Exploring the manipulation toolkit: the failure of Doral Financial Corporation

ABSTRACT

The 2015 bankruptcy of Doral Financial Corporation, once ‘the best’ U.S. bank according to U.S. Banker, is the largest since April 2010. The bankruptcy concludes years of management manipulation and efforts to recover. SEC investigation revealed fraud related to Doral’s valuation of interest only strips (IOs). We show that Doral management’s misconduct also includes reckless hiring, over investing, insiders trading, and opportunistic stock splits. Investigating the full range of Doral management’s misconduct reveals new tactics that managers use to pool with good firms and aids our understanding of the economic impact of managerial misconduct.

KEYWORDS:

• Manipulation
• earnings management
• bankruptcy
• SEC investigation

JEL CLASSIFICATION:

• G21
• G14
• G33
• M41
• G34

Acknowledgements

We thank workshop participants at the University of Memphis, discussants and conference participants at the Eastern Finance Association 2015, and Southwestern Finance Association 2015 annual meetings. We have received helpful comments and suggestions from Zhaodan Huang, Tarun Mukherjee, Steven Dennis, Wendy Wu, Christine Jiang, Sandra Mortal, Ronald Spahr, Quentin Chu, Mark Sunderman, Steven Jordan, Lei Gao and Ghada Ismail. This article was previously titled Corporate governance, compensation plans and financial reporting frauds: Doral financial corporation-case study.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ Appendix A provides a summary of Doral’s manipulation and investigation conducted by the SEC.

² A similar claim is provided by Devos, Elliott, and Warr (2015), however, stock split is exogenous in their paper, so they don’t claim that split is a manipulation tactic by itself.

³ Healy and Wahlen (1999) define earnings management as ‘managers’ use of judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting practices’.

⁴ See among other Jones (1991), DeFond and Jiambalvo (1994), Perry and Williams (1994). Dechow, Sloan, and Sweeney (1995), Guay, Kothari, and Watts (1996), Teoh, Welch, and Wong (1998a), Teoh, Welch, and Wong (1998b), Erickson and Wang (1999), Shivakumar (2000) Louis (2004), Kothari, Leone, and Wasley (2005), Efendi, Srivastava, and Swanson (2007) Gong, Louis, and Sun (2008), and Cohen and Zarowin (2010).

⁵ See among others Baber, Fairfield, and Haggard (1991), Eli (1993), Fudenberg and Tirole (1995), Bushee (1998), Healy and Wahlen (1999), Dechow and Skinner (2000), Bens, Nagar, and Franco Wong (2002), Thomas and Zhang (2002), and Roychowdhury (2006).

⁶ See among others Healy (1985), Smith and Watts (1992), Gaver and Gaver (1993), Baber, Janakiraman, and Kang (1996), Hall and Liebman (1998), Eli and Mohanram (2004), Qiang and Warfield (2005), Bergstresser and Philippon (2006).

⁷ Value of unexercised in-the-money stock options is acquired from firm’s proxy statement (form DEF 14A).

⁸ See among others Bhagat and Jefferis (2005), Core, Guay, and Rusticus (2006), Larcker, Richardson, and Irem Tuna (2007), Bhagat, Bolton, and Romano (2008), and Johnson, Moorman, and Sorescu (2009).

⁹ These losses may happen due to the unnecessary costs associated with pooling-oriented actions, competitive disadvantages associated with moving to newer locations, extra set up and training costs, and costs associated with opening and then closing business branches.

¹⁰ We are not claiming that Doral’s executives’ compensation contracts design stimulated their misconduct. However, carefully studying compensation plans of firms that went through earnings restatements and regulatory actions has several benefits. First, it enables us to investigate possible interlinks between compensation plans and financial reporting fraud. Second, it provides a natural environment to investigate how firms design compensation plans before and after manipulation announcements. Finally, studying Doral’s experience enables us to investigate not only amounts of the compensation – which could be studies through archive type research- but also terms and provisions of compensation plans.

¹¹ Doral’s compensation committee justified this change by stating that ‘incentives for volume of originations were eliminated because the Committee felt that these incentives were less appropriate for a larger and more mature company such as the Corporation’.

¹² Although the firm argued that options grants were used to align executives’ interests with those of shareholders, changes that the compensation committee made following the scandal might imply that the magnitude and timing of option grants were possibly among reasons that triggered Doral’s earnings misstatements.

¹³ In other words, reducing option grants from 400,000 – old and unexercised – to 300,000 can also be seen as an increase of the CEO stock options portfolio from 400,000 to 700,000 stock options.

¹⁴ Doral’s post-scandal compensation committee also highlighted several other changes. First, the firm started to use performance vesting in addition to time vesting requirements for stock options granted. This enables the firm to forfeit granted options if certain business objectives are not met properly. Second, the firm adopted a new vesting system at which options granted vested gradually over longer time periods rather than all being vested at specific date. Third, the firm started to schedule the payment of bonuses rather than paying them all at once. According to the new plan, 50% of CEO’s bonus is divided into two postponed instalments. The payment of these instalments is contingent on the company remaining well capitalized on the dates of payment of the two pending instalments. Finally, compensation committee added a retroactive claw back provision to the bonus plan. Under this provision, the full bonus amount is subject to a claw back in the event that the company is affected by any enforcement action imposed by its regulators.

¹⁵ Using the forward curve, internal model would have produced lower values of IOs.