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date: 21 September 2020

# Behavioral and Social Corporate Finance

## Summary and Keywords

Corporate finance is about understanding the determinants and consequences of the investment and financing policies of corporations. In a standard neoclassical profit maximization framework, rational agents, that is, managers, make corporate finance decisions on behalf of rational principals, that is, shareholders. Over the past two decades, there has been a rapidly growing interest in augmenting standard finance frameworks with novel insights from cognitive psychology, and more recently, social psychology and sociology. This emerging subfield in finance research has been dubbed behavioral corporate finance, which differentiates between rational and behavioral agents and principals.

The presence of behavioral shareholders, that is, principals, may lead to market timing and catering behavior by rational managers. Such managers will opportunistically time the market and exploit mispricing by investing capital, issuing securities, or borrowing debt when costs of capital are low and shunning equity, divesting assets, repurchasing securities, and paying back debt when costs of capital are high. Rational managers will also incite mispricing, for example, cater to non-standard preferences of shareholders through earnings management or by transitioning their firms into an in-fashion category to boost the stock’s price.

The interaction of behavioral managers, that is, agents, with rational shareholders can also lead to distortions in corporate decision making. For example, managers may perceive fundamental values differently and systematically diverge from optimal decisions. Several personal traits, for example, overconfidence or narcissism, and environmental factors, for example, fatal natural disasters, shape behavioral managers’ preferences and beliefs, short or long term. These factors may bias the value perception by managers and thus lead to inferior decision making.

An extension of behavioral corporate finance is social corporate finance, where agents and principals do not make decisions in a vacuum but rather are embedded in a dynamic social environment. Since managers and shareholders take a social position within and across markets, social psychology and sociology can be useful to understand how social traits, states, and activities shape corporate decision making if an individual’s psychology is not directly observable.

# Introduction

Over the past two decades, there has been a rapidly growing interest in augmenting standard frameworks in corporate finance research with novel insights from cognitive psychology and, more recently, social psychology and sociology. This emerging subfield in finance research has been dubbed behavioral corporate finance (e.g., Baker, Ruback, & Wurgler, 2007; Baker & Wurgler, 2013). In fact, this is a natural evolution of the broader field of behavioral finance, which was initially primarily devoted to detecting anomalies in returns of stocks and other securities, that is, departures from the efficient markets hypothesis (e.g., Barberis & Thaler, 2003; Hirshleifer, 2015; Thaler, 2016), but not concerned with corporate financial decision making.1

One may speculate why it took significantly longer for behavioral approaches to enter corporate finance than asset pricing research. One potential reason may be that stock return data have been accessible longer than data on influential corporate decision makers, for example, chief executive officers (CEOs). Another reason may be that corporate finance decisions are made by professional and skilled managers who are often educated at top universities and are subject to strong financial incentives, for example, stock-based compensation and other corporate governance mechanisms.

The question arises what exactly makes behavioral corporate finance behavioral and what non-behavioral corporate finance framework can it be contrasted with? At its core, corporate finance is about understanding the determinants and consequences of the investment and financing policies of corporations. One of the earliest frameworks in corporate finance is the profit-maximizing corporation (e.g., Coase, 1937), that is, corporate finance policies—whether investment, financing, or any other policies are set optimally to maximize a firm’s expected future cash flows and/or minimize the cost of capital.

Since in many firms, and particularly in large public corporations, ownership and control are separated (e.g., Berle & Means, 1932), more contemporary frameworks in corporate finance focus on this separation of ownership and control, specifically the differentiation between risk-bearing and decision making. One example is the principal-agent theory (e.g., Holmstrom & Tirole, 1991; Jensen & Meckling, 1976), in which agents, that is, managers, make corporate finance decisions on behalf of principals, that is, shareholders. In this framework, managers maximize their private benefits as shareholders can not perfectly observe a manager’s skills (ex ante) or actions (ex post) due to the presence of asymmetric information, coupled with inherently incomplete contracts and financial incentives. This may result in corporate finance policies that are associated with increased costs for shareholders. A classic example is the evidence that managers prefer relatively lower debt in a firm’s capital structure as they would experience much higher personal costs of a corporate bankruptcy compared to well-diversified shareholders who therefore take on higher debt levels (e.g., Berger, Ofek, & Yermack, 1997). Crucially, in principal-agent models, managers are still rational maximizers, they are just not necessarily maximizing the value of the firm.

# Behavioral Principal-Agent Framework

Our definition of behavioral corporate finance is straightforward in that it is a combination of a standard principal-agent framework and empirical evidence from psychology research on human behavior. In a behavioral framework, there are two types of actors whose behavior departs from what is assumed in standard neoclassical models: principals and agents.

Figure 1 shows a 2 × 2 matrix with standard versus behavioral principals and agents, with the neoclassical quadrant containing rational principals interacting in financial markets with rational agents (Quadrant Q1). These standard assumptions may still result in deviations from a first-best market equilibrium with potentially significant agency costs because of the presence of economic frictions related to, for example, asymmetric information, taxes, or transaction costs. Hence, actions such as managerial empire-building (e.g., Jensen, 1986) or enjoying the quiet life (e.g., Bertrand & Schoar, 2003) are not what makes corporate finance behavioral.

Figure 1. Standard versus behavioral principals and agents (own illustration).

Quadrants Q2 to Q4 show behavioral principals versus behavioral agents and what makes corporate finance behavioral. One set of assumptions is that principals are behavioral, that is, systematically affected by various psychological biases (Quadrant Q2). Importantly, limits of arbitrage is a necessary condition for the existence of behavioral shareholders. Here, agents are rational and either exploit or induce mispricing of securities caused by the existence of imperfectly rational shareholders. In a classic example, managers cater to shareholders by paying dividends when the stock market assigns a valuation premium on dividend payers (e.g., Baker & Wurgler, 2004b). In standard corporate finance models, there is no rational reason for such catering behavior as the stock market only impounds information related to the fundamental value of a company.

Another set of assumptions is that agents are behavioral, that is, deviate from the commonly assumed behavior of homo economicus in systematic ways as predicted by research in psychology (Quadrant Q3). If financial markets are efficient, then limits of governance is a necessary condition for the existence of behavioral managers, that is, standard governance and incentive-based contracting may have limited effects as an imperfectly rational manager may well believe that she is maximizing the firm’s value. As a concrete example, there is evidence that various personal and professional experiences, for example, entering the labor market in a boom versus bust, significantly affect a manager’s style and consequently corporate decision making (e.g., Bertrand & Schoar, 2003; Malmendier & Nagel, 2011; Schoar & Zuo, 2016). In contrast, managerial experiences would only affect policies in standard corporate finance models to the extent that they affect a manager’s information set.

The last quadrant illustrates the coexistence of behavioral principals and behavioral agents (Quadrant Q4). While researchers agree that both actors may exhibit non-standard beliefs or preferences, open puzzles remain with regard to how behavioral agents would take advantage of stock dislocations caused by behavioral principals or how investment and financing distortions arise as a result of misinterpreting shareholders’ naiveté (e.g., Baker & Wurgler, 2013; Barberis & Thaler, 2003; Malmendier & Tate, 2015; Shefrin, 2009).

## Behavioral Principals

In this section, papers with behavioral shareholders but with rational managers are reviewed (Quadrant Q2, Figure 1). Specifically, financial markets are not fully informationally efficient, and rational managers are able to exploit deviations of market from fundamental values by selecting specific corporate policies.2

Figure 2 shows a firm whose fundamental value is increasing over time as a rational manager is maximizing the firm’s expected value, that is, incentives are set optimally, by investing in positive NPV projects. The figure shows that mispricing may arise for two distinct reasons, with different implications for managerial behavior. First, mispricing may be exogenous from the perspective of a rational manager, that is, the manager did not exert any actions to bolster the firm’s value. However, she can exploit such mispricing by timing the market (Actions A1 and A2). Second, a rational manager may engage in catering, that is, entice irrational shareholders based on the prevalent sentiment on capital markets (Action A3). In this situation, the manager is directly responsible for increasing the market value of the firm and thus creating a wedge between market and fundamental values by selecting specific policies.

Figure 2. Behavioral principals versus standard agents and firm value (own illustration).

