Journalof

ELSEVIER Journal of Banking & Finance 21 (1997) 1085-1106

BANKING & FINANCE

Managerial reputation and divisional sell-offs: A model and empirical test

Jose Guedes a, Roch Parayre b,*
a Universidade Cat61iea Portuguesa, Faculdade de Ci~ncias Eeon6micas e Empresariais, Lisboa. Portugal b Edwin L. Cox School of Business, Southern Methodist University. Dallas, TX 75275, USA

Received 13 May 1994; accepted 11 February 1997

Abstract This paper presents a reputation model of divestiture activity that yields a sharp cross-sectional implication for event studies of sell-off announcements: A decision to divest a division that is known to be successful conveys good news about the division; in contrast, a decision to divest a division that is known for underperformance conveys no news about the division. We test these hypotheses on a sample of sell-off announcements for which we find stories in the Wall Street Journal unambiguously characterizing the division being sold as either a "winner" or a "loser". The stock price reaction to the sell-off of losers is indistinguishable from zero while the stock price reaction to the sell-off of winners is a statistically significant 2.5%. These results are strengthened when we expand the sample to include divisions whose profitability was announced in the company's annual report. For this expanded sample, the average stock price reaction to the announcements of sell-offs of losers remains indistinguishable from zero, while returns from the sell-offs of winners average a highly significant 3.4%.
J E L classification: G14 ; G33 Keyword~." Divestitures; Sell-offs; Managerial reputation; Signalling

*Corresponding author. Tel.: 1 214 768 3587; fax: 1 214 768 4099; e-mail: rparayre@mail.cox.smu.edu. S0378-4266197l$17.00 1997 Elsevier Science B.V. All rights reserved. PIIS037 8-4266(97)000 1 6-2

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1. Introduction

A number of papers have shown that managers who are concerned with outsiders' perceptions of them or their firms face distorted incentives to take actions that enhance their own or their firm's short-term reputation. For example, in Narayanan (1985), Stein (1988, 1989), Brennan (1990) and Thakor (1990) a concern with reputation induces an excessive managerial preference for early cash flows. Hirshleifer and Chordia (1991) clarified that the bias for early cash flows featured in these models is a manifestation of the more fundamental bias toward early resolution of uncertainty about managerial quality that arises when managers care about reputation. 1 We use this intuition to develop a reputation-based model of divestiture activity. The model starts with a manager making a divisional investment which he views as a value-enhancing decision. The manager's aptitude as a judge of project quality is initially uncertain to everyone including himself, and is revealed through time from the division's publicly observed performance. At an intermediate date, the manager observes a noisy private signal of the division's quality which combined with the division's publicly observed performance gives him a better, yet imprecise, estimate of the division's value. After observing the private signal the manager decides whether to divest the division. The feature of the divestiture decision that we emphasize in our model is that the decision influences the timing of the public resolution of the division's value and, since the division's value is a signal of managerial competence, of the timing of the public resolution about managerial aptitude. Specifically, in our model a decision to divest triggers a sell-off investigation by potential acquirers that immediately resolves the remaining uncertainty about the value o f the division. A decision not to divest, in contrast, delays resolution since the remaining uncertainty is then only resolved through future performance or through a future divestiture. Where managers are concerned with their short-term reputation, the observation of a favorable private signal creates a desire to advance resolution, whereas the observation of an adverse private signal induces a preference for late resolution. Our model predicts that a separating equilibrium - whereby only managers with favorable private signals divest - exists only if the division's public performance is viewed as positive. The intuition for this result can be explained as follows: A manager of a division that is a known winner enjoys a reputation for high ability and therefore has an incentive to avoid ac-

i Hirshleiferand Chordia (1991) also give examples where manager's preferenceto advance the resolution of uncertaintyabout their aptitude actually induces a preferencefor late cash flows. For example, a manager may make an investmentdecision that reduces short-run cash flows, and yet provides good news to the market about the manager's ability.

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tions with the potential to harm his reputation. 2 Thus managers of winning divisions may prefer not to divest even when their private information suggests that the division is undervalued by outsiders. This occurs because there is a chance that the sell-off investigation will reveal the division's true quality to be below what the public originally believed, in spite of the manager's favorable, but noisy, private signal about the division's quality. Those who choose to divest and bear the risk of being wrong about the division's quality will be the ones who are the most confident, because of their highly favorable private signals, that the sell-off investigation will reveal the division to be at least as good as was originally believed by the public. The desire to hedge reputation, however, is not shared by managers of divisions that are known losers since their ability is likely to be perceived as poor. These managers have no reluctance against advancing gambles on their reputation and hence will always subject their divisions to the scrutiny of potential acquirers when their private signals suggest that outsiders overstate the extent of the divisions' troubles. With every manager of losing divisions choosing to divest when their inside information indicates excessive pessimism by outsiders, all but those divisions receiving the lowest private signals will be objects of sale. 3 In short, the model predicts that all managers will choose to sell divisions that are known losers, while only those receiving the most favorable private signals will choose to sell divisions that are known winners. 4 Two implications for event studies of divisional divestitures follow immediately: First, disclosures of attempts to sell divisions will elicit, on average, a positive stock price reaction for samples containing both winning and losing divisions; second, and more importantly, announcements of attempts to sell winning divisions will trigger a positive market response while announcements of attempts to sell losing divisions will prompt no market response since these are fully anticipated by the market. It is important to stress, however, that these predictions apply to announcements of attempts to divest and not to announcements of divestiture completions since our theory deals with the managerial decision to subject their divisions to external scrutiny, and not the outcome of that process.

2 H o l m s t r o m and Ricart i Costa (1986) and Hirshleifer and T h a k o r (1992) develop models where reputational concerns induce successful managers to be conservative in their investment decisions. 3 This result is an example of the corollary to Proposition 3 in Hirshleifer and Chordia (1991). There the authors show that when advancing resolution is costless, managers will advance resolution regardless of their private signals. 4 Similar results are obtained if management's pay displays downward stickiness, since the incentives for risk taking will then vary negatively with performance. With a b o u n d on downside pay, the compensation of a m a n a g e r of a losing division is like an out-of-the-money call option. We thank an a n o n y m o u s referee for pointing this out.

