Does the presence of executives with a legal background affect stock price crash risk?

• Published date: 01 January 2023
• Author: Can Huang,Kung‐Cheng Ho
• Date: 01 January 2023
• DOI: http://doi.org/10.1111/corg.12435

ORIGINAL ARTICLE

Does the presence of executives with a legal background

affect stock price crash risk?

Can Huang

1

| Kung-Cheng Ho

2

1

School of Management, Guangdong

University of Technology, Guangzhou, China

2

School of Finance, Zhongnan University of

Economics and Law, Wuhan, China

Correspondence

Kung-Cheng Ho, School of Finance, Zhongnan

University of Economics and Law, Wuhan,

China.

Email: kcho731101@163.com

Funding information

Natural Science Foundation of Guangdong

Province, Grant/Award Number:

2018A030310572; Soft Science Project of

Guangdong Province, Grant/Award Number:

2020A1010020036; National Natural Science

Foundation of China, Grant/Award Numbers:

71903199, 71902040; Innovation and Talent

Base for Digital Technology and Finance,

Grant/Award Number: B21038; NSSFC,

Grant/Award Numbers: 19ZDA061, 19AJY027

Abstract

Research Question/Issue: Executives with a legal background have superior knowl-

edge of the law compared with executives who do not have such a background. This

study investigates how executives who are well informed of the law can reduce stock

price crash risk and how this is significant from a corporate governance perspective.

Research Findings/Insights: We collected and evaluated 23,031 firm-year observa-

tions from 2008 to 2018, which resulted in the following findings: (1) Executives with

a legal background can effectively reduce stock price crash risk. (2) When the comp-

any's external or internal supervision is weak, the effect of executives with a legal

background in reducing stock price crash risk is particularly prominent. (3) The execu-

tives' ability to reduce stock price crash risk is particularly conspicuous when the

company's intention to hide bad news is low or when there is a high risk of the bad

news being leaked.

Theoretical/Academic Implications: Stock price crash risk is a critical problem to

address in the Chinese capital market. The prevailing explanation for crash risk

emphasizes executives' concealment of bad news as a primary factor. Since the sup-

pression of bad news by company executives is the main reason for stock price crash

risk, observing the influence of executives on this risk is a viable direct approach.

Executives with a legal background, in particular, have a critical influence on compa-

nies. They possess a superior understanding of the law compared with those who do

not have such a background and are more willing to respect and abide by the law. As

a result, they have a lower tolerance for inappropriate acts by the executive team,

namely, concealing bad news, which reduces the risk of stock price crash.

Practitioner/Policy Implications: In China, the world's largest transitional economy,

investor protection and information environments are still developing. Countries with

less developed regulations can adopt substitutive mechanisms, such as making the

employment of executives with a legal background mandatory, to facilitate the

healthy development of their capitalist markets. Given the capacity of these execu-

tives to reduce stock price crash risk, thereby supporting continuous and stable

development of the capital market, regulatory authorities should encourage listed

companies to hire executives with a legal background. Furthermore, they should also

start in-depth promotion of and education on the rule of law among employees to

improve their legal competence.

Received: 23 July 2020 Revised: 18 February 2022 Accepted: 18 February 2022

DOI: 10.1111/corg.12435

Corp Govern Int Rev. 2023;31:55–82. wileyonlinelibrary.com/journal/corg © 2022 John Wiley & Sons Ltd 55

KEYWORDS

corporate governance, stock price crash risk, executive characteristics, executives with a legal

background

1|INTRODUCTION

A stock price crash may occur when bad news about a listed com-

pany that its executives have concealed accumulates to a point

where it can no longer be hidden and is suddenly exposed to the

market, resulting in a slump in company stock price. Stock price

crash risk can negatively influence the stability of the development

of the capital market in the long term. For example, Chinese sea-

food producer Zoneco (Shenzhen Stock Exchange: 002069) delayed

reporting various massive scallop wipeouts that led its stock price

to crash, causing tremendous losses to its large base of investors.