### Timing

Timing refers to situations in which rational managers capitalize on transitory mispricing of their firm’s value (Actions A1 and A2, Figure 2). Specifically, deviations from the fundamental value are caused by factors beyond the control of the manager, including overconfidence of investors or limits of intermediation (e.g., Adebambo & Yan, 2018; Daniel, Hirshleifer, & Subrahmanyam, 1998; Ljungqvist, Nanda, & Singh, 2006; Santos, 2017).

#### Investment Policies

Real Investments. Consistent with Stein’s (1996) seminal model involving “Rational Capital Budgeting in an Irrational World,” Baker, Stein, and Wurgler (2003) find that a firm’s investment policy is sensitive to mispricing of stock prices. Managers time capital expenditures in part due to deviations between market and fundamental values. In particular, if a firm is overvalued, then, ceteris paribus, the firm’s cost of equity is reduced, which results in an increase in corporate investments (e.g., Gilchrist, Himmelberg, & Huberman, 2005). In contrast, when a firm is undervalued, managers are reluctant to invest in positive NPV projects since the cost of capital is high. This mispricing–investment relation is most pronounced for equity-dependent and financially constrained firms (e.g., Alzahrani & Rao, 2014; Baker et al., 2003).

Research and Development (R&D). The evidence related to mispricing and R&D investments is less clear. On the one hand, Alzahrani and Rao (2014) cannot confirm a market timing hypothesis when investing in R&D, possibly due to the endogenous nature of mispricing. To address this, Parise (2013) creates a liquidity-based exogenous measure of mispricing and concludes that underpriced firms innovate less as shareholders are myopic and fail to value the long-term payoffs from R&D. Hence, instead of engaging in innovation, managers rather repurchase the firm’s shares in order to time the market.

Mergers and Acquisitions (M&A). Shleifer and Vishny (2003) develop a theoretical framework, which shows that mispricing on capital markets affects the outcome of who acquires whom, the choice of stock versus cash payment, the valuation of mergers, etc. In line with a market timing view, this implies that managers of overvalued companies increase their M&A activity and rely more on stock payment when mispricing is prevalent. Several studies confirm Shleifer and Vishny’s (2003) predictions by using empirical data and controlling for factors predicted by neoclassical theories (e.g., Anderson, Huang, & Torna, 2017; Baker, Foley, & Wurgler, 2009; Dong, Hirshleifer, Richardson, & Teoh, 2006; Gao, 2010; Van Bekkum, Smit, & Pennings, 2011).

From the target’s perspective, however, the question arises as to why rational target managers should accept such overvalued stock payments (e.g., Rhodes-Kropf & Viswanathan, 2004). Vermaelen and Xu (2014) argue that it is not irrational to accept stock bids if the acquirer is able to justify the equity financing based on the firm’s fundamentals. Also, since acquirers pay relatively higher premiums when using stocks instead of cash, the question is not why target’s should not accept the higher payment but rather why bidding managers prefer to pay a higher premium for their targets. In their paper, Baker, Coval, and Stein (2007) explain that such stock M&As are used as a channel to nudge the acquirer’s shareholders toward issuing equity passively, that is, shareholders automatically accept market timing, which often is less costly in the short term as compared to issuing equity directly, where shareholders have to actively engage in purchasing overvalued shares (e.g., Lamont & Stein, 2006). Hence, in the latter case, managers may plan to time the market, but it can happen that they end up not doing so as a result of shareholders’ lack of active participation in the planned issuance program.

In the long term, however, it is questionable whether issuing equity indirectly is indeed the cheaper option to issuing equity directly. Shleifer and Vishny (2003), for example, provide theoretical evidence that these overvaluation-driven M&As exhibit poor post-event performance. Empirically, Ang and Cheng (2006) as well as Savor and Lu (2009) cannot fully confirm the long-term underperformance of stock M&As but show that acquirers are, on average, better off when conducting market-driven acquisitions than if they do not acquire any target at all.

Generally, through the adoption of shelf registrations rules in the early 1980s, a higher flexibility in market timing through direct equity issuances is provided to firms (e.g., Autore, Kumar, & Shome, 2008; Kadapakkam & Kon, 1989). Specifically, companies need to file only a single registration statement for all future issues within the next two years (for further information on shelf registrations Rule 415, see e.g., Kidwell, Marr, & Thompson, 1987). As a consequence, borrowing costs are reduced due to increased competition but can also increase since the opportunity to perform intensive due diligence is limited (e.g., Kidwell et al., 1987). Thus, firms receive a higher amount of freedom to issue shares quickly and easily, which reduces the cost of engaging in direct equity issuances.

#### Financing Policies

Equity Financing. The equity market timing hypothesis originates from the initial public offering (IPO) issuance puzzle (e.g., Loughran & Ritter, 1995; Ritter, 1991). IPOs provide a natural setting to study equity issuances since their financing purpose is straightforward, that is, IPOs are the financing event of a company, and asymmetric information pre-IPO provides a base for corporate misvaluation (e.g., Alti, 2006). An important consequence of timing behavior is the well-documented long-run underperformance of firms issuing equity and repurchasing shares (e.g., Ikenberry, Lakonishok, & Vermaelen, 1995; Spiess & Affleck-Graves, 1995; Schultz, 2003). In specific, formal behavioral models of timing imply that equity issuances predict abnormal returns negatively and repurchase activity positively (e.g., Daniel et al., 1998; Stein, 1996). Baker and Wurgler (2000) find that managers systematically market time when their firm’s equity is overpriced. Similarly, managers repurchase shares when market values are lower than fundamentals (e.g., Dittmar & Field, 2015). A survey by Graham and Harvey (2001) confirms the market timing practice as a majority of chief financial officers (CFOs) respond that they would issue equity if their stock is overvalued and almost as many answered that they would sell if the price increased lately. Several studies confirm empirically that market timing considerations are relevant in equity issuance decisions for firms listed in other countries, including the United States (e.g., Dong, Hirshleifer, & Teoh, 2012; Henderson, Jegadeesh, & Weisbach, 2006) and for cross-listing (e.g., Sarkissian & Schill, 2016).

As the aforementioned studies may suffer from endogeneity, more recent literature focuses on a more clear identification or more complete characterization of market timing incentives. For example, Jenter, Lewellen, and Warner (2011) examine manager-related timing effects based on put sales conducted by CEOs. They argue that managers would not sell puts if they did not believe that they could time the market. Baker and Xuan (2016) study how much of the market timing effect is attributable to the firm versus the CEO and find that equity issuance decisions are largely dependent on the manager’s identity rather than the firm characteristics.

Further, moderating effects involved in different types of equity issues are considered as well. For IPOs, for example, Ljungqvist et al. (2006) and Santos (2017) provide support for the market timing hypothesis in the presence of investor sentiment. Also, Derrien and Kecskés (2007) explore two-stage IPOs and find that such equity issues offer an opportunity for managers to time the market twice, with the second issuance being faster and less costly. In seasoned equity issues (SEOs), market timing effects also depend on the influence of controlling or institutional shareholdings (e.g., Alti & Sulaeman, 2012; Hovakimian & Hu, 2016; Intintoli, Jategaonkar, & Kahle, 2014; Larrain & Urzúa I., 2013).

Debt Financing. Graham and Harvey (2001) find that market timing of debt issuance occurs when CFOs believe that interest rates are low. Baker, Greenwood, and Wurgler (2003) explain that issuing debt at low costs is consistent with a behavioral view and emphasize that if debt issues are long term rather than short term, then subsequent excess bond returns are predicted to be low. In this vein, Henderson et al. (2006) examine firms operating in international markets, which issue foreign rather than domestic debt, motivated partially by timing considerations.

In contrast to equity issues, in which managers have market timing abilities due to more private information (e.g., Jenter et al., 2011), the question arises as to why managers believe they have a comparative advantage over publicly available debt-related information. Greenwood, Hanson, and Stein (2010) explain that such an advantage is indeed not based on the manager’s forecasting ability with regard to bond returns but in the provision of liquidity. Specifically, when the supply of long-term government securities increases relative to short-term ones, then the former provide higher expected returns, and firms that are able to provide liquidity can exploit the supply shocks by market timing debt issues.