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To test these hypotheses we identified a sample of 370 events of firms announcing either current attempts or plans to sell particular divisions, and then searched the Wall Street Journal for stories over the three years prior to the announcement that unambiguously characterized the division that is the object of sale as either a winner or a loser. For the entire sample the average stock response to sell-off announcements is positive (1.6%) and significant. For the subsample of divisions with favorable press coverage (n = 34), the stock price reaction is also positive (2.5%) and significant. However, for the subsample of divisions with negative press coverage (n =- 42), we cannot reject the hypothesis of a zero stock price reaction to the sell-off announcement. These results are strengthened when we expand the sample to include divisions whose profitability was announced in the company's annual report. The average stock price reaction from this expanded sample of winners is a highly significant 3.4%, while the average return from the sell-offs of losers remains indistinguishable from zero. Our model contrasts with existing models of divestiture activity. In Boot (1992), managers select a project and then decide whether to divest it based on a private signal of project quality. The value-maximizing decision is to divest all low quality projects and to keep all high quality projects. Managers receiving an adverse signal of project quality are reluctant to divest because a divestiture is an admission of a poor project choice at the initial date. Managers of high ability, however, are more prone to divest and admit the error because they expect future project choices to reveal their superior ability. This leads to an equilibrium whereby good managers with adverse signals divest with a higher probability than bad managers with adverse signals. On the other hand, no manager receiving favorable private signals on project quality ever divests. Therefore, a decision to divest is always bad news about the company. In a related paper, Kanodia et al. (1989) develop a model where reputation concerns induce managers to escalate their commitment to a project when faced with private information indicating that re-deployment of resources is the value-maximizing action. Although the authors focus on an escalating equilibrium where no firm ever divests, they point out that if the negative impact of a decision to redeploy resources on the manager's reputation grows with the longevity of the commitment, all managers will redeploy if adverse information is received early enough. In this case, the choice to divest would send bad news to the market. Existing models of divestiture activity thus predict that the decision to divest a division sends bad news about the company. The empirical evidence, however, indicates that attempts to divest convey positive information. For example, firms disclosing that they are undertaking or initiating discussions with potential buyers about the sale of particular divisions experience positive market reactions in Rosenfeld (1984), Jain (1985), Klein (1986), Hite et al. (1987) and Hirsche3) and Zaima (1989). In addition, existing models predict no rela-

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tionship between divisional p e r f o r m a n c e and the information conveyed by the decision to sell the division. T o our knowledge, the event study literature has also not p r o d u c e d cross-sectional evidence o f this type. This paper addresses the foregoing issues. In Section 2 we develop the model and derive the testable implications. Section 3 tests the hypotheses on a sample o f sell-off announcements. The conclusions are drawn in Section 4

2. The model
2.1. Assumptions and notation The model has three dates, indexed t = 0, l, 2. A t = 0, a m a n a g e r invests in a new division. The divisional investment consists o f choosing a project whose quality, [2, is a continuous r a n d o m variable with support [ - ~ c , +oc]. s The m a n a g e r ' s ability to select high-quality projects is initially u n k n o w n b o t h to himself and to outsiders; managers and outsiders infer managerial aptitude over time f r o m various signals o f project quality. 6 Between t = 0 and t :- 1 two signals o f project quality are observed: A binary public signal on the division's performance, S, indicating whether the division is a clear winner (S = W if f2 >> 0) or a clear loser (S = L if f2 << 0), 7 and a continuous private signal, s (vc < s < +oc), observed solely by the manager. While outsiders update their beliefs of project quality and managerial ability based solely on the public signal, the m a n a g e r updates her own beliefs on the base o f both the public and the private signals. Assume that EIf2Is,S] is m o n o t o n i c a l l y increasing in the private signal s and furthermore, that lim Elf,[s, S = W] = + o c ,
S~+3C,

lim E[f~[s, S = W] >7 0,

.S'~ Oc

(1) lira E[f~ls, S = L] ~< 0,

,s' ~ + O c

lim E[f~[s, S = L] = - o c .
s~ -3o

A s s u m p t i o n Eq. (1) states that the private signal c a n n o t change the qualitative assessment o f the division m a d e on the basis o f the public signal. Projects that are k n o w n winners (losers) will never be viewed as losers (winners) after obser-

s The new division can either be developed internally or be the result of an acquisition. 6 Many papers use a similar framework where both the labor market and the manager start with an imprecise but symmetric knowledge of the manager's ability. Subsequently the manager develops private information about his ability by learning from his performance on the job. Examples are Kanodia et al. (1989), Holmstrom and Ricart i Costa (1986), and Scharfstein and Stein (1990). 7 For divisions that are neither clear winners nor clear losers there either is no public signal, or the public signal reveals an inconclusive project quality.

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ving the private signal, no matter how negative (positive) the signal is. 8 The private signal, however, still causes the manager to review his estimate of divisional quality. F o r example, a high private signal indicates to a manager of a winning division that true quality is even better than the quality suggested by the favorable public signal; conversely, it indicates to a manager of a losing division that his division is not as big of a loser as had been suggested by the negative public signal. The private signal, however, is noisy, so that management's estimate of quality is subject to error. At date t - - 1, the manager decides whether to divest the division. A decision to divest triggers an investigation of the division by potential acquirers with expert knowledge in the division's line of business. The investigation generates a second public signal of project quality leading outsiders to update the distribution of project quality and reassess the manager's ability. For simplicity, we assume that the sell-off investigation immediately resolves the remaining uncertainty about project quality, i.e., that it fully reveals f2 at date t = 1.9 A decision not to divest, on the other hand, delays the revelation of f2 until t=2. Managers' decisions are driven by reputational concerns. Following Boot (1992), Hirshleifer and Chordia (1991), H o l m s t r o m and Ricart i Costa (1986) and Scharfstein and Stein (1990), the manager's current wages are determined by his current reputation which, in our model, is a function of perceived project quality only. The manager's problem is to choose an action, A (A = D (Divest), A = N (Do not divest)), at t -- 1 to maximize his intertemporal utility of wages. I f he divests (A = D), the sell-off investigation advances the resolution of project quality (and hence of managerial aptitude) to t = 1, and the payoff is W(A -~ D) = E{U[w(~)]Is, S}[1 + (1 + r)-l], (2)

where w[ ] is the wage function, U{w[ ]} is the utility function for wages, r is a discount factor, and E is the expectation operator. In contrast, if the manager doesn't divest, the unknown project quality is only revealed at t = 2. In this case, his lifetime utility of wages is W(A = N) = U{w[E(f~[S,A = X)]} + (1 + r)-lE{U[w(~)]ls, S}. (3)

