Breaking Bad CEOs

Vox Research-Based Policy Analysis (This is where unethical corporate culture originates.)

Business ethics and Sarbanes-Oxley: This study identifies unethical CEOs as an important cause of unethical corporation behavior. CEOs do not always invest the resources delegated to them as the owners would like; and sometimes fail to accurately inform investors about how business is going – especially when it is not going well. This can be seen in the market losses associated with financial statement frauds uncovered at firms such as Enron, WorldCom, Tyco, and HealthSouth.

We propose a novel way to identify an unethical pattern of behavior, based on an executive’s systematic participation in "options backdating", which refers to the manipulation of stock option grant or exercise dates (and therefore grant or exercise prices) in order to maximize an individual’s eventual pay-out – without reflecting the magnitude of the compensation on firm financial statements (or to the tax authorities).

Option grant dates were often backdated to reflect grant on an earlier date when the stock price was lower. This meant the corresponding option strike price was also be reduced. Option exercise dates were at times backdated to correspond with dates with low market stock prices. This was to minimize the tax burden incurred by the executive receiving new shares of their underlying stock.

One might recall that a great deal of attention was focused on this controversial practice, common in the late 1990s, following a series of articles published by the Wall Street Journal in 2006. Options backdating for top executives likely indicates stealth (nefarious) activity undertaken for personal gain and to the detriment of shareholders and taxpayers.

In a nutshell, we assume systematic participation in options backdating serves as a reasonable indicator of unethical behavior on behalf of the chief executive officer. This allows us to test whether this behavior is associated with an unethical corporate culture.

We use a largely data-driven approach to identifying CEOs who personally benefited from options backdating. We consider CEOs to be 'suspect' if at least 30% of their options events (grants and/or exercises) were likely backdated. Using data from 1992 to 2009, we identified 249 suspect CEOs using this rule, and augmented this list with 12 additional CEOs who were specifically named in enforcement actions or backdating settlements.

Our results indicate a strong association between the identified executives and other forms of corporate misbehavior. Firms with backdating CEOs are almost 15% more likely than other similar firms to narrowly meet or beat analysts’ quarterly earnings forecasts – a tendency previous researchers have pointed to as evidence of accounting manipulations aimed at bolstering stock prices.

Consistent with this interpretation, firms with backdating CEOs also use significantly more positive discretionary accruals (i.e. accounting manipulations) in the quarters when they narrowly attain these thresholds.

We extend our analyses by investigating the investment activities of firms with backdating CEOs. We find that firms with backdating CEOs make significantly more acquisitions; and that their acquisition announcements are met with a significantly lower market response.

Prior studies provide evidence that excessive acquisitions (i.e., 'empire building') provide numerous pecuniary benefits for bidder firm executives, but often damage the welfare of shareholders. Interestingly, these firms were particularly more likely to acquire private targets. This may reflect a practice by unscrupulous managers of acquiring opaque assets, the reported values of which may be manipulated at the time of combination in order to gain flexibility for further earnings manipulations.

It is also notable that the questionable acquisitions and earnings management activities that we document are concentrated in firms that hired their suspect CEOs from outside of their firm.

This pattern suggests that the greater information asymmetry faced by boards when bringing in external candidates may at times lead to costly adverse selection of chief executives who are ethical 'lemons'.

Our tests also demonstrate that there are significant increases in earnings management and acquisition activity after backdating CEOs arrive at their new firms, relative to that observed around CEO transitions at other similar firms.

These results suggest that hiring a CEO with low character can lead firms to adopt questionable corporate practices, and illustrate the importance of rigorous due diligence by boards when selecting new executives.

Impact on market valuation: Our study concludes by assessing possible adverse consequences that might result from hiring an unethical CEO. We find that the market did not penalize firms with unethical CEOs during the run-up of the late 1990s and early 2000s. However, during the ensuing market correction, these firms were 25% more likely to experience severe stock price declines (defined as at least a negative 40% annual return).

If there was a silver lining to that storm, it is that it helped the boards of firms with unethical CEOs to see the error of their ways, as they also replaced their ill-chosen CEOs with a greater frequency.

Concluding remarks: This work suggests that integrity – in particular, executives’ integrity – matters for corporate outcomes. It provides evidence that the ethics of corporate leaders is an important determinant of the ethical cultures of the firms they manage, in support of an ethical dimension to the “upper echelons theory” of corporate behavior first proposed by Hambrick and Mason (1984). It also should serve as notice to investors and directors of the extent of damage that can accompany a poorly managed executive search.