Capital Structure. Several studies focus on the interacting effect of issuing equity and debt as well as its long-term consequences for a firm’s financial leverage (e.g., Baker & Wurgler, 2002; Dong, Loncarski, ter Horst, & Veld, 2012). For example, Baker and Wurgler (2002) show that equity market timing has a persistent effect on a firm’s capital structure. Specifically, firms issue more equity than debt when mispricing conditions are favorable and thereby do not set their debt level optimally as suggested by trade-off or pecking order theories (e.g., Baker & Wurgler, 2000; Dong, Hirshleifer, & Teoh, 2012; Lewis & Tan, 2016). Indeed, Yang (2013) finds that excessive equity financing activities from market timing as well as debt conservatism distort capital structure decisions.

Alti (2006) and Bonaimé, Öztekin, and Warr (2014) show that firms adjust their leverage to an optimal level, but only when debt is cheap. Similarly, Axelson, Jenkinson, Strömberg, and Weisbach (2013) and Gompers, Kaplan, and Mukharlyamov (2016) document similar behavior for the capital structure decisions by private equity funds.

### Catering

Catering refers to situations in which rational managers exploit variation in investor sentiment by exerting specific actions at their disposal to actively boost stock prices above fundamental values (Action A3, Figure 2). Such actions include catering to short-term investor preferences by undertaking investments or packaging the firm’s financing and other decisions in a way that is appealing to mainly incoming shareholders (e.g., Baker & Wurgler, 2000; Lee, Shleifer, & Thaler, 1991). For example, as shareholders often categorize stocks, which managers are aware of, managers therefore transition their firms into an in-fashion category preferred by shareholders to create a short-term valuation increase (e.g., Barberis & Thaler, 2003; Chen, Cohen, & Lou, 2016).

#### Investment Policies

Real Investments. Polk and Sapienza (2009) examine the relation between market inefficiencies and corporate investment decisions stemming from catering, that is, stock prices are inflated by management through real investment decisions. These effects are larger when market frictions are relatively small and capital markets are more developed (i.e., lower costs of raising capital and more opportunities to undertake such catering actions; e.g., Kusnadi & Wei, 2017).

R&D. Research on mispricing stemming from managerial actions as a result to prevalent market sentiment is less evident for R&D decisions (e.g., Polk & Sapienza, 2009; Kusnadi & Wei, 2017). For example, Brown, Fazzari, and Petersen (2009) argue that if managers want to cater to incoming shareholders through investment, they would be reluctant to invest in R&D as it cuts down accounting profits and requires higher subsequent adjustment costs as compared to investments into, for example, physical capital. In addition, exploiting short-term investor preferences is less attractive for management since R&D has long-run rather than short-run value effects (e.g., Ravenscraft & Scherer, 1982).

Since effects stemming from timing are not always easy to distinguish from catering effects, Dong, Hirshleifer, and Teoh (2019) focus on a cleaner identification to disentangle the two effects when engaging in innovative spending. They find that most of the total effect on R&D expenses can be explained by the catering channel using exogenously as well as endogenously determined sentiment measures. Thus, short-term shareholders do appreciate risky and audacious projects and are willing to pay an innovation premium for firms engaging in highly risky “moon shot” projects.

M&A. Massa and Zhang (2009) construct a sentiment index based on the popularity of firms that exhibit a certain investment style. They find that the difference in popularity between the acquirer and the target is positively related to increased market values as well as target premiums. Thus, managers of bidding companies cater to favored investment styles through “cosmetic mergers.” They will therefore select an acquisition target that has a style that is relatively more popular than their own.

#### Financing Policies

Equity Financing. Since managerial financing has the goal to satisfy long-term rather than short-term investors, there is little support for the catering theory in this domain. Nevertheless, Hirshleifer, Jian, and Zhang (2018) show that catering can matter. In specific, they study stock listing codes in Chinese IPOs and find that lucky numbers are more frequent than unlucky ones. They argue that if shareholders prefer IPOs with lucky numbers, then either the manager or the stock exchange can cater to shareholders’ superstitions.

Debt Financing. De Jong, Duca, and Dutordoir (2013) examine shareholders’ preferences in convertible bonds favoring catering incentives. They observe that demand is not perfectly elastic to the fundamental values of equity as proposed by Ammann, Kind, and Seiz (2010) and find empirical evidence that firms issue either a greater amount or set a higher price for their offer when demand is higher. Yet catering evidence is limited with regard to the design of convertible bond offerings.

#### Distribution Policies

Dividend Payment. Baker and Wurgler (2004b) find that shareholders are willing to pay dividend premiums and suggest a catering theory for dividends which may partially explain the disappearing dividends puzzle (e.g., Baker & Wurgler, 2004a; Fama & French, 2001). Specifically, when dividends are highly valued by the stock market, non-payers initiate dividend payments to cater toward shareholders (e.g., Baker, 2009). For example, in bust markets, the sentiment for value stocks is high and shareholders seek secure dividends rather than risky growth or capital gains. Baker and Wurgler (2004b) also control for dividend clienteles (e.g., Becker, Ivković, & Weisbenner, 2011) to investigate whether the origin of shareholders’ differing dividend taste stems from traditional sources (e.g., taxes, transaction costs).

The catering view is confirmed for dividend changes by Li and Lie (2006) and for U.K. data by Ferris, Sen, and Yui (2006). Ferris, Jayaraman, and Sabherwal (2009) show that in civil law countries, managers are less disciplined to satisfy shareholders due to poorer shareholder rights and investor protections, introducing a potential limit to the catering theory (for further international evidence, see also Denis & Osobov, 2008).

Shefrin and Statman (1984) develop behavioral explanations for why shareholders may prefer dividends and provide theoretical arguments that these must be based on self-control issues, prospect theory, or regret aversion. By examining cross-country differences in dividend payment policies, Breuer, Rieger, and Soypak (2014) find that shareholders are willing to pay dividend premiums if they are loss averse, ambiguity averse, or impatient.

Some studies recognize limitations to the catering theory (e.g., Chetty & Saez, 2005; Kale, Kini, & Payne, 2012; Manconi & Massa, 2013; Turner, Ye, & Zhan, 2013). For example, Hoberg and Prabhala (2009) control for several risk components and imply that risk, and not sentiment, explains the variation in dividend payments (for a similar analysis, see also Bulan, Subramanian, & Tanlu, 2007).

Hartzmark and Solomon (2013) rule out risk-based theories of both the firm dividend policy and market dividend premium, in favor of the behavioral view, by compiling the “dividend month premium,” which is not conditioned on the actual dividend payment, and controlling for macroeconomic risks. They compare months in which dividends are expected versus not expected as well as analyze dividend-seeking shareholders buying the dividend paying stock in the month before payment and find that returns increase in the dividend predicting month.

Share Repurchases. Jiang, Kim, Lie, and Yang (2013) and Kulchania (2013) argue that the lack of catering incentives as promoted by Hoberg and Prabhala (2009) can be explained by substitution effects between dividend payments and share repurchases, both examples of corporate distribution policies. To account for this, Jiang et al. (2013) incorporate in their study a dividend and repurchase premium and Kulchania (2013) compile a difference premium, which jointly considers the distribution activity of dividend-paying and repurchasing firms. The authors find that catering effects are present when firms’ switching behavior from paying dividends and repurchasing shares are taken into account.

#### Other Policies

Nominal Stock Price Management. Theoretically, share price management through stock splits should not affect market values since no benefits are created. Baker and Gallagher (1980) use CFO survey data and conclude that companies focus on the demand of small investors.

Baker et al. (2009) propose a catering view for undertaking stock splits. They argue that if the market assigns higher value to low-price firms, a rational manager will supply a higher amount of shares at lower nominal prices. As small investors become wealthier and hence migrate away, Minnick and Raman (2014) argue that stock splits stemming from catering considerations are reduced.

Green and Hwang (2009) ask why nominal share prices matter to investors and propose a “nominal share price illusion,” which states that shareholders categorize stocks based on prices and thus perceive stocks as being cheaper. In a recent study, Birru and Wang (2016) are able to explore this psychological bias, that is, linking nominal share prices to future return expectations, and show that shareholders indeed overestimate the room to grow when stocks are priced at lower levels as it is the case for skewed assets.