The curvature of function U{w[-]} in Eqs. (1) and (2) determines managers' attitudes toward fair gambles on their reputations. We assume that U{w[.]} is

s This assumption is motivated by our empirical work. Our sample consists of divested divisions for which there is press coverage, prior to the actual divestiture, clearly indicating whether the division is a winner or a loser. Unless the press gets it all wrong, it is extremely unlikely that divisions characterized as winners will turn out to be losers (and vice versa). 9 This assumption is not essential. The results also hold in the case where the sell-offinvestigation only sends a noisy signal of project quality. The essential feature of the model is that the decision to divest accelerates the resolution of some of the uncertainty about project quality.

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concave for managers of winning divisions (S = W) but non-concave for managers of losing divisions ( S = L). These assumptions are substantiated in the next section. The assumed curvature of the function U{ w[.]} implies that managers of winning divisions dislike taking gambles on their reputation and hence, ceteris paribus, prefer not to sell-off at t = 1; managers of losing divisions, in contrast, don't view gambles on their reputation negatively and thus do not object to having the uncertainty about project quality resolved earlier through a sell-off.
2.2. Discussion o f managerial preferences 2.2.1. Promotion and wages

Let us first assume a risk neutral manager (i.e., a manager with a linear utility function) and develop plausible conditions that make the wage function Sshaped in the manager's current reputation. Suppose that the job opportunities available to managers consist of divisional level positions and more senior - and better paid - corporate level positions. Moreover, assume that there are substantial wage differentials across position levels but little cross-sectional wage variability within position levels. t0 At each date, divisional managers may be promoted to corporate level jobs, depending on the labor market's current assessment of managerial ability. In this context, the expected wage of a manager at date t can be written
w[0,] = [1 - c ( 0 , ) ] w D + c ( 0 , ) w c ,

(4)

where Ot is the manager's reputation at t, G(0t) is the probability of getting a corporate level job given current reputation, and wD and Wc are, respectively, the wages at divisional level and corporate level positions. Inspection of Eq. (4) indicates that the wage function is S-shaped if the probability of obtaining a corporate level job is S-shaped. There are several ways to motivate an S-shaped probability function. For example, if promotion is based on whether perceived managerial ability is above or below a hurdle whose value is not exactly known to the manager (the hurdle may be uncertain because it varies across firms or because it changes over time, reflecting current demand and supply for managers), the manager will view his chances of getting a corporate level job as an S-shaped

~oThe empiricalimportance of promotion-basedincentivescombinedwith the virtual absence of pay-for-performancecompensationpoliciesamong top executiveshas been documentedby Medoff and Abraham (1980) and Murphy (1985). These authors also find that between-job-levelearnings differentials are much more important than within-job-leveldifferentials.

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function o f his reputation. 11 A n S-shaped probability function will also be obtained if managers compete for a limited n u m b e r o f senior corporate level slots, on the basis o f their reputations. To see how, suppose n managers are competing for a single corporate level slot, each with a reputation d r a w n f r o m a base p o p u l a t i o n with c.d.f. P(O). The j o b goes to the m a n a g e r with the best reputation. Consider m a n a g e r A with reputation 0 A. We can r a n k - o r d e r the reputations o f the other ( n - 1) managers f r o m worst to best as 0(~), 0(2), 0(3 ) ..... 0(~_1). F o r m a n a g e r A to get the j o b requires that 0(,_1) ~< 0 A. So the probability that m a n a g e r A gets the corporate level j o b is equal to the probability that the (n - 1)st order statistic is less than 0 A, i.e., is equal to the c.d.f, o f the (n - 1)st order statistic evaluated at 0 A. Letting Fn_l(O) be the c.d.f, o f the (n - 1)st order statistic 0(,_1), we have F.-1(0) = Pr{all other O(i ) ~ 0)
=

[P(O)] n-'.

(5)

Plots o f F._~ (0) show it to be S-shaped, for a variety o f u n i m o d a l distributions o f P(O). 12 In this discussion, m a n a g e r s w h o are highly regarded or perceived as talented, and who therefore enjoy g o o d chances o f landing a senior level job, have m o r e to lose f r o m downgrades in perceived ability than to gain f r o m upgrades, as their odds o f getting the j o b are somewhat insensitive to an improvement in their reputation. Hence, they avoid actions with the potential to alter perceptions a b o u t their ability. In contrast, managers w h o are viewed as incompetent and, as a result, only have low if any chances o f obtaining a senior level j o b do not face similar incentives t o w a r d conservatism since their exposure to downside risk is limited. 13 Evidence on this a s y m m e t r y o f preferences t o w a r d risk is reported by Shefrin and Statman (1985) w h o f o u n d that portfolio managers hedge after abnormally g o o d p e r f o r m a n c e and gamble after a b n o r m a l l y p o o r performance. These authors d o c u m e n t a "disposition effect" - a tendency to sell winning stocks too early and hold on to losing stocks too long. Such a finding is consistent with an S-shaped wage function, as well as with prospect theory, to which we n o w turn.

H Suppose the reputation threshold necessary to get a corporate leveljob is k + z, where z is an error term with probability distribution Pr{z < Z} =F(Z). Then, if the manager's current reputation is Or, his chances of getting a corporate level job are Pr{0t > k + z} = Pr{z < Ot - k} =F(Ot - k). Therefore, as long as F(Z) is S-shaped, the probability of getting a senior level job is also S-shaped. 12 The normal and Student-t are examples. 13 In organizational structures employing up-or-out (or up-or-down) promotional systems, there is also an incentive to act conservatively when perceived ability is high and gamble when perceived ability is low. The assistant professors writing this paper can attest to the importance of these incentives. The reader can judge whether the present paper constitutes a hedge or a gamble!

