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Friday, April 01, 2005

Compensation, Governance, and Fraud

This from The Atlantic (by way of Jane Galt at Asymmetrical Information):

Corporate scandals often happen at the most successful firms—or at least at firms where the appearance of success breeds a megalomaniac CEO, reams of stock options, overoptimistic goals, and gaga recommendations from Wall Street equity analysts. This is the conclusion of a Boston Consulting Group study that analyzes the companies responsible for twenty-five of the largest corporate frauds since 1996. Compared with their clean competitors, "fraud firms" offered their CEOs eight times as much stock-based pay and set corporate performance targets 250 percent higher. Other factors associated with executive malfeasance were inflated stock prices and attention from the press (before their downfalls, fraud-firm CEOs were three times as likely to be quoted in the media as their competitors). Moreover, two interesting insights emerged. First, good corporate governance—of the sort mandated by post-bubble regulations—may have done little to prevent fraud. Enron's board, for instance, was rated among the nation's five best-governed in 2000. Second, while crooked execs may have fooled analysts, the media, and the public, the market sniffed them out. The median fraud firm lost 40 percent of its value in the year before its actions came to light. (One wonders who was selling …)

—"Corporate Governance Revisited: How Greed and Ego Can Destroy Companies and the Lessons to Be Learned," Kees Cools, Boston Consulting Group [This item is unavailable online.]

There have been a number of academic studies that are closely related to this news. They examine factors related to earnings restatements (rather than fraud), but the two events are pretty closely related):

1) Palmrose, Richardson and Wu that examined what factors predict earnings restatements :

...firms restating earnings have high market expectations for future earnings growth and have higher levels of outstanding debt. We also find that a primary motivation for the earnings manipulation is the desire to attract external financing at a lower cost. Furthermore, our evidence suggests that restating firms have been attempting to maintain a string of consecutive positive earnings growth and consecutive positive quarterly earnings surprises. Together, our evidence is consistent with capital market pressures acting as a motivating factor for companies to adopt aggressive accounting policies.
Click here for a copy of the working paper from the SSRN.

2) A paper by Agrawal and Chadha in the Journal of Law and Economics:

... We find that several key governance characteristics are unrelated to the probability of a company restating earnings. These include the independence of boards and audit committees, and the provision of non-audit services by outside auditors. We find that the probability of restatement is lower in companies whose boards or audit committees have an independent director with financial expertise; it is higher in companies where the CEO belongs to the founding family.
The article isn't available online, but an earlier version (also on the SSRN) can be found here.

The first piece is consistent with executives having incentives to manipulate earnings to enhance corporate "reputation" (if we construe the term "reputation" broadly to include the need to be able to attract funds at a reasonable price). In particular, firms more likely to need external financing (i.e. higher growth firms) are more likely to manipulate their earnings.

The second piece board governance matters in constraining earnings manipulation, but that the simple "is the board independent" measure is not the best way to capture how well the board is governing. It's more important that the board members be "smart". Other words, the key seems to be the presence of a "sophisticated" independent director (one with financial expertise). Several years ago (pre-SOX), ther was a study that found that the typical independent director spends less than three hours a week on board-related duties. Given this relatively short time commitment, it's tough to do any effective monitoring unless you really know what you're doing.

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