Company Name Management. Cooper, Dimitrov, and Rau (2001) examine name changes to a “.com” name and discover that the stock price is boosted surrounding such announcements. The authors argue that name changes are catering actions toward prevailing investor tastes as even non–Internet-related companies switch to a “.com” name. Similarly, Cooper, Khorana, Osobov, Patel, and Rau (2005) study such cosmetic name changes in times of negative sentiment levels toward Internet stocks. If Internet-related firms want to appear as non-Internet firms during busts of Internet stocks, they eliminate “.com” from their names, and a positive price increase around the name change is observed.

Wu (2010) casts doubt on the catering theory as she finds that name changes just reflect future business changes. Bae and Wang (2012) also study non–catering-driven name effects and examine Chinese companies listed on U.S. stock exchanges. The authors show that Chinese stocks with “China” in their name outperform during boom times. They propose that this is a result of increased investor attention to, and not preference for, Chinese stocks.

Financial Reporting Policy. Rational managers may incite misvaluation through upwards earnings management or disclosure decisions (e.g., Brown, Christensen, Elliott, & Mergenthaler, 2012; Hirshleifer, 2015). For example, firms inflate accounting accruals to increase cash flows and consequently earnings before going public (e.g., Teoh, Welch, & Wong, 1998a) or seasoned equity offerings (e.g., Teoh, Welch, & Wong, 1998b). Chen and Lin (2011) also show that managers cater to shareholders by excessive earnings management. Specifically, if earnings surprises are high, firms’ return on equity (ROE) adjustments are slower, which is the result of pronounced earnings management policies.

The reason why inciting prices by management is possible can be traced back to limited attention and reference-dependent expectations by investors. For example, Carslaw (1988) and Degeorge, Patel, and Zeckhauser (1999) examine the underlying mechanism of sentiment-driven earnings management and find that numbers are shaped by catering concerns in order to meet or exceed investors’ expectations with regard to certain financial thresholds. Similarly, Chen et al. (2016) use the regulatory change of primary industry classification by the U.S. Securities and Exchange Commission (SEC) and find that firms manipulate sales to be part of a specific industry classification that is favored by shareholders, referred to as “industry window dressing.”

## Behavioral Agents

In this section we review studies with behavioral managers who interact with shareholders in efficient capital markets (Quadrant Q3, Figure 1). The beliefs or preferences of such behavioral agents depart from the commonly assumed rational behavior of homo economicus in systematic ways, which may be explained by seminal research in psychology. In particular, in his book Principles of Topological Psychology, published in 1936, psychologist Kurt Lewin (a.k.a. the “founder of social psychology”) proposed what has become known as Lewin’s equation:

$Display mathematics$

where $B$ is behavior and $S$ is the “life space,” which may be separated into $P$ (Person) and $E$ (Environment)—that is, an individual’s behavior is a function of the person and her environment.3

This dynamic function of an agent’s behavior also influences corporate policies. Specifically, the notion that behavior in the personal domain spills over to professional decision making is referred to as behavioral consistency in psychology (e.g., Sherman, Nave, & Funder, 2010) and has been identified in behavioral corporate finance research (e.g., Ali & Hirshleifer, 2019; Cronqvist, Makhija, & Yonker, 2012; Davidson, Dey, & Smith, 2015).

Behavioral characteristics related to a person are categorized as traits, states, and activities (e.g., Chaplin, John, & Goldberg, 1988; Norman, 1967), which can be influenced by the environment. These influences can be further classified as macro variables, that is, the surrounding environment encountered throughout the course of one’s personal or professional life, and micro variables, that is, acute environments that affect a person’s current emotional state or mood (e.g., Lewin, 1951).

### Behavioral Traits

An agent’s behavior is shaped by deeply ingrained and stable personal traits. Such characteristics are innate, more or less determined by nature (e.g., gender) and largely time-invariant (also referred to as managerial “style” fixed effects; e.g., Bertrand & Schoar, 2003).4

In addition, the human’s environmental context, for example, certain life conditions, also shapes personal traits and determines behavior (even) later in life and thus corporate finance decisions. Life experiences either have (1) an exogenous foundation, for example, exposure to the Great Depression (e.g., Malmendier & Nagel, 2011; Schoar & Zuo, 2016) or to a natural disaster (e.g., Bernile, Bhagwat, & Rau, 2017), which are often linked to stress or trauma, or (2) an endogenous origin, for example, holding an aircraft pilot license (e.g., Cain & McKeon, 2016), which usually contributes positively to an individual’s enjoyment.

#### Investment Policies

Real Investments. Heaton (2002) provides a model in which excessively optimistic managers overvalue corporate programs and therefore overinvest in negative NPV projects. At the same time, they also believe that financial markets undervalue their firm’s shares, and thus underinvest in positive NPV projects, if they have to be financed externally. Similarly, Malmendier and Tate (2005a) categorize CEOs as overconfident if they persistently fail to reduce their personal exposure to company-specific risk, that is, they do not exercise vested in-the-money options in the firms they manage. They find that overconfident managers overestimate the returns to their investment projects and view external funds as unduly costly. As a result, they overinvest when they have abundant internal funds but curtail investment when they require external financing.

These results have been confirmed by several other studies. First, using a measure based on media’s description of CEOs, Malmendier and Tate (2005b) find similar results. Second, Ben-David, Graham, and Harvey (2013) argue that commonly used overconfidence measures rather reflect optimism, construct a new measure, and show that executives who have miscalibrated beliefs about the stock market invest more. Finally, the availability of internal funds to finance projects is determined endogenously, raising concerns about causality (e.g., Ben Mohamed, Fairchild, & Bouri, 2014; Malmendier & Tate, 2005a). Malmendier and Tate (2015) address endogeneity by exploiting the exogenous variation in debt markets during the global financial crisis and find that investment decisions by overconfident managers are indeed more sensitive to external financing costs than those by rational CEOs.

R&D. Hirshleifer, Low, and Teoh (2012) examine potentially advantageous effects of managerial overconfidence on innovation input, output, and impact: overconfident CEOs invest more in R&D, produce more patents as well as patent citations, and obtain greater innovative success for given R&D expenditures. In other words, overconfident CEOs, identified by option- and media-based measures, may have a greater willingness to bear risks and therefore overcome their risk aversion toward risky projects, an effect that is particularly strong in highly competitive and innovative industries.

Galasso and Simcoe (2011) provide similar results when focusing on CEOs of large firms and suggest that overconfident CEOs are important drivers who can take firms to the next technological level.

M&A. The role of overconfidence in the market for corporate control was initiated by Roll (1986) with his “hubris hypothesis.” He shows that bidding managers are too confident when evaluating transaction synergies as compared to rational CEOs and therefore pay higher takeover premiums. Hayward and Hambrick (1997) examine the role of a CEO’s hubris, or exaggerated self-confidence, in explaining the large size of some premiums paid for acquisitions. Several indicators of CEO hubris are associated with the size of premiums paid: the acquiring company’s recent performance, recent media praise for the CEO, and a measure of the CEO’s self-importance. Malmendier and Tate (2008) apply their option and media-based construct of overconfidence in an M&A investment context and find that M&A activity and premiums increase due to managerial overconfidence resulting in a significant loss in shareholder wealth after the deal is consummated. Ferris, Jayaraman, and Sabherwal (2013) confirm these findings for international M&As, yet find that overconfidence characteristics differ across countries and are more pronounced in firms headquartered in countries with high degrees of individualism (i.e., individuals are less integrated into groups within a country, as is the case for, e.g., the United States).

Other studies focus on the personal trait of narcissism, which is defined as a “pattern of grandiosity, need for admiration, and lack of empathy” toward others (e.g., American Psychiatric Association, 1994; Campbell, Goodie, & Foster, 2004). For example, Aktas, De Bodt, Bollaert, and Roll (2016) find that narcissistic CEOs are more likely to initiate deals and negotiate them in less time. The authors identify CEOs who are prone to narcissism by counting the first-person singular pronouns in their speeches. Furthermore, Chatterjee and Hambrick (2007) examine narcissistic CEOs using a complementary proxy, for example, prominence of picture in annual reports, and find that narcissistic CEOs conduct more and larger acquisitions. However, CEOs who are prone to narcissism do not generally perform worse than non-narcissistic ones since narcissists work extremely hard so that they receive external admiration.

