It’s All About Timing: A Study on the Strategic Vehicle Recalls in US

Vehicle recalls are common among major US car manufacturers. A CUHK study reveals large recalls are timed strategically to minimize the impact of recalls on the cost of external finance

By Mabel Sieh, Managing Editor, China Business Knowledge @ CUHK

The Common Occurrences of Vehicle Recalls

Vehicle recalls are common among major U.S. car manufacturers. Since 1966, the “Big Three” – General Motors, Ford and Chrysler being the largest automakers in the United States and Canada, have issued multiple recalls almost every year, totaling well over 1,000 recalls. From January 1966 to July 2010, there were 724 recalls affecting more than 100,000 defective vehicles.

In 2014, General Motors recalled 29 million cars in North America in connection with faulty ignition switches, issuing 45 recalls in the year. A probe by the US Attorney Anton Valukas found that the switch problem had lingered so long because of poor judgement by some employees and a lack of communication within the company, and completely absolved the responsibility of the recall away from the top executives.

A recent study at the Chinese University of Hong Kong (CUHK) Business School suggests that the timing of vehicle recalls in the U.S. is often a strategic decision and a tactic to weaken the impact of recalls on the cost of raising finance. It is found that firms would delay recalls to avoid disruptions to capital raising activity. Contrary to company statements and some internal investigations, the study also suggests that top management is typically aware of product defects.

The Study and Findings

The working paper titled “Costly External Finance, Regulatory Regime, and the Strategic Timing of Vehicle Recalls” was written by Professor Jin Xie of the School of Accountancy at CUHK Business School, with co-author Professor Sudipto Dasgupta of the Department of Accounting and Finance at Lancaster University.

The study includes 11,492 recall files taken from the monthly recall reports since 1966, and recorded by the NHTSA. These reports contain the campaign number, vehicle/equipment make, vehicle/equipment model and year, component description, the name of the manufacturer that filed the report, beginning and end date of manufacturing, the potential number of units affected, the date owners being notified by the manufacturer, and the recall initiator.

According to the study, the most striking finding is that firms actually time their recalls strategically by avoiding recalls prior to refinancing maturing debts in the near term.

“We find striking evidence indicating that when large issuances of debt and equity and large recall announcements occur in close timing, they are sequenced in such a way that adverse consequences of recalls on the cost of finance is avoided,” says Prof. Xie.

The results show that higher levels of maturing debt will lead to later recalls. “The need to raise higher amounts of external financing would make it more likely that firms delay recalls,” he says.

In other words, if a firm has debt that is due to mature shortly after they find a potential defect in the product, the firm might delay the recall until after new financing has been raised to repay the debt.

“This is because the recall would convey an adverse signal to the market, thus making the new financing more expensive, as we find in our study that major recalls are associated with loss of sales and credit rating downgrades,” says Prof. Xie.

“Large recalls are associated with a higher likelihood of ratings downgrades of firms with high levels of maturing debts. This suggests that the higher cost of external finance is a possible explanation for the loss of firm value beyond the direct costs of recalls.” – Prof. Jin Xie

TREAD Act and NHTSA

The effect of maturing debt on recall timing is also related to a change of regulation of the TREAD Act, the study shows.

In response to the significant number of injuries and fatalities associated with the Ford Explorers fitted with Firestone tires, the TREAD (Transportation Recall Enhancement, Accountability, and Documentation) Act was signed into law by President Bill Clinton in 2000 with an aim to regulate the environment for vehicle safety.

A key feature of the TREAD Act is self-reporting of a variety of safety-related data by car manufacturer as part of the Early Warning Reporting System. The information will form basis of the pre-investigation phase for the National Highway Traffic Safety Administration (NHTSA), an Executive Branch of the U.S. government and part of the Department of Transportation responsible for reducing deaths, injuries and economic losses resulting from motor vehicle crashes. The data is to be reported quarterly and analyzed before a potential defect can be referred to the Defects Assessment Division which will then prepare and conduct a formal investigation. The process is a long one.
Adding to the lengthy procedure are the poorly designed reporting system and insufficient guidelines to manufacturers regarding the categorization of incidents.

“The long procedure for investigation also creates more opportunities for manufacturers to delay their recall to suit their interest,” says Prof. Xie. “We find that the fraction of investigations leading to recalls that occur within one year from the beginning of manufacturing is twice as high in the pre-TREAD period than in the post-TREAD period,” he adds.

Implications

Economists have long been interested in the complex issue of regulatory design and how that addresses the incentives of regulators, especially in the context of financial regulation. Financial researchers have proposed a number of ways in which a firm’s financial structure affects aspects of its operations. For example, how debt affects product market strategies, product quality and investment.

“We add to this research by showing that financial structure also affects how firms choose the timing of product recalls, which is likely to have major implications on consumer welfare,” says Prof. Xie.

“We find that large recalls are associated with a higher likelihood of ratings downgrades of firms with high levels of maturing debts. This suggests that the higher cost of external finance is a possible explanation for the loss of firm value beyond the direct costs of recalls,” he says.

In terms of regulatory design, the study suggests that the presence of more information with manufacturers and more stringent reporting requirements may create an “offsetting” effect on the incentives of regulators.

As the study reveals, regulatory environment may have been an important factor for vehicle defects not being investigated and recalls not being issued in a timely manner. While TREAD has greatly enhanced information production, it has also slowed the speed of regulatory response to reports of incidents made directly to the regulator. The lengthy process thus created opportunities for strategic delay for the manufacturers.

“The passage of the TREAD Act with the imposed reporting requirements on vehicle manufacturers often delays the speed with which the NHTSA could launch defect investigations, as well as undermines incentives to identify safety issues,” says Prof. Xie.

Another implication of the study is on how financial structure affects the incentives of firms to disclose information, more specifically, about “who knew what and when” in the case of the GM’s switch problem.

“Considerations such as the possible impact of recalls on the cost of finance are top management-level issues,” Prof. Xie says. “If recalls are being timed to mitigate the financial impact of recalls, it’s very likely that the potential vehicle problems will be made know to the upper levels of management,” he concludes.

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