Editor's Note: The following post comes to us from Lee Biggerstaff of the Department of Finance at Miami University, David Cicero of the Department of Finance at the University of Alabama, and Andy Puckett of the Department of Finance at the University of Tennessee.

Trust is part of the foundation of public markets. Scandals at firms such as Enron and HealthSouth fractured this foundation and motivated market participants to ask why executives and other employees at these firms misled investors. Some regulators and experts conjecture that the roots of these scandals can be traced to the actions and attitudes of those at the very top of corporate leadership. In the words of Linda Chatman Thomsen (Director, Division of Enforcement, Securities and Exchange Commission) “Corporate character matters—and employees take their cues from the top. In our experience, the character of the CEO and other top officers is generally reflected in the character of the entire company.” In our paper, Suspect CEOs, Unethical Culture, and Corporate Misbehavior, forthcoming in the Journal of Financial Economics, we provide evidence consistent with this perspective by demonstrating an empirical link between CEOs’ revealed character and the misbehaviors of the firms they manage.

Click here to read the complete post...

" /> Editor's Note: The following post comes to us from Lee Biggerstaff of the Department of Finance at Miami University, David Cicero of the Department of Finance at the University of Alabama, and Andy Puckett of the Department of Finance at the University of Tennessee.

Trust is part of the foundation of public markets. Scandals at firms such as Enron and HealthSouth fractured this foundation and motivated market participants to ask why executives and other employees at these firms misled investors. Some regulators and experts conjecture that the roots of these scandals can be traced to the actions and attitudes of those at the very top of corporate leadership. In the words of Linda Chatman Thomsen (Director, Division of Enforcement, Securities and Exchange Commission) “Corporate character matters—and employees take their cues from the top. In our experience, the character of the CEO and other top officers is generally reflected in the character of the entire company.” In our paper, Suspect CEOs, Unethical Culture, and Corporate Misbehavior, forthcoming in the Journal of Financial Economics, we provide evidence consistent with this perspective by demonstrating an empirical link between CEOs’ revealed character and the misbehaviors of the firms they manage.

Click here to read the complete post...

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Suspect CEOs, Unethical Culture, and Corporate Misbehavior

The following post comes to us from Lee Biggerstaff of the Department of Finance at Miami University, David Cicero of the Department of Finance at the University of Alabama, and Andy Puckett of the Department of Finance at the University of Tennessee.

Trust is part of the foundation of public markets. Scandals at firms such as Enron and HealthSouth fractured this foundation and motivated market participants to ask why executives and other employees at these firms misled investors. Some regulators and experts conjecture that the roots of these scandals can be traced to the actions and attitudes of those at the very top of corporate leadership. In the words of Linda Chatman Thomsen (Director, Division of Enforcement, Securities and Exchange Commission) “Corporate character matters—and employees take their cues from the top. In our experience, the character of the CEO and other top officers is generally reflected in the character of the entire company.” In our paper, Suspect CEOs, Unethical Culture, and Corporate Misbehavior, forthcoming in the Journal of Financial Economics, we provide evidence consistent with this perspective by demonstrating an empirical link between CEOs’ revealed character and the misbehaviors of the firms they manage.

Investigating the potential link between a chief executive’s character and broader corporate malfeasance is challenging since such an analysis requires measurement of a CEO’s character/ethics. We propose a novel way to measure an unethical pattern of behavior, based on a CEO’s systematic participation in options backdating. In the late 1990s and early 2000s, a number of executives and directors of public companies enriched themselves financially by backdating either the grant or exercise dates of their executive stock options, often in secret and at a cost to shareholders (Lie, 2005; Heron and Lie, 2007; Cicero, 2009). While these actions could have been undertaken legitimately, our review of the facts alleged in a number of cases before the S.E.C. suggests the practice was often best characterized as inappropriate. We classify an executive as “suspect” if they appear to have engaged in systematic options backdating for their own benefit. Using data from 1992 to 2009, we identify 249 such CEOs—which is approximately five times more than we should find by random chance. Our empirical analysis compares the corporate actions and financial reporting quality of these firms with those of control firms of similar size from the same industries.

Our investigation shows that the firms run by these suspect CEOs are approximately three times as likely as control firm to engage in fraud (8.82% versus 2.94%). Additional analyses further support a conclusion that suspect firms overstate their profitability. Firms with backdating CEOs are 14.55% more likely than control firms to narrowly meet or beat analysts’ quarterly earnings forecasts, a tendency previous researchers point to as evidence of accounting manipulations aimed at bolstering stock prices (Hayn, 1995; Degeorge et al, 1999). Consistent with this interpretation, we find that suspect firms use significantly more positive discretionary accruals in the quarters when they narrowly attain these thresholds.

The questionable actions taken by these firms also shows up in their investment policies. Suspect firms make significantly more acquisitions and their acquisition announcements are met with a lower market response. Excessive acquisition activity could reflect selfish empire building (Jensen, 1986; Lang, Stultz, and Walkling, 1991; and Morck, Shleifer, and Vishny, 1990) or may serve earnings management purposes. [Shilit (2010) describes how the accounting rules for dealing with acquisitions allow firms to manage earnings upward by booking revenue from sales of the target’s inventory without having to account for the expenses associated with producing the goods.] Consistent with the latter interpretation, these results are stronger when considering the acquisition of private targets, whose opaque assets could be easier to manipulate in order to manage earnings.

An interesting pattern that emerges is the relationship between externally hired suspect CEOs and corporate malfeasance. Our results suggest that externally hired CEOs are more effective in altering the culture of high-level decision makers and effectively changing corporate activities. These findings are consistent with the managerial discretion literature, which predicts that externally hired CEOs are likely to enjoy greater discretion in shaping the culture around them.

Our primary results establish a correlation between CEOs that engage in options backdating and other forms of corporate misbehavior. However, correlations do not necessarily indicate a causal link. To help establish causation, we contrast the actions of firms led by suspect executives to those of control firms around the arrival of new CEOs. Using difference-in-differences tests we find significant increases in earnings management and acquisition activity after suspect CEOs arrive at their new firms. We also continue to find that these results are concentrated in firms whose suspect CEOs are outside hires.

Our work provides evidence that the ethics of corporate leaders is an important determinant of the culture of the firms they manage, consistent with the “upper echelons theory” of corporate behavior first proposed by Hambrick and Mason (1984). We also show that suspect CEOs and/or their firms experience adverse consequences as a result of their actions. Firms with suspect CEOs hired from the outside are not treated differently by the market during the run-up of the late 1990s and early 2000s. However, during the ensuing market correction, these firms were 25.4% more likely to experience severe stock price declines and the CEOs were significantly more likely to be fired.

Given our findings, we propose some questions for future work. For example, is there a role for executive search firms in helping firms identify executives of high integrity, or can appropriate compensation or employment contract design reduce the losses associated with a poor hiring decision? By gaining additional insights into these questions, we could perhaps help firms make better decisions in the future and help insure against the possibility of further large losses of corporate value.

The full paper is available for download here.

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