#### Financing Policies

Equity Financing. Excessively optimistic and overconfident managers are reluctant to issue equity as they believe that their firm’s stock is undervalued. Hence, external financing is perceived as costly by the CEO, which is why she prefers to repurchase rather than issue shares (e.g., Heaton, 2002; Malmendier & Tate, 2005a, 2005b; Malmendier, Tate, & Yan, 2011). Banerjee, Humphery-Jenner, and Nanda (2018) find that overconfident managers repurchase stock despite low levels of cash holdings and are more likely to substitute repurchases for dividends or capital expenditures. Rational shareholders recognize this behavior and react less positively to these repurchase announcements.

Debt Financing. Graham, Harvey, and Puri (2013) examine how managerial optimism, measured by a survey question, influences debt maturity choices. They find that optimistic managers select short-term rather than long-term debt compared to their non-optimistic peers. Consistent with a demand side story, Huang, Tan, and Faff (2016) find that firms with overconfident CEOs adopt a shorter debt maturity structure. Adam, Burg, Scheinert, and Streitz (2018) show that overconfident managers are more likely to issue rate-increasing performance-pricing provisions in loan contracts than regular debt.

In addition, Landier and Thesmar (2009) examine the effects of managerial optimism on financial contracting. They show that optimistic managers self-select into short-term debt and rational managers into long-term debt. Short-term debt is optimal for optimists by letting the manager bet on the project’s success.

Capital Structure. Hackbarth (2008) incorporates optimism and overconfidence into a model of capital structure to study the impact on corporate financial policy. Optimistic as well as overconfident managers choose higher debt levels and issue debt more often. Malmendier et al. (2011) also show that managerial characteristics have significant explanatory power for capital structure decisions. For example, overconfident managers use less external finance and, conditional on accessing external capital, issue less equity than their peers.

Cronqvist et al. (2012) examine a firm’s capital structure by looking directly at CEOs’ private preferences for leverage. Specifically, they show that there is a positive relationship between personal and firm leverage, that is, CEOs’ personal preferences spill over to the corporate domain. Similarly, Hutton, Jiang, and Kumar (2014) detect that CEOs who exhibit conservative personal ideologies, that is, certain preferences for conservative political parties, follow conservative rather than aggressive financial policies. In contrast, Cain and McKeon (2016) use private pilot licenses to proxy for CEOs’ personal risk preferences and find that pilot CEOs are associated with firms that exhibit high financial risk, for example, elevated levels of leverage.

CEOs may self-select into companies that fit their preferences, and thus unobservable standard factors may determine capital structure decisions, which causes endogeneity concerns regarding the outlined behavioral explanations. To address this, Malmendier et al. (2011) compare financial outcomes of different CEOs in the same firm and exploit formative early-life experiences of exogenous nature that shape non-standard beliefs and preferences toward capital structure choices. The authors find support for a causal relation. For example, CEOs who grew up during the Great Depression exhibit less trust and faith in capital markets and thus prefer internal over external funds. These CEOs behave more conservatively and underutilize leverage relative to optimal levels. Equivalently, Feng and Johansson (2018) provide empirical evidence that firms managed by CEOs who were exposed to a traumatic experience during childhood, for example, the Great Famine in China, have more conservative policies such as lower leverage.

Schoar and Zuo (2017) focus on adulthood experiences, which also shape the decisions of CEOs. For example, managers who start their career during economic recessions exhibit lower levels of leverage compared to non-recession CEOs. In contrast, CEOs who served in the military, especially those with combat or war experience, behave less conservatively and choose higher leverage ratios (e.g., Malmendier et al., 2011). Employing a broader sample, Benmelech and Frydman (2015) find that military CEOs prefer lower leverage.

Bernile et al. (2017) argue that exposure to a particular life event does not have a unidirectional effect on corporate decisions, but rather the intensity of exposures matters for CEOs’ risk-taking and hence corporate policies. By examining the degree to which CEOs were exposed to natural disasters (e.g., hurricanes), the authors find that CEOs who experienced disasters with low fatality rates exhibit a higher risk tolerance toward financing policies. CEOs highly exposed to natural disasters prefer a capital structure with lower debt proportion.

#### Other Policies

Financial Reporting Policy. Ahmed and Duellman (2013) and Hribar and Yang (2016) study overconfident CEOs and show that such CEOs exhibit more aggressive earnings forecast disclosures and less conservative accounting policies. Also, if executives own luxury goods or have legal records, they are more likely to conduct misreporting, or even corporate fraud, during their tenure. In contrast, CEOs who grew up as more frugal, that is, being exposed to the Great Famine in China, exhibit a reduced likelihood of unethical behavior (e.g., Feng & Johansson, 2018).

### Behavioral States

Several situational factors, that is, the context in which a human is located, affect behavior in the short term. For example, acute situations can influence the emotional state (i.e., irrational enthusiasm) and trigger certain temporary actions. As behavior is observed in an environmental context, it must not be consistent across situations or time but rather related to a specific domain or task (e.g., Lewin, 1935). For example, Mannor, Wowak, and Bartkus (2016) interview CEOs and find that managers who exhibit job-related anxiety take fewer strategic risks compared to their less stressed peers.

#### Investment Policies

Real Investments. Chhaochharia, Kim, Korniotis, and Kumar (2019) examine how managerial mood affects capital expenditures. They find that managers exhibit more optimistic expectations if they operate in favorable situations, that is, sunny periods, which has a persistent effect with regard to investments. The authors argue that it takes relatively long to debias such mood-induced expectations as small business managers are not exposed to a market containing rational shareholders they can learn from or listen to (e.g., Kau, Linck, & Rubin, 2008; Luo, 2005).

#### Other Policies

Financial Reporting Policy. Malmendier and Tate (2009) examine shifts in CEO status through prominent business awards and find that firms who are managed by media-induced superstar CEOs exhibit inferior stock and operating performance. The behavior of superstars changes due to cultivating their public status: managers spend more time outside the company, for example, on other firms’ boards or on private leisure activities such as playing golf. Due to private and professional distractions, managers may find it especially challenging to meet or exceed market expectations and therefore engage in active earnings management. Indeed, managers start to artificially increase earnings relative to their pre-superstar status and current peers in order to maintain their success and to not receive negative attention for their inferior performance. However, the superstar CEOs cannot sustain this in the long term, and eventually negative earnings are reported.

### Behavioral Activities

Simon (1955) suggests a behavioral model of human decision making, arguing that information acquisition, time, and cognitive costs result in bounded rationality and thereby biases. More recent contributions in this spirit include Gabaix (2014) and Hirshleifer and Teoh (2003), who model a “sparse max” agent, who builds a model of the world that is sparse.

These mental shortcuts are summarized under behavioral activities. Such heuristics are within a decision maker’s control and therefore can be improved through cognitive skills or with experience, specifically if the benefits from applying more rational behavior increases. In this vein, Ljungqvist and Wilhelm (2005) show that CEOs with more experience are less likely to exhibit behavioral biases when choosing their IPO underwriters.

#### Investment Policies

Real Investments. Krüger, Landier, and Thesmar (2015) introduce with the “WACC fallacy” a heuristic used by managers when evaluating business projects for allocations of capital expenditures. Based on prior literature, the authors argue that executives use a firm-wide discount rate instead of making risk-adjusted investment decisions, and therefore managers of conglomerate firms underinvest (overinvest) in relatively safe (risky) divisions (e.g., Brigham, 1975; Graham & Harvey, 2001; Trahan & Gitman, 1995). The application of such a heuristic decreases with time as financial innovation increases, and as a consequence more sophisticated discount rates are used by managers.

M&A. Krüger et al. (2015) examine M&As and stock market reactions around deal announcements. Under the WACC fallacy, acquirers use their own cost of capital when evaluating targets’ cash flows, hence not adjusting to a target’s risk profile. Therefore, acquirers pay higher premiums if the acquirer’s risk is higher than the target’s, and vice versa. In addition, the authors find that if the acquirer overestimates a target’s value by using a unique discount rate, returns around deal announcements are poor and reflect the lack of value creation.