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2.2.2. Risk attitude and utility Behavioral results also suggest that the utility function may have the curvature properties just described. A large body of empirical evidence from decision theory, originating with prospect theory (Kahneman and Tversky (1979)), demonstrates that decision makers evaluate outcomes as gains and losses relative to some reference point, or aspiration level, rather than over total wealth. Moreover, the dominant tendency is toward risk-seeking in the domain of losses (relative to the reference point) and toward risk-aversion in the domain of gains. A manager facing the prospect of low wages will likely take more risks to try to get at or exceed his aspiration level, while a manager who expects to receive high wages is unlikely to make decisions that might compromise that prospect. 14 Prospect theory therefore predicts that the utility of wages function will be convex over losses and concave over gains, so that even if the wage function is linear in perceived project quality, the aggregate function U{w[.]} will display the properties defined above. 2.3. Equilibrium divestiture decisions of losing divisions ; S = L)
The nature of the private information about project quality gleaned through the private signal also influences managers' attitudes toward sell-offs. A favorable private signal gives the desire to accelerate the resolution of project quality. Thus a manager with favorable private information will always divest unless he views a gamble on his reputation negatively. Since the curvature of the function U{w[.]} implies that managers of losing divisions have no desire to hedge their reputations, managers of losing divisions with favorable inside information always prefer to sell-off. This in turn implies that, in equilibrium, all losing divisions are object of sale. 15 Attempts to sell known losers are therefore fully anticipated by outsiders and thus convey no information.

2.4. Equilibrium divestiture decisions of winn&g divisions ( S = W)

In contrast with their counterparts in losing divisions, managers of winning divisions avoid actions that put their reputation at risk. A manager of a win-

14 This story could also be couched in terms of a firing threshold. In that case, managers that are viewed as incompetent are likely to be fired and have no job. They therefore want to take a lot of risk in the hope of beating the firing threshold. Managers who are perceived as talented keep their jobs by avoiding risk. ~5 Suppose there was an equilibrium where managers with private signals, s' < s < s", chose not to divest. Then managers with signals s satisfying E(s[s' < s < s") < s < s" would be better off by divesting and defecting from the conjectured equilibrium.

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ning division with f a v o r a b l e inside i n f o r m a t i o n takes a g a m b l e on his r e p u t a tion i f he c h o o s e s to sell-off. T h e following p r o p o s i t i o n gives sufficient c o n d i tions for a s e p a r a t i n g e q u i l i b r i u m to exist, w h e r e b y o n l y m a n a g e r s with the m o s t f a v o r a b l e p r i v a t e signals c h o o s e to divest. 16

Proposition 1. L e t 7r(s) be the insurance risk premium that a manager of a

winning division who observes private signal s wouM be willing to pay to be able to convey his private signal directly to outsiders instead of having project quality resolved through the sell-off investigation. 17 I f Tr(s) is positive and non-increasing in s, then there exists a separating equilibrium whereby managers with private signals above a finite threshold s # choose to divest their divisions while those with signals below s # choose not to divest. 18 2.5. Summary o f testable implications
T o s u m m a r i z e , the m o d e l yields the following testable hypotheses: 1. T h e a n n o u n c e m e n t o f the a t t e m p t to sell a division t h a t is a k n o w n loser is fully a n t i c i p a t e d b y the m a r k e t a n d , as a result, generates n o significant a b n o r m a l stock price reaction. 2. T h e a n n o u n c e m e n t o f the a t t e m p t to sell a division t h a t is a k n o w n w i n n e r c o n v e y s positive news a b o u t the value o f the division and, as a result, generates a positive stock price reaction. 3. T h e f r e q u e n c y o f divisions t h a t are objects o f sale is s u b s t a n t i a l l y higher a m o n g k n o w n losers t h a n t h a t a m o n g k n o w n winners. O u r e m p i r i c a l w o r k will focus o n h y p o t h e s e s (1) a n d (2). O u r event selection a n d classification m e t h o d o l o g y will o n l y generate a n e c d o t a l evidence a b o u t hyp o t h e s i s (3).

16A simple numerical example illustrating this separating equilibrium is available from the authors upon request. 17 Formally, n(s) = U{w[E(f2ls,S)]}- E{U[w(I2)]s,S]}. Thus the insurance risk premium is related to the curvature of the utility of wages function - i.e., a concave U{I2} entails a positive insurance risk premium. By paying this premium the manager would share her private signal with outsiders while avoiding the uncertainty surrounding the outcome of a sell-off investigation. Recall that the manager's private signal is noisy, which makes her assessment of project quality subject to error. Since a sell-off investigation reveals the true project quality, its outcome is uncertain from the manager's perspective. 18 The proof of this proposition consists of showing that two conditions are fulfilled. First. that there exists a marginal private signal, s#, that makes the manager indifferent between not divesting and divesting. Second, that for managers with signals above s , advancing resolution through divestiture is preferred to deferring resolution whereas for managers with signals below s#, deferring resolution dominates advancing resolution. A detailed mathematical proof of these two conditions being fulfilled is available from the authors upon request.

