negative relationship between adverse selection and agency problems, and investors reaction. The above mentioned hypothesis has some literature evidence .One or two hypotheses have not much literature evidence. Our hypotheses is very much similar to the one which h was addressed by Huang an Tompkins (2010).But they didnt came up with the mediating variables that are used in our paper. They discussed adverse selection and agency problems as concerning issue but didnt mention their relation. Our study came

up with the model that gave two more variables in their exiting model. These variables are mediating variables and are adverse selection and agency problems. There is a direct relation ship between above mentioned corporate governance mechanism and investors reactions .But our model suggests that adverse selection problems and agency problems both can influence their relationship. Like, for instance if there is lack of good corporate governance mechanism, it will lead to create the problems like adverse selection problems and agency problems. And that will further influence the investors reaction. Investor reaction will be negative to this type of the situation. Discussion and Practical Implications: This paper discusses the question that whether investors are worried about adverse selection and agency problem or not? This question cannot be answered only by means of using variables related to the corporate governance mechanism. For this answer there has to be a detailed study .A comprehensives survey of the firms, which sell their shares is needed. For this there should be more than five organizations should be taken. Data collection for this type of query is a difficult task. Because all the forms do not allow one t o access all the private information particularly about the corporate governance issues. But for this study this is needed despite of complexity. Questioner will be prepared for getting the investors point of view about their behavior towards the adverse selection and agency problems that are cause d by corporate governance weakness. The aim of this study to check the behavior of the investors towards purchasing the shares .There has been a lot of study on the reaction of the e investors on different issues related to the stock exchange but issues related to corporate governance lack the attention of the researchers. This study has an implication in practical life. It provides evidence that have a stronger board structure; companies can attract more investors to purchase the shares of the company. There are also evidences that adverse selection and agency problems can be reduced if company is having a stronger corporate mechanism. Conclusion and Future Research: This study considered different corporate governance variables which can affect the investors reaction. Two mediators, adverse selection problems and agency problems are also added to the exiting model of Hunag and Tompkins (2010).Previous studies found that investors reaction can vary with the type of corporate governance which a
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company has. While our study enhances the relationship between corporate governance mechanism and investors selection .This study gives the evidences that weaker corporate governance mechanism can result in creating problems like adverse selection and agency problems which further can influence the investors reaction. There are also few limitations in this study .It does not mention the complete corporate governance variables. It only discusses few variables. Secondly this study can have more practical implications if financials variables like market capitalization, total debt ratio, return volatility etc are also considered as dependent variables. So there is an opportunity for the researchers to further more enhance this study by focusing the above mentioned limitations. A good study can be done if some more variables of corporate governance and financials variables are taken.

References:

Rongbing Huang & James G. Tompkins (2010). Corporate governance and investor reactions to seasoned equity offerings. Managerial Finance, 36: pp. 603-628. John R. Becker-Blease & Afshad J. Irani (2008). Do corporate governance attributes affect adverse selection costs? Evidence from seasoned equity offerings. Rev Quant Financial Accounting, 30: pp 281296. E. Han Kim & Amiyatosh Purnanandam (2006).Why Do Investors React Negatively to Seasoned Equity Offerings? Ross School of Business Working Paper Series, 1043. Nichalae Gerleanu & Lesse Hedge Pederson (2004).Adverse Selection and Required return. The Review of financial studies, 17: pp 644-665 Shane A. Corwin (2003). The Determinants of Under pricing for Seasoned Equity Offerings. Journal of Finance, 58(5): pp 2249-2279 James R. Booth Marcia Millon Cornett B & Hassan Tehranian (2002). Boards of directors, ownership, and regulation. Journal of Banking & Finance, 26: pp 19731996 M.B.Solvin, M.E.Shuska & K.W.L.Lai (2000). Alternative Floatation method, adverse selection and ownership structure: Evidence from seasoned equity issuance in UK .Journal of Financial Economics, 57: pp 157-190.
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Bonnie F. Van Ness, Robert A. Van Ness, & Richard S. Warr (2001). How Well Do Adverse Selection Components Measure Adverse Selection? Financial Management .pp 5 30. Thomas Hellmann &Joseph Stieglitz (2000). Credit and equity rationing in markets with adverse selection. European Economic Review, 44: pp 281-304 Patrik Sandis (1999). Adverse Selection and Competitive Market Making: Empirical Evidence from a Pure Limit Order Market. The Rodney L. White Center for Financial Research.