Kim (2013) focuses on the personal activity directly and analyzes managers with biased self-attribution, that is, crediting their own ability for successes and blaming external factors for failures, which can also reinforce overconfidence in decision making (e.g., Gervais & Odean, 2001; Libby & Rennekamp, 2012; Miller & Ross, 1975). The author studies CEO interviews on CNBC and examines how often they reference themselves versus the economy when explaining reasons for failures. The results are in line with positive self-attribution, that is, self-referencing in cases of M&A success only.

Doukas and Petmezas (2007) exploit the time series of multiple acquisitions and argue that a self-attribution bias is prevalent if managers engage in further acquisitions after completing successful deals. They find that managers tend to credit the initial success to their own ability and therefore become overconfident and engage in more deals. Similarly, Billett and Qian (2008) find that CEOs’ first deals exhibit a zero return while subsequent deals exhibit negative announcement effects, and they interpret these results as consistent with a self-attribution bias. In contrast, Aktas, de Bodt, and Roll (2009) and Aktas, de Bodt, and Roll (2011) show that rational managers as well as those who are prone to overconfidence systematically learn from market signals and hence their ability to evaluate targets’ risks improves over time (e.g., Martin & Davis, 2010).

#### Financing Policies

Debt Financing. Dougal, Engelberg, Parsons, and Van Wesep (2015) introduce anchoring effects in firms’ loan decisions and show that a firm’s prior credit spread determines the rate at which a company can currently borrow. If spreads have moved in the firm’s favor, that is, declined, it is charged a higher interest rate than is justified by current fundamentals, whereas if spreads have moved to the firm’s detriment, it is charged a lower rate.

#### Other Policies

Risk Management. Adam, Fernando, and Golubeva (2015) use a unique data set of corporate derivatives positions and show that managers increase their speculative activities using derivatives following speculative cash flow gains, while they do not reduce their speculative activities following speculative losses. This asymmetric response is consistent with the selective self-attribution associated with overconfidence. In this vein, Beber and Fabbri (2012) show that CEOs’ cognitive errors stemming from self-attribution are reduced, that is, less speculation is observed, when managers exhibit more work experience or are older.

Moreover, Dessaint and Matray (2017) examine an availability bias when managers assess salient risks, inferred from a hurricane’s recent occurrence. Humans recognize salient events faster and easier, and therefore may become prone to an availability heuristic (e.g., Tversky & Kahneman, 1973, 1974). Indeed, the authors show that managers overreact to the salience of risk if hurricanes hit neighboring areas. As a result, managers temporarily increase their corporate cash holdings as well as emphasize their risk concerns by mentioning hurricane threats in company filings.

## Behavioral Principals and Agents

So far, only one of the actors in this behavioral principal-agent framework was assumed to be human. In reality, both actors may exhibit non-standard beliefs or preferences (see, e.g., the anecdotal evidence presented in Shefrin, 2009). However, without a novel identification strategy, it is empirically challenging to examine if and why behavioral managers capitalize on behavioral shareholders’ beliefs or preferences. One possibility to address this is to use a behavioral finance approach that does not focus on the non-standard behavior of certain parties, for example, behavioral states or traits, but instead on the deviations from standard predictions, that is, the detection of anomalies (e.g., Glaser, Nöth, & Weber, 2004). This direct approach is often applied when examining behavioral activities.

One example is the study by Baker, Pan, and Wurgler (2012), in which the authors detect reference points in M&A prices. Offer premiums are based on prior peak prices that serve as anchors. If target premiums exceed historical peaks, acquirer shareholders react negatively at deal announcement and target shareholders are more willing to accept the offer. Baker and Wurgler (2013) emphasize that in this scenario both actors may be prone to reference dependent biases. Theoretical models can also be valuable in examining less than fully rational principals and agents. One starting point for further research is the behavioral signaling theory introduced by Baker, Ruback, and Wurgler (2007), which is based on less rational managers as well as quasi-rational shareholders and therefore captures a broader range of implications. For example, managers use previously set reference points as a lower bound for dividend payments to cater to shareholders’ preferences and to signal superior information about the firm’s financial stability.

Figure 3 illustrates the coexistence of behavioral principals and behavioral agents. For example, if shareholders undervalue the company, overly optimistic managers may engage in excessive share repurchases which would distort firm value (Action A1). Similarly, in times of positive shareholder sentiment, a firm with no internal funds led by managers which would miss the opportunity to invest into a potentially value-increasing M&A deal since they would be reluctant to raise external capital (Action A2). Thus, behavioral principals and agents distort investments to a greater degree than if only one of the two actors would exhibit non-standard behavior (Actions A2 and A3).

Figure 3. Behavioral principals versus behavioral agents and firm value (own illustration).

# Social Corporate Finance

The notion of social finance was recently coined by Hirshleifer (2015), who argues that “the time has come to move beyond behavioral finance to social finance, which studies the structure of social interactions, how financial ideas spread and evolve, and how social processes affect financial outcomes” (p. 133). This approach draws on social psychology as well as sociology, that is, individuals underlie their “life-space” at any given moment in time, which is driven by forces that arise in specific social situations (e.g., Lewin, 1951). In Lewin’s (1951) field theory of personality, the underlying psychological mechanism of behavior, which is shaped by the environment, is examined directly. However, if the behavior is not directly observable, sociological factors are valuable in explaining behavior indirectly, for example, uncovering potential behavioral distortions within a social environment. In specific, a social environment is characterized by the presence of other individuals or groups, who create social channels, define processes, and make decisions. For example, Lewin (1951) describes social channels as definite formalized social systems, which contain established beliefs and values (hereafter social traits). In such systems, social processes, the ways of interaction between individuals in a particular situation, can be located. Social processes, to which interacting individuals are jointly exposed, can be changed and readjusted through social interactions (hereafter social states). Individuals within a social system may act as social receivers as well as social senders who consequently influence humans’ decision making, for example, changing the potency of frames and reference points (hereafter social activities). Therefore, in social environments direct or indirect communication between subjects is an essential medium. If information gets lost through communication, that is, information senders slice distal characteristics into proximal ones, then a receiver’s judgment may be formed probabilistic and not deterministic, leading to a biased mind (e.g., Brunswik, 1943). Thus, the concept of social traits, states, and activities can be investigated to identify humans’ cognitive dynamics toward a biased mind in accord with established social theorizing.5

Figure 4 illustrates the extension of the behavioral principal-agent framework toward a social approach. Specifically, the humans’ “life-space” is widened by its social atmosphere (e.g., Allport, 1954; Lewin, 1951). Thus, actors, that is, standard or behavioral principals and agents, are not isolated from others but take a social position within or across different environments. Hereby, social influence arises from the presence of others who are part of an individual’s environment.

Importantly, not all sociological determinants result in biased outcomes. In the following section, social corporate finance constructs are presented, and how socialization (i.e., social traits, states, and activities) can influence individuals’ cognitive behavior is discussed.

Figure 4. Social and behavioral principal-agent frameworks (own illustration).

## Social Traits

Social traits, like behavioral traits, are relatively stable. Individuals exhibit similar social traits if they belong to a similar organized institution. The most prominent social trait is culture, which is defined as a set of shared norms and values within a system that unifies individuals in social structures (e.g., Aggarwal, Faccio, Guedhami, & Kwok, 2016; Guiso, Sapienza, & Zingales, 2015; Smircich, 1983; Van den Steen, 2010b). For example, Crémer (1993) and Van den Steen (2010a) define culture theoretically as a “way of thinking” or “way of doing.” Thus, in the presence of bounded rationality, culture serves as implicit rules or a common language that facilitates the formation, processing, as well as transmission of information and ideas (e.g., Crémer, 1993; O’Reilly & Chatman, 1996).

However, cultural or social norms may not reduce complexities but be potentially harmful as they are “embrained,” and therefore decisions do not require cognitive mediation (e.g., Fazio & Olson, 2003; Kitayama & Uskul, 2011). For example, Weld, Michaely, Thaler, and Benartzi (2009) document that nominal share prices remain at a low levels since the 1930s even though it is costly for shareholders. The authors argue that this constancy is caused by corporate managers’ adherence to a social norm as there is no rational explanation that would explain this puzzle.

