By investigating the relationship between corporate fraud and the connectedness of CEOs with senior executives and board directors, the authors find that a higher level of CEO appointments of top company executives and directors is correlated with an increased occurrence of corporate fraud. These CEO appointments also decrease the chances of detecting corporate fraud and decrease the costs of fraud. CEO connections based on networking (e.g., education, social organizations, or past employment) have an insignificant effect on the occurrence, detection, and costs of corporate fraud.
What’s Inside?
Corporate fraud is a problem in the United States and is accompanied by decreased investor confidence, decreased shareholder value, misallocation of capital, and increased market instability. The authors investigate whether the connections between a company’s top executives and board of directors and its CEO have any effect on the incidence of corporate fraud.
Corporate CEOs often use their own connections to help them choose top executives and propose board members. This connectedness can range from appointment decisions (where the CEO directly appoints a top executive) to network ties (where the executives or board members are familiar through less direct connections). The authors ask specifically whether CEO connections with other leaders of the firm are related to either an increase or a decrease in occurrences of corporate fraud. More fraud may result from weaker checks and balances for the prevention and detection of fraud. Less fraud could result from closer relationships between the connected parties.
The authors find that a higher percentage of CEO appointment decisions is related to a greater likelihood for the occurrence of corporate fraud. This connectedness is also related to lower costs of fraud, decreased likelihood of fraud detection, and a reduction in the chances of the CEO being forced to leave the company when fraud occurs.
The results of the research show that during the period studied, a company whose top four executives were appointed during a CEO’s tenure is 20% more likely to have an incidence of fraud and 12% less likely for the fraud to be detected compared with a company with none of the top four executives appointed by the CEO. A company with all of the directors appointed during a CEO’s tenure has a 19% higher fraud incidence and a 14% lower likelihood of fraud detection than a company with none of the directors appointed during the CEO’s tenure. The likelihood of fraud and fraud detection varies between these extremes as the percentage of CEO appointments varies.
The large financial reporting frauds that came to light as late as 2006 originated prior to the passage of the Sarbanes–Oxley legislation. So, there is some question whether, at least with respect to financial reporting fraud, the authors’ findings are applicable today.
How Is This Research Useful to Practitioners?
The results from this study are statistically significant as well as useful from a practitioner’s standpoint. The increased incidence of fraud when a higher number of executives are appointed by the CEO is alarming. But the percentage of top executives appointed by the CEO and the percentage of directors appointed during the CEO’s tenure can easily be determined and analyzed. These findings should lead to increased scrutiny from investment analysts and regulators. The market will determine whether companies with higher CEO appointment ratios ultimately have to pay a higher cost for capital.
How Did the Authors Conduct This Research?
The authors examine data from 2,736 US companies for the years 1996 to 2006. Data are obtained from the Federal Securities Regulation (FSR) database from Karpoff and Martin (Karpoff, Lee, and Martin 2014, University of Washington working paper), the SEC’s litigation releases, and the Stanford Securities Class Action Clearinghouse. Using 17,797 firm-year observations, they collect data on CEO appointment decisions. Two sources of CEO connectedness are examined: appointment decisions, where the executive or the board member was appointed under the CEO’s tenure, and connections from prior network ties. The first is measured by the fraction of top executives and directors appointed during a CEO’s tenure. The second is found to be insignificant on the incidence of corporate fraud.
Abstractor’s Viewpoint
This article is important, well researched, and well written. The question posed by the authors is fairly simple, but the results provided are very noteworthy. CEO connectedness appears to be significantly correlated with the incidence of corporate fraud and thus should be an important factor for investors and regulators to examine. The authors point out that CEO appointments do not always have negative effects. The positive effects of this connectedness need to be researched further.