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3. Empirical analysis
3.1. Review o f previous empirical studies o f sell-offs

Several studies in recent years have examined the valuation effects of sellotis. M a n y of these are event studies which have investigated the stock price performance surrounding disclosures o f attempts to sell-off divisions, which is the primary focus of this paper. Divestment announcements can range from mere announcements of the intention to divest, to disclosures of ongoing negotiations with a potential buyer, to the actual sale of a division being finalized, where the buyer's name and purchase price are released. Alexander et al. (1984) found positive but insignificant cumulative abnormal returns for firms engaging in talks to sell divisions for the two-day window at the announcement date. They found that disclosure of the sell-off took place following negative abnormal returns, suggesting that attempts to sell-off took place following the release of negative information about the firm. Using a larger sample, Jain (1985) found small yet significant positive abnormal returns for firms disclosing negotiations to sell divisions, also following a period of significant negative abnormal returns. Positive returns at the announcement date for negotiation disclosures were also found by Rosenfeld (1984), Hire et al. (1987), and Hirschey and Zaima (1989). Klein (1986) found initial announcements of sell-off negotiations at the consideration stage (i.e., no signed agreement between the two parties) to result in significant positive abnormal returns when a bid price was announced, and non-significant when the price was not announced. Similarly, Afshar et al. (1992) in a study of sell-offs in the U K , reported that the disclosure of the intention to sell-off a division triggers a positive stock price reaction only when a bid price is revealed. 19 In summary, event studies of sell-off attempts generally indicate a positive market reaction, although the nature and extent of the reaction depends on details of the announcement, such as whether a bid price is released. None of these studies, however, relates divisional performance to the information conveyed by the announcement. Ravenscraft and Scherer (1991) examined the frequency of sell-offs among winners and losers using Federal Trade Commission Line of Business Surveys for the years 1974-1981. They found that divested lines of business had on

L9Klein (1986) and Afshar et al. (1992) also investigated the market reaction to announcements pertaining to the completion of divisional sell-offs.They found that announcements of completion elicited a more positive response than announcements of attempts to sell-off. They also found a pattern for the influence of price disclosure on market reactions similar to the one found for the intention announcements.

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average experienced negative operating profits in the year prior to the sell-off, while non-divested lines in the same industry had significant positive profits over the same period. This result suggests that losers are much more likely to get divested than winners, an interpretation supported by their logit analysis of the probability o f a line of business being sold-off. They report that the line of business profitability in the years prior to divestiture is the most powerful predictor of sell-offs, both in terms of its highly significant regression coefficient and of its impact on the probability of divestiture. Specifically, they estimate that a four standard deviation decrease in profitability - from the sample mean plus two sample standard deviations to the mean minus two standard deviations - increases the probability of divestiture by 15 times. 20 This is consistent with the prediction made in our third hypothesis that the managers of losers wish to sell-off, while only a fraction of the managers of winners wish to sell-off.

3.2. Sample and sampling procedures An event study was conducted to test the preceding hypotheses. The first step was to identify firms from the C O M P U S T A T Annual Industrial Tape and from the C O M P U S T A T Research Industrial Tape that reported "significant" losses or gains from discontinued operations (data item 66) for the years 1967-1987. Specifically, firms whose losses or gains from discontinued operations exceeded 10% (in absolute value) o f operating income 21 of the firm in that year were chosen. These firms were believed to have discontinued operations "significant" enough for the sell-off announcements to prompt share price movement. In all, 2034 firms fulfilled this initial requirement. The Wall Street Journal Index was then used to obtain the announcement dates of the decisions to sell-off operations of projects or divisions for the 2034 firms and years identified above. "Termination" announcements (where a division is discontinued but its assets are not sold-off) were deleted from consideration. Sell-off announcements were often made quite gradually: first intent to sell-off a division, then negotiating the sale, then reaching a preliminary agreement on the sale, and finally sold. Each of these announcements conveys information on the increased likelihood of an actual sale, becoming a certainty with the sold announcement. Hence, each of these announcements may prompt share price movement. We used the very first initial public announcement since it is the one which first conveys management's objective to sell the division. The

20 This impact on the probability of divestiture is computed by holding all other regressors at their sample means. 21 Operating income is computed as net sales less cost of goods sold and selling, general and administrative expense.

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results of Vetsuypens (1985) and Klein (1986) show that the market's strongest reaction to a sell-off usually occurs at the first announcement of intent. The sample screening process resulted in winnowing down the sample for of the following reasons: firms not on the C R S P tape; firms not found in the Wall Street Journal Index search; firms for which no sell-off announcement was found; firms having multiple sell-off announcements in the same year; 22 firms with confounding announcements on the event day; 23 event dates or comparison period window not on CRSP; sell-offs involving cases of recent management change (over the past year); miscellaneous deletions because of untraceable name changes, company identification (CUSIP) number changes, or sell-off announcements straddling multiple fiscal years. 24 This left us with a final sample of 370 sell-offs. This sample was reasonably spread across a wide variety of industries, years and months, and the discontinuations were of various relative sizes. 25 O f the 370 sell-offs, 218 resulted in losses from discontinued operations, while 152 resulted in gains. Daily stock returns were then obtained from the CRSP tape for a fixed period around the sell-off announcement date for the 370 firms in our sample of sell-offs. A sell-off announcement will usually be reported on the Dow-Jones News Wire on the day it is made (day - 1 ) and appear in the next day's Wall Street Journal (day 0). The effect of that announcement on stock prices will therefore occur in day -1 or in day 0. Days -1 and 0 thus represent the '~announcement period".

22 A firm selling off"multiple divisions in the same year will usually show a single dollar figure in C o m p u s t a t ' s Income from Discontinued Operations, which sums the income from the various selloffs. In such cases, while total Income from Discontinued Operations may exceed our "significance" threshold of 10% of operating income for the year, it is not known which of the sell-offs is significant (in terms of its size and hence potential market reaction), and which is not. As a result, our inability to determine the significance of any divisional sell-off in relation to the firm's total portfolio forced us to exclude multiple sell-off announcements from our sample. 2~ Observations with simultaneous announcements introduce potential confounding causes for a single share price reaction. Most of these involved earnings announcements. Some involved the announcement of a m a n a g e m e n t change, still others involved the announcement of a second or third division being discontinued. Because of our inability to discriminate between these multiple causes, any observation involving a simultaneous announcement was deleted from further consideration. 24 In cases of sell-off announcements straddling multiple fiscal years, there was ambiguity about which year the resulting accounting entry showed up on Compustat. As such, the resulting size of the discontinuation could not be readily established. 25 A list of c o m p a n y names, event dates and other descriptive information is available from the authors upon request.

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Our model assigns a role to the performance of the division and not the performance of the firm in determining the market reaction to a sell-off attempt. Because the overall performance o f the firm can be a p o o r surrogate for the performance of the division being divested, tests based on firm performance will yield low power in evaluating the hypotheses under scrutiny. 26 We therefore relied on measures of divisional performance which involved, in part, qualitative judgments.