In the context of (non-)standard corporate finance, the cultural environment plays a role since it shapes a decision maker’s behavior, for example, their (non-)standard preferences and beliefs (e.g., Zingales, 2015). The main challenge in finance research is to operationalize the latent construct culture. While some studies analyze culture at the geographical level, others characterize it at the firm or individual level.

Frijns, Gilbert, Lehnert, and Tourani-Rad (2013) exploit the geographical variation in culture and find that firms located in countries with high degrees of risk tolerance, measured by Hofstede’s cultural dimension of uncertainty avoidance, conduct deals that require higher takeover premiums. In addition, cultural differences between countries lead to low cross-border deal volumes as the probability for cultural clashes and integration costs increase (e.g., Ahern, Daminelli, & Fracassi, 2015; Graham, Harvey, Popadak, & Rajgopal, 2017; Olie, 1990). In terms of financing decisions, Chui, Kwok, and Zhou (2016) examine Schwarz’s cultural dimension of embeddedness, that is, the opposite of autonomy, as well as mastering, that is, harmony and egalitarianism, and find that both dimensions have a negative effect on bankruptcy risk and agency costs, and therefore companies located in countries that score high on those dimensions profit from low costs of debt.

Local measures of culture and social capital, for example, religiosity or gambling attitudes, are also used to capture social norms. For example, firms headquartered in counties with high scores in religiosity or cooperative behavior, for example, high voting or organ donation rates, exhibit a lower rate of investment in tangible capital or R&D (e.g., Hilary & Hui, 2009) and receive more favorable debt financing terms, for example, lower bank loan spreads (e.g., Hasan, Hoi, Wu, & Zhang, 2017; He & Hu, 2016). In contrast, CEOs of companies located in areas with high propensities to gamble overvalue and invest into projects with high skewness, which is detrimental to shareholder wealth (e.g., Schneider & Spalt, 2016).

At the firm level, several facets of an organization’s culture can be examined as well. For example, studies measure ethics and competition versus creation-oriented cultures from company-specific texts such as annual reports (e.g., Fiordelisi & Ricci, 2014; Loughran, McDonald, & Yun, 2009). Others, like Tate and Yang (2015) and Guiso et al. (2015), rely on or use data from employee surveys or employment allocations to analyze the positive wealth effects of corporate cultures characterized with high levels of integrity and female friendliness. Also, Tian and Wang (2014) analyze tolerance for failure of venture capitalists and show that a culture with strong tolerance for failure results in increased start-up innovation.

Individual cultural heritage itself may affect managers’ risk preferences and thus corporate decision making (e.g., Liu, 2016; Pan, Siegel, & Wang, 2017). For example, Nguyen, Hagendorff, and Eshraghi (2018) show that CEOs’ ancestral origin, that is, having an immigrant background, leads to higher profitability compared to an average firm. The authors exploit shocks to the banking industry to eliminate issues stemming from endogenous CEO to firm matching. In addition, Cronqvist and Yu (2017) examine CEOs’ descendants and find that CEOs are shaped by their daughters, that is, CEOs identify themselves with female preferences when parenting a daughter, and exhibit corporate social responsibility ratings higher than those of an average firm.

Social states can shape a reduced way of thinking and lead to cognitive or spatial limits. In this case, corporate social finance can be particularity valuable to understand the behavior of principals and agents. Making social inferences from cultural differences is one approach—for example, how to identify the exact psychological source of suboptimal behavior (e.g., Norenzayan, Choi, & Nisbette, 2002). For example, Hirshleifer et al. (2018) focus on the Chinese culture to detect anomalies stemming from superstition. They find that lucky listing numbers dominate the Chinese IPO market and show that either the stock exchange or managers cater to shareholders’ superstitious beliefs, which does not exclude that managers may also be superstitious. Without this specific social setting, they would not be able to find non-standard behavior stemming from superstitious beliefs.

## Social States

Social states comprise social processes between individuals. In a social process, individuals are in the same state, that is, being exposed to similar circumstances. As social states are an artifact of a particular period of time, they can either evolve, change, or dissolve (e.g., Uzzi, 1997).

Recent developments with regard to social states are found in the nature, causes, and effects of trust in interpersonal relationships. Trust is defined as a “psychological state . . . to accept vulnerability based upon positive expectations of the . . . behavior of another” (Rousseau, Sitkin, Burt, & Camerer, 1998, p. 395; see also Mayer, Davis, & Schoorman, 1995) and is found to be a crucial social phenomenon in a company’s corporate culture (e.g., Guiso et al., 2015). For example, managerial personal indiscretions, for example, domestic violence, sexual misadventure, or drug charges, affect the trust of the company’s stakeholders and leads to a significant decrease in firm value (e.g., Cline, Walkling, & Yore, 2017). Similarly, Bargeron, Lehn, and Smith (2015) find that if managers conduct large M&As, which are not favored by employees, trust levels decrease.

While trust can be a beneficial source of efficiency, Audi, Loughran, and McDonald (2016) show that companies that exhibit a trusting corporate culture also increase their efforts to control and verify information toward outside shareholders. Thus, in a corporate context it depends on the situation and state whether or not formal rules, contracts, or other legalistic mechanisms serve as a facilitator or blockade in restoring trust (e.g., Sitkin & Roth, 1993).

As environments change, social states are an interesting venue for corporate finance research, especially when organizations maneuver in times of instability. In order to respond appropriately to dynamic social situations, individuals need an accurate perception of reality to prevent behavioral distortions (e.g., Cialdini & Goldstein, 2004). For example, CEOs with strong levels of job anxiety support hires of trusted friends as chief operating officers (COOs) because they serve as social buffers when facing difficult decisions (e.g., Mannor et al., 2016).

## Social Activities

Social activities synthesize managerial assessments and decision-making actions, in the presence of other individuals or groups. Hirshleifer and Teoh (2018) refer to this as a social transmission bias, that is, how ideas spread and evolve to be appealing to a group even though they would not be considered as catchy by an individual in a vacuum. For example, Jochem and Peters (2019) show that managerial optimism is transmitted to other firms through customer-supplier networks and suggest that such a transmission bias can even impact business cycle fluctuations.

The main social activity is the mimicking or herding behavior of managers or companies toward peer groups. Managers observe and follow their (local) peers with a biased mind, for example, an overattribution to common thinking or local information, so that investments and financing distortions arise (e.g., Bikhchandani, Hirshleifer, & Welch, 1992; Scharfstein & Stein, 1990). In social psychology, researchers refer to this flawed decision making as the “birds of a feather” hypothesis, which is based on the homophily concept in sociology, that is, individuals have the tendency to form social links to and be influenced by people that are similar to them (e.g., McPherson, Smith-Lovin, & Cook, 2001; Silver, 1990; Stolper & Walter, 2019). Hence, if managers interact within homogeneous networks, the homophily of social interactions can slow down or even prevent the convergence of good practices among corporations (e.g., Golub & Jackson, 2012).

A challenge is to infer a firm’s choice of defining peers since the composition of reference groups is endogenous and sometimes not based on direct but rather indirect interactions (e.g., Manski, 1993). Adhikari and Agrawal (2018) and Leary and Roberts (2014) use a conventional approach to identify peers and create similar firm groups based on industry affiliation. The authors show that a company’s financing and payout decisions are highly influenced by their industry peers. This behavior is found to be prevalent among smaller, less successful, and financially constrained firms as well as in markets with high product competition, which is consistent with a rivalry-based theory of imitation. Another classical approach is to use managerial compensation peers as a reference group. Compensation peers have to be documented in a company’s annual report, when firms determine a CEO’s variable pay. However, Bizjak, Lemmon, and Nguyen (2011) show that firms have incentives to choose peers that inflate executive pay, so compensation peers do not necessarily reflect the true peer group.

Hoberg and Phillips (2010) suggest a text-based alternative to identify firms’ similarity in terms of their product portfolio. This product similarity measure outperforms conventional industry-based measures since it captures that firms may operate in several product markets despite belonging to a specific industry. Applying this measure, Ammann, Horsch, and Oesch (2016) analyze peer effects of superstar CEOs on competitors. They show that superstar CEOs have a positive welfare impact on their peers, especially when award winners are geographically close. Peer superstars take more risks and innovate to a greater extent.

