CEO Connectedness and Corporate Frauds

The following post comes to us from Vikramaditya Khanna, Professor of Law at the University of Michigan; E. Han Kim, Professor of Finance at the University of Michigan; and Yao Lu of the Department of Finance at Tsinghua University.

The collective behavior of corporate leaders is often critical in corporate wrongdoing, and the CEO often plays the central role. Yet there is no comprehensive study exploring how CEOs and their influence within executive suites and the boardroom impact corporate wrongdoing. In our paper, CEO Connectedness and Corporate Frauds, which was recently made publicly available on SSRN, we focus on the effects of CEOs’ social influence accumulated during the CEO’s tenure through top executive and director appointment decisions.

We find appointment-based CEO connectedness is positively related to the likelihood of corporate fraud and negatively related to the likelihood of detection, given fraud. The relation is economically meaningful, statistically significant, and robust to instrumental variables regressions using CEO death, the number of executives’ and directors’ death during the current CEO’s tenure, and geographic remoteness of a firm’s headquarters as IVs. The relation is also robust to alternative specifications, several alternative measures of CEO connectedness, an alternate sample construction, and clustering standard errors at different levels.

We also identify likely channels through which appointment-based CEO connectedness facilitates wrongdoing—by delaying detection, lowering the likelihood of CEO dismissal after fraud discovery, and reducing coordination costs of conducting frauds, all of which reduce the expected costs of wrongdoing. Furthermore, only audit committee independence helps counteract the adverse effects of CEO connectedness. Other standard internal and external monitoring mechanisms seem rather ineffective.

CEOs can also be connected to their executives and board members by sharing common network ties established through past employment, education, and membership to various social organizations. We investigate the link between these connections and fraud incidence, detection, forced CEO turnover-fraud sensitivity, and the number of people charged in fraud. The estimation results confirm some of the earlier findings by Chidambaran et al. (2012). However, CEOs’ network ties with executives or board members show mostly insignificant relations to fraud detection probability, the ability of CEOs tainted with fraud to retain their job, and the coordination cost of wrongdoing as measured by the number of people charged in frauds.

Taken together, these results imply that the fraction of top executives and board members appointed during a CEO’s tenure (1) is a critical factor in assessing a firm’s likelihood of engaging in wrongdoing, (2) has effects that are not mitigated by standard monitoring mechanisms, except for audit committee independence, and thus (3) is worth the close attention of investors, regulators, and governance specialists. Further, our results underscore the importance of CEO connections built through personnel decisions in assessing the quality of governance and managing risk, as the connections seem to magnify the risk of corporate fraud.

The full paper is available for download here.

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