3.3. Dow-Jonesl Wall Street Journal classification

The market's opinion about the status of a division - about whether a division is a winner or a loser - is in large part subjective. To capture this subjectivity, we employed a qualitative approach in our sample classification methodology. We used prior market information about a division's operating performance appearing in the business press to classify winners versus losers. Our sample of sell-offs was separated into three groups, as a function of the information publicly available about divisions' operating incomes: Group 1: the " k n o w n losers" group - divisions for which news of their financial (or other) difficulties appeared in the Wall Street Journal or on the DowJones News Wire within three years prior to the initial sell-off announcement; Group 2: the " k n o w n winners" group - divisions known to be earning positive profits (or for which positive statements about the division's status were made), as published in the Wall Street Journal or on the Dow-Jones News Wire within 3 years prior to the initial sell-off announcement; Group 3." the " n o information" group - all other divisions, not meeting the preceding criteria. This classification criterion produced 42 known losers, 34 known winners, and 294 no information divisions.

3.3.1. Results

Reactions to the initial sell-off announcements are summarized in Table 1. The test statistic for determining the mean market reaction to a sell-off an-

26 Because firms experiencing financial distress are often forced to sell their best performing divisions (the "jewels of the crown") as a means to raise cash quickly and in significant amounts, the performance of the division being divested and the performance of the divesting firm can even be negatively correlated.

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Table I A n n o u n c e m e n t period abnormal returns, by sell-off type for the Dow-Jones/Wall Street journal sample Type of sell-off No. of firms in sample Announcement period mean abnormal return (and standard deviation of returns) 0.0042 (s = 0.0583) 0.0246 (s=0.0710) 0.0166 ( s = 0.0748) 0.016 (s=0.0726) t-value (and level of significance) # positive l# negative returns (and binomial test result on sign of returns)

K n o w n losers K n o w n winners N o information Entire sample

42 34 294 370

0.46 2.02 (~ < 0.03) 3.8 (~ < 0.001) 4.2 (~ < 0.001)

18/24 ( z = - 0 . 9 3 ; p =0.18) 23lll (z =- 2.06; p = 0 . 0 2 t 1621132 (z = 1.75: p =0.04) 2031167 ( z = 1.87: p = 0 . 0 3 )

*The difference in mean abnormal returns between known winners ( = 0.0246) and known losers (--0.0042) is significant at the c~= 0.10 level, with a t-value of 1.35. Returns are market-adjusted abnormal returns, s u m m e d up over the two days in the event window (the day of the sell-off announcement in the Wall Street Journal, plus the day preceding it). K n o w n winners are divisions unambiguously characterized as such in a Wall Street Journal story prior to the sell-off announcement. A similar definition applies to known losers.

nouncement, based on market-adjusted returns 27 for the 2-day windows (days 1, 0) around the initial intent of sale announcements, is t = R/(slqn), where R is the announcement period mean market-adjusted return for the firms in the sample, s is the cross-sectional standard deviation of the returns, 2g and n is the number of firms in the sample. The t-value for losers shows that the market reaction was not significantly different from zero, in concordance with our hypothesis concerning losing divisions. The t-value for winners is significant at the ~=0.025 level (one-tailed), substantiating our second hypothesis that
-

27 Market-adjusted returns do not adjust for differences in systematic risk of individual stocks. In using market-adjusted returns, we are making the implicit assumption that the average market risk for each of our subsamples are equal. This assumption allows for the m e a n abnormal returns to be tested directly, without requiring the use of market model adjusted returns. The assumption seems justified here as each subsample is similar in its composition, encompassing divestor firms of different sizes spanning a variety of different industries - leading to similar average market risks for each subsample. Nonetheless, all of our market-adjusted results were fully corroborated by the similar results obtained via market model adjusted returns. Moreover, a frequency analysis showed no calendar time clustering of the event dates in our various samples, making it appropriate to use market-adjusted returns. 28 The average or "typical" standard deviation of returns computed across our time series of returns over days [-201, -51] is lower than the cross-sectional standard deviation used in our tests. Using these "typical" standard deviation n u m b e r s in our tests would actually increase our t-values and the levels of significance of our results, thus strengthening our conclusions.

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sell-offs of known winners result in positive stock price reactions. The proportion of positive returns (68%) is also significant at the ~ = 0.025 level. 29 Table 1 also shows a significantly positive reaction for the no information sample. We find this result entirely consistent with the model because our classification methodology identifies only a subset of winners and losers. Given the limited amount of space available in the Wall Street Journal and the DowJones News Wire to air stories on corporate performance, we can expect to find press reports on the performance of only a fraction of the divisions in our sample - those particularly conspicuous divisions, or ones showing extreme or unexpected performance. The no information sample therefore contains many winning and losing divisions overlooked by our classification methodology and is expected to result in a positive stock price reaction.

3.4. Expanded sample classification

Classifying divisions into known winners and known losers by using information publicly available from the Dow-Jones News Wire or from the Wall Street Journal is the way most likely to capture widely held views about a division's status. Yet this approach only allowed us to classify 76 of our 370 selloffs into one of these two categories. In order to increase the size of our known winners and know losers subsamples, a complementary method was used on the remaining divisions, to move some of them out of the no information group. The key was to determine whether the division's operating income prior to the discontinuation was publicly known. To accomplish this, individual companies' annual reports (for the year in which the discontinuation took place) were accessed on the Nexis-Lexis data base, and searched for sector notes or accounting footnotes for entries on income from discontinued operations. 30 As a rule, the annual reports which contained such notes provided the following information for an operation which had been discontinued during that year: the operating income from that division for that year (up until its discontinuation date), as well as (in most cases) the operating income from that same division in the year prior to the year of its discontinuation. It was the sign of this last number - whether the division showed an operating profit or an operating loss for the year prior to the year of its discontinuation - which was used

29 Abnormal returns according to the market model were as follows for the WSJ sample. For known losers, 2-day returns averaged 0.4% (t = 0.43). For known winners, 2-day returns averaged 2.0% ( t - 1.81, ~ < 0.05). These results are fully consistent with the ones obtained using market adjusted returns. 30 Several of the firms located in the early years of our sample period were not on Nexis-Lexis, and many other annual reports which were on Nexis-Lexis did not have details at the division level or any detailed sector notes or footnotes concerning discontinued operations.