The main reason for this stock price crash was the concealment of

bad news by Zoneco executives that was ultimately revealed to

the public. Therefore, in February 2018, Zoneco was investigated

by the China Securities Regulatory Commission (CSRC) for its fail-

ure to disclose relevant information as instructed by the law. This

example shows that it may be important to investigate how execu-

tives of listed companies can be restrained from hiding bad news,

thus potentially reducing stock price crash risk in the capital

market.

In China, the world's largest transitional economy, investor pro-

tection policies and information environments are still developing.

Countries with less-developed regulations can adopt substitutive

mechanisms, for instance, mandating the employment of executives

with a legal background and education on the rule of law for

employees to improve their legal competence, to facilitate the healthy

development of their capital markets. Therefore, China is an ideal

experimental environment for investigating the effects of substitutive

mechanisms on investment returns.

Most previous studies have explored how monitoring of execu-

tives affects the risk of stock price crash by focusing on several char-

acteristics of nonexecutive board members. Since concealment of bad

news by company executives may be a major factor triggering stock

price crash risk, observing the influence of executives on this risk is a

viable direct approach. In this study, we focus on the importance of

having executives with a legal background. Notably, the proportion of

listed companies that have executives with a legal background in

China increased from 6.86% in 2008 to 14.98% in 2018. One possible

reason for this rise may be that an increasing number of companies

have realized the value of acquiring executives with a legal back-

ground. Pham (2020) finds that executives with a legal background

can improve stock liquidity. Jiang et al. (2021) explore the impact of

executives with a legal background on insider trading. We consider

the influence of executive members with a legal background on stock

price crash risk. In simple terms, an executive with a legal background

can be either a “custodian,”someone who provides technical guid-

ance on how to interpret the law to help the company bypass the

sanctions of legal regulations (i.e., breaking the law knowingly and

exploiting legal loopholes), or someone who acts “self-disciplinary,”

someone who is more focused on the adverse consequences of con-

cealing bad news and thus makes deliberate efforts to reduce the pos-

sibility of the executive team hiding bad news by respecting and

abiding by the law. Given the differences in these two approaches,

the effect of executives with legal expertise on companies remains

unclear.

Using data of A-share listed companies in China from 2008 to

2018, we research the effect of executives with a legal background

on stock price crash risk. The following results are obtained: First,

executives with legal expertise reduce stock price crash risk. We

employ various robustness tests, including propensity score

matching (PSM), an instrumental variable (IV) approach, a fixed-

effect model, a residual model, a placebo test, and alternative mea-

sures to verify the robustness of the empirical results. In addition,

we also exclude the influence of the legal adviser system of state-

owned enterprises (SOEs). Second, there is a reduction in stock

price crash risk, because the presence of executives with a legal

background enhances an executive team's legal awareness of the

adverse consequences of concealing bad news. Accordingly, these

executives restrain other executive team members from

suppressing bad news about the company, thereby reducing stock

price crash risk. This supports the self-discipline hypothesis. Third,

to understand the causal mechanism, we discuss the influence of

relevant factors affecting the self-discipline of executives. We

observe that the effectiveness of executives with a legal back-

ground in reducing stock price crash risk is particularly prominent

when the legal system and environment are unfavorable, social

trust is low, stock price synchronicity is high, audit quality is low,

and the executive team does not possess any foreign or academic

experience. Regarding the effect of the exposure of bad news that

was concealed, the effectiveness of executives with legal expertise

in reducing stock price crash risk is more prominent when the

damage owing to such exposure is greater (i.e., the company does

not have director and officer liability insurance or political connec-

tions). Fourth, in terms of the effect of executives' intention to

hide bad news, we observe that the effectiveness of executives

with a legal background in reducing stock price crash risk is espe-

cially high when the company has a low intention to hide any bad

news. The CSRC issued the draft for comments on “Rules for the

Determination of Administrative Liability for Information Disclosure

Violations”on December 27, 2010, indicating stronger monitoring

and regulation on information disclosure. The response from inves-

tors was more positive for companies having an executive with a

legal background than for those without an executive with a legal

background.

56 HUANG AND HO