Kaustia and Rantala (2015) suggest a relatedness measure based on firms’ joint analyst coverage and show that such a self-organizing approach outperforms others, that is, determining groups based on industry classifications. They find that firms follow their peers’ strategy in stock splitting but fail to capitalize on direct benefits of stock splits. Gomes, Gopalan, Leary, and Marcet (2017) compare analyst as well as industry measures and confirm a mimicking behavior in firm leverage. In contrast to the aforementioned studies, another strand of literature focuses on directly observable interactions, that is, emphasizing individuals’ and firms’ social networks. For example, Fracassi (2017) identifies social peers by examining private and professional social ties, for example, connections from current and past employment, education, as well as leisure activities. The author finds that managers who share social connections with each other exhibit similar capital investment decisions. Similarly, Shue (2013) examines executives’ educational background, that is, graduates from a renowned business school, and finds that future CEOs who were randomly assigned to the same class execute more similar corporate decisions, for example, M&A activities.

Ishii and Xuan (2014) study educational ties between acquirer and target CEOs and find that if those are high, deals are more probable than deals by less connected M&A partners. However, the deals are characterized by significantly negative abnormal returns for the acquirer as well as for the combined corporation. Similarly, Chikh and Filbien (2011) focus on French networks and find that well-connected CEOs are less likely to listen to the market and thus complete deals for which market reaction is unfavorable. A study by Jaspersen and Limbach (2018) investigates demographic similarity between fund managers as well as CEOs and finds that fund managers overweight firms run by CEOs who possess resembling features, for example, age, ethnicity, and gender.

Managerial envy defined as a mixture of emotions triggered by a self-comparison with another person or other groups who possess desired attributes and make one feel inferior is also related to social activities (e.g., Elster, 1991; Smith & Kim, 2007). In their theoretical models, Becker (1974) and Goel and Thakor (2005, 2010) introduce envy as a driver for investment distortions and merger waves. Also, Doukas and Zhang (2016) specifically examine envious banking CEOs and provide evidence that executives rush into inefficient M&A deals just because others are doing so. Social peers or ties can also be seen as strategic in terms of individuals behaving rationally to take advantage of their social connections to get access to superior information at lower cost or just because the social penalty of distancing themselves from social networks is too costly (e.g., Cohen, Gurun, & Malloy, 2017; Granovetter, 2005). Also, a strong social network may secure a CEO’s future employment opportunities. For example, Faleye, Kovacs, and Venkateswaran (2014) show that well-connected CEOs invest more in R&D and also produce more impactful innovation than their less connected peers. They argue that personal social networks decrease individuals’ risk aversion as CEOs have superior information to evaluate projects and personal insurance in the labor market.

However, if managers pay too much attention to how their peers behave, it can lead to distorted decisions as managers overweight the “social information” due to availability heuristics. For example, peers’ actions may be an easily accessible information source that is noisy, and managers mistake this noise for a valuable signal and therefore act in a certain way that is not beneficial for their own shareholders (e.g., Kaustia & Rantala, 2015). Social networks and peer effects allow researchers to link inferior decision making to behavioral distortions without directly observing the underlying psychological bias.

# Conclusion

This article summarizes the currently existing academic research on behavioral and social corporate finance. First, a behavioral principal and agent framework is introduced, which systematically categorizes and differentiates between rational and behavioral decision makers. Second, a social principal and agent view is proposed as actors do not make decisions in a vacuum but rather behave de-isolated in a dynamic social environment.

The presence of behavioral shareholders leads to market timing and catering behavior by rational managers. Specifically, such managers will opportunistically time the market and exploit mispricing by investing capital, issuing securities, or borrowing debt when costs of capital are low and shunning equity, divesting assets, repurchasing securities, and paying back debt when costs of capital are high. Rational managers also cater to non-standard preferences of shareholders by transitioning their firms into an in-fashion category to boost the stock’s price. If prices deviate from their fundamental values, they can be exploited and shifted at the same time, so an important goal for future research is to quantify the interactive effect between market timing and catering.

The interaction of behavioral managers with rational shareholders also leads to distortions in corporate decision making. For example, managers perceive fundamental values differently and systematically diverge from optimal decisions. Several personal traits, for example, overconfidence or narcissism, and environmental factors, for example, fatal natural disasters, shape behavioral managers’ preferences and beliefs, short or long term. These factors can bias the value perception by managers and thus lead to inferior decision making. Which behavioral aspects, that is, traits, states, and activities, contribute the most to managerial distortions remains an open question and is an active research area. It is important to emphasize that behavioral managers can also be valuable to the firm. For example, overconfident CEOs positively influence R&D and innovation.

Specific corporate governance mechanisms can help to improve managerial decision making. For example, CEO stock ownership supports CEOs with de-biasing their beliefs, preferences, and expectations in order to prevent value-decreasing, or encourage value-increasing, actions (e.g., Banerjee, Humphery-Jenner, & Nanda, 2015; Kolasinski & Li, 2013). In extreme negative cases, the board of directors is able to identify CEOs with excessive behavioral biases and force them to depart (e.g., Campbell, Gallmeyer, Johnson, Rutherford, & Stanley, 2011; Goel & Thakor, 2008). Further research is required to assess which governance mechanisms work to capitalize on managers’ non-standard beliefs or preferences as well as evaluate whether and when performance benefits outweigh the losses of hiring behavioral CEOs.

A social principal-agent framework is developed to serve as a guide for future research in corporate finance. Sociology is useful to understand how social traits, states, and activities shape corporate decision making if an individual’s psychology is not directly observable. Since managers and shareholders take on a social position within and across markets, further research may increase the focus on novel identification strategies of how to explain certain corporate finance anomalies when both parties exhibit less than fully rational behaviors.

Another interesting topic is the idea to extend the social principal-agent framework involving behavioral intermediaries, for example, underwriters, analysts, and rating agencies, whose existence is justified by reducing information asymmetries between principals and agents. Research in corporate finance shows that actions of intermediaries can either be traced back to or influenced by behavioral or social traits, states, and activities (e.g., Malmendier & Shanthikumar, 2007, 2014; Richardson, Teoh, & Wysocki, 2004). To sum it up, social agents, principals, and intermediaries have an impact on the destabilization of fundamental prices or on biasing of managerial decision making or both.

# Acknowledgments

We thank the editor and, in particular, the anonymous reviewers for many constructive suggestions. We are also thankful for comments and suggestions from Malcolm Baker, Markus Glaser, David Hirshleifer, Danling Jiang, Markku Kaustia, Gesa-Kristina Petersen, Ville Rantala, and Frank Yu. This project was pursued in part when Cronqvist was Visiting Scientist at Ludwig-Maximilians-Universität München, Center for Advanced Management Studies and Institute for Capital Markets and Corporate Finance, and when Pély was Visiting Scholar at the University of Miami Business School, which they thank for their support. We thank Csenge Kukolya for excellent research assistance. We apologize in advance to all the authors whose research related to behavioral and social corporate finance is not cited in this review owing to severe space constraints.

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## Notes:

(1.) Of course, behavioral finance is in and by itself an outgrowth of behavioral economics, which started to develop with the seminal research by Simon (1955) and subsequently Kahneman (2003) and Thaler (1980).

(2.) Arguments for why managers may be relatively more rational than shareholders include information advantages and no short-sales constraints. For a review of papers showing that mispricing does occur in financial markets, see Shleifer (2000).

(3.) It is important to note that specific personal characteristics must not always lead to non-standard beliefs or preferences but can also be correlated with standard factors, for example, gender differences in (standard) risk-taking preferences. In this section, we review studies which take a behavioral standpoint. However, it is not the focus of this study whether or not managers are “rationally irrational,” that is, make seemingly less than fully rational decisions to rationally maximize the firm’s value, or “irrationally rational,” that is, act in line with standard predictions even though resulting in less than fully rational results. For further information on this topic, see Malmendier (2018) and Ang (2018).

(4.) In this article, behavioral factors that may shape individuals’ standard beliefs and preferences, for example, gender that influences humans’ risk preference elicitation, are not presented. The focus is on non-standard factors that bias individuals’ decision making. For a (tabular) overview of personality traits that influence financial decisions, see Cronqvist and Siegel (2014).

(5.) Note that social activities comprise thought processes as well as behavioral distortions and not actual social decision by individuals, for example, corporate social responsibility actions.