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to classify additional divisions (from the old no information subsample) into k n o w n winners and k n o w n losers. 31 The resulting expanded classification, combining the two classification approaches, p r o d u c e d 85 k n o w n losers, 63 k n o w n winners, and kept 222 divisions in the no information group. 32
3.4.1. R e s u l t s

The expanded classification o f our sample essentially doubled the size o f our k n o w n winners and k n o w n losers subsamples. Stock price reactions for the exp a n d e d sample are shown in Table 2. Stock price reaction for k n o w n losers in the a n n o u n c e m e n t w i n d o w continues to be not significantly different f r o m zero. K n o w n winners display a stock price reaction o f nearly 3.4%, significant at the ~ = 0 . 0 0 1 level. The p r o p o r t i o n o f positive returns is 66%, significant at the = 0.005 level. These results provide strong evidence in support o f our h y p o t h esis o f the positive effect o f selling off a winner. As in our earlier sample classification, sell-offs o f no information divisions still result in a significant positive average stock price movement. The t w o - d a y stock price reaction w i n d o w was also expanded, to a c c o u n t for the possibility that the m a r k e t was anticipating the sell-off announcements. Results for two such expanded windows for days [ - 5 to 0] as well as for days [ - 2 0 to 0] are shown in Table 3. F o r losers, the 6-day window results in a non-significant mean price reaction o f 1.33%, with approximately equal p r o p o r t i o n s o f positive and negative price reactions. W h e n expanding the w i n d o w to 21 days, average price reaction for losers drops to a non-significant 0.94%, with as m a n y positive as negative returns. A 61-day w i n d o w produces an average price reaction equal to an insignificant -0.3%. All in all, previous conclusions f r o m our subsample o f losers remain u n c h a n g e d when the event window is expanded. Prior anticipation o f the sell-off a n n o u n c e m e n t , if any, did not significantly affect stock price. Sell-offs o f winners, on the other hand, seem to show a greater anticipation effect. A 6-day window results in a highly significant price reaction of 4.57%

31 The level of public knowledge about the status of these divisions is likely to be less than for those divisions classified from the Dow Jones News Wire or the Wall Street Journal. Under this new classification criterion, a division's status was publicly disclosed in the company's annual report following the sell-off. At the time of the sell-off, however, the division's profitability may have been informally known on "the street", but had not been formally reported in the company's annual report. So we expected the larger known winners and known losers subsamples to result in somewhat noisier data than before. 32 The original and extended samples were compared for their similarity by applying the extended sample's classification criterion to the firms in the original sample. Out of the 76 total firms contained in the original WSJ sample of "known winners" and "known losers", Nexis-Lexis contained information on 10 of the discontinued divisions. Of those 10 divisions, only one was classified differently under our two classification procedures.

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Table 2 Announcement period abnormal returns, by sell-offtype - expanded sample Type of sell-off No. of Announcement t-value (and firms in period mean abnormal levelof sample return (and standard significance) deviation of returns) 0.0058(s = 0.0720) 0.0337 (s=0.0768) 0.0149 (s=0.0716) 0.016 (s= 0.0726) 0.74 3.48 (ct < 0.001) 3.10 (ct=0.001) 4.2 (6 < 0.001) # positive/# negative returns (and binomial test result on sign of returns) 36/49 (z=-1.41; p = 0.08) 42/21 (z= 2.65; p =0.004) 125/97 (z= 1.88;p=0.03) 203/167 (z= 1.87;p =0.03)

Known losers 85 Known winners 63 No information 222 Entire sample 370

The difference in mean abnormal returns between known winners (=0.0337) and known losers (= 0.0058) is significant at the c~= 0.015 level, with a t-value of 2.24. Returns are market-adjusted abnormal returns, summed up over the two days in the event window (the day of the sell-offannouncement in the Wall Street Journal, plus the day preceding it). Known winners are divisions unambiguously characterized as such in a Wall Street Journal story prior to the sell-offannouncement, or whose financial status was publicly revealed in the company's annual report. A similar definition applies to known losers. (~ < 0.001), with a n equally significant 70% p r o p o r t i o n o f positive returns. The 21-day w i n d o w produces a 6.25% stock price reaction (a < 0.001), with a n equally high p r o p o r t i o n o f positives. A similar result is f o u n d for the 61-day window, where the average stock price reaction is 7.39% (~ < 0.005). Clearly, selling off w i n n e r s generates highly positive news, some - b u t n o t all - o f which seems to be anticipated by the market. 33' 34 As for o u r third testable hypothesis a b o u t the frequency o f sell-offs a m o n g losers a n d winners, the evidence provides some weak s u p p o r t for the model, since we expected to find a significantly greater incidence of negative stories t h a n o f favorable stories a m o n g divisions that are later divested. As it is, there are slightly m o r e k n o w n losers t h a n there are k n o w n winners in o u r g r o u p o f sell-offs. O u r evidence is also consistent, albeit weakly, with the results o f R a venscraft a n d Scherer (1991) who reported a powerful negative effect of operating profits o n the likelihood o f a sell-off. The weakness o f this result m a y stem in part from o u r classification m e t h o d o l o g y , which classified winners a n d losers from a n initial overall sample o f sell-offs. The base-rates o f w i n n e r s a n d losers in the overall p o p u l a t i o n o f divisions, i n c l u d i n g those that get soldoff a n d those that do not, could n o t be d e t e r m i n e d from o u r sample m e t h o d o l -

33 These conclusions about winners and losers remain intact when an extended window analysis is performed on the original WSJ sample. 34 Abnormal returns according to the market model were as follows for the expanded sample. For known losers, 2-day returns averaged 0.2% (t = 0.26); 6-day returns averaged 0.4% (t = 0.38); 21-day returns averaged -0.4% (t=-0.28); and 61-day returns averaged -1.7% (t=-0.62). For known winners, 2-day returns averaged 2.7% (t = 3.22, ct < 0.001); 6-day returns averaged 3.7% (t=3.32, ct < 0.001); 21-day returns averaged 6.3% (t=3.71, c~< 0.001); and 61-day returns averaged 6.9% (t=2.55, c~< 0.01). These results are once again fully consistent with the ones obtained using market adjusted returns.

