Wednesday, January 13, 2021

The Diffusion of Cleverness: Ups and Downs of Reverse Mergers

Management scholars have spent much time studying the diffusion of innovations, starting with work on new technologies and continuing to research on social practices such as institutional innovations and even strategic positions in markets. By now we know a lot about why some organizations are early adopters, and how other organizations are influenced by the number and status of early adopters, and by how close to them they are geographically or in social networks.

How about the diffusion of cleverness? By cleverness I mean small inventions that manipulate the rules in ways that are beneficial for the user, and may or may not be harmless to others. Clever innovations are very common in financial markets, where rules are everywhere, and clever interpretations of rules can be used as shortcuts. Because such clever interpretations often go against the original intent of the rule, they are usually controversial. A great example of cleverness is reverse mergers, which were studied by Ivana Naumovska, Ed Zajac,and Peggy Lee in a recent article in Academy of Management Journal.

A reverse merger (RM) is done as follows. A law firm registers a publicly listed company with stock, but the company does no business – it is just a shell. A private company that actually does business then goes public through a merger with the shell company, paying a small fee for the shell company and keeping the same ownership, unless the private owners also want to use the reverse merger to invite new ownership. This is a simple and inexpensive way to go public compared with an initial public offering. Clever, right? And as you might expect, US capital markets saw the diffusion of cleverness in the form of RMs during the mid-2000s, as Naumovska and coauthors found. They also found that this looked a lot like a regular diffusion process, where firms were more likely to use an RM the more prior RMs had happened.

So, is there anything special about the diffusion of cleverness? Yes, because clever innovations are shortcuts, and with shortcuts come controversy. Those who lose their advantage from the rules will be opposed, the press may become interested, and the regulators who made the rules will not be happy. And this happens more the more adoptions of cleverness have happened, so the cleverness is promoted by past adoptions but also undermined by past adoptions. Indeed, the SEC made rules to increase the reporting requirements of RM, though they did not otherwise make RMs harder. More importantly, the press turned against RMs and even stock market investors became skeptical and delivered lower returns to RM firms.

So, what does this teach us about the diffusion of cleverness? In some ways, it is similar to the diffusion of technological or business innovations, because innovations always come with uncertainty, and often the drawbacks of innovations are not discovered until many have adopted. When that happens, the process that follows is very similar to the RM diffusion and its later collapse. But there is an important difference that we need to keep in mind. Technological innovations are uncertain, so we know that some of them are mistakes but we do not know which ones.

Cleverness is different. Cleverness involves controversy nearly every time, so we can be confident that the diffusion of cleverness will see a collapse at some point. That is a good reason to be careful when evaluating a clever innovation, especially in financial markets where they are so frequent.

Naumovska, Ivana, Edward J. Zajac, and Peggy M. Lee. 2020. "Strength and Weakness in Numbers? Unpacking the Role of Prevalence in the Diffusion of Reverse Mergers." Academy of Management Journal forthcoming.

 

3 comments:

  1. Thanks for sharing this work. I found the difference between uncertainty (technological innovation) and cleverness (novel but often debatable financial innovations) quite interesting. Cleverness is a ticking time bomb for adopters, you just don't know how long before it explodes. Thanks for sharing Prof. Henrich.

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