Table 3 Abnormal returns for expanded returns windows, by sell-off type - expanded sample t-value (and % positive/ level of % negative significance) returns (and binomial test result on sign of returns) (Day - 2 0 to Day 0) window mean abnormal return (and standard deviation of returns) 0.69 4.28 (~<0.001) -0.11 t-value (and % positive/ level of % negative significance) returns (and binomial test result on sign of returns) (Day - 6 0 to D a y 0) window mean abnormal return (and standard deviation of returns) t-value (and % Positive/ level of % negative significance) returns (and binomial test result on sign of returns)

e~

Type of sell-off (and sample size)

(Day - 5 to day 0) window mean abnormal return (and standard deviation of returns)

1.52 4.44 (~<0.001)

K n o w n losers (n = 85) Known winners(n=63)

0.0133" ( s - 0.0803) 0.0457* ~s=0.0817)

48/52 (z = - 0 . 3 3 ) 70/30 (z=3.43; p - 0.0003)

0.0094** (s = 0.1255) 0.0625"* (s=0.1157)

51/49 (z=0.11) 70/30 (z-3.43; p = 0.0003)

-0.0030*** (s = 0.2512) 0.0739'** (s=0.2195)

2.67 (ct < 0.005)

56/44 ( z - 1.11) 75125 (z =4.58; p-0.0001)

z~

*The difference in mean abnormal returns between known winners ( = 0.0457) and known losers ( = 0.0133) for the [-5, 0] window is significant at the
t~j

0.01 level, with a t-value of 2.43. *'The difference in mean abnormal returns between known winners ( = 0.0625) and known losers ( = 0.0094) for the [-20,0] window is significant at the

= 0.005 level, with a t-value of 2.66. " T h e difference in mean abnormal returns between known winners ( = 0.0739) and known losers ( = -0.0030) for the [-60,0] window is significant at the
O

= 0.025 level, with a t-value of 1.98. Returns are market-adjusted abnormal returns, s u m m e d up over the 6, 21 or 61 days, in the event window (the days leading up to and including the sell-off

announcement date in the Wall Street Journal). K n o w n winners are divisions unambiguously characterized as such in a Wall Street Journal story prior to the sell-off announcement, or whose financial status was publicly revealed in the company's annual report. A similar definition applies to known losers.

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ogy. As a result, we could not formally test whether a greater proportion of losers (as a fraction of the total population of losing divisions) than winners (as a fraction of the total population of winning divisions) got sold-off.
3.5. A n attenuation hypothesis

Might other hypotheses lead to the observed stock price reactions? One plausible interpretation of our results is that sell-offs are positive events both for known winners and known losers, but because losers are much more likely to be divested, their stock price reaction is attenuated. Malatesta and Thompson (1985), Lanen and Thompson (1988) and Acharya (1988) discuss how the stock price reaction to an event can be decomposed into the economic impact of the event and the market's surprise. This decomposition implies that an event that is partially anticipated will produce, on average, an announcement effect that is an attenuated signal of the event's economic impact. Moreover, the degree of attenuation increases with the probability of the event occurring. To support our model we would therefore like to reject the hypothesis that a sell-off of a known loser is a positive but largely anticipated event in favor of the alternative that it is fully anticipated and hence conveys no information. The attenuation hypothesis can be investigated by looking at cumulative abnormal returns over long event windows leading up to announcements of divestitures of losing divisions. If the announcement of a sell-off of a losing division is a positive but partially anticipated signal, its full positive economic impact will be released in gradual fashion over time as the market updates selloff probabilities from the division's performance (see e.g., Malatesta and Thompson (1985)). Thus one might expect to find significant positive abnormal returns for losing divisions over event windows longer than the standard 2-day size. Table 3 reports that the cumulative abnormal return of losing divisions over the 21-day period leading up to - and including - the announcement date is statistically insignificant. A similar conclusion is reached with a 61-day window. If divestitures of losers are positive events, then this evidence indicates that the market is not anticipating the good news, at least not during the months of trading preceding the announcement date. 35 We therefore interpret our results as evidence against the attenuation hypothesis.

35Of course, even longer windows could test for more gradual anticipation. With longer windows however, we run the risk of increasing the noise-to-signal ratio in cumulative abnormal returns, since we would also pick up more noise in the returns. Given this uncertainty about the optimal length of the window, our choice of 21 days (one month) and 61 days (three months) appears reasonable.

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4. Conclusions
This paper has presented a reputational model o f divestiture activity. The novel feature o f the model is that it yields a sharp cross-sectional testable implication for event studies o f sell-off announcements: a decision to divest a division that is k n o w n to be successful conveys g o o d news a b o u t the division; in contrast, a decision to divest a division that is k n o w n for u n d e r p e r f o r m a n c e conveys no news a b o u t the division. We tested this hypothesis on a sample o f sell-off a n n o u n c e m e n t s for which we found stories in the W a l l Street Journal that u n a m b i g u o u s l y characterized the divisions being sold as "winners" or "losers". The stock price reactions for winners is a statistically significant 2.5% while that for losers is indistinguishable f r o m zero. W h e n the sample was expanded to include divisions whose profitability had been disclosed in the firm's annual report, sell-offs o f winners resulted in a highly significant 3.4% average stock price increase over the 2-day event window. The 21-day w i n d o w leading up to the event date for winners showed a highly significant 6.25% stock price increase. The expanded sample also p r o d u c e d a stock price reaction for losers that is indistinguishable from zero over both short and long event windows. These results are consistent with our model, and inconsistent with the alternative hypothesis that sell-offs are universally positive events but that divestitures o f losers are more extensively anticipated by the market.

Acknowledgements
The c o m p u t a t i o n a l support o f J o d y Magliolo and J o n a t h a n Sokobin is gratefully acknowledged. The usual disclaimer applies.

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