Study Shows CEOs With Poor Ethics Hurt Their Firms

Study Shows CEOs With Poor Ethics Hurt Their Firms

Academics Lee Biggerstaff (Miami University), David Cicero (University of Alabama) and Andy Puckett (University of Tennessee) recently published a paper titled Suspect CEOs, Unethical Culture, and Corporate Misbehavior in the Journal of Financial Economics. In the paper, the authors describe a study that demonstrates “an empirical link between CEOs’ revealed character and the misbehaviors of the firms they manage.”

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Methodology of CEO ethics study

Examining the relationship between the character of a CEO and broader corporate malfeasance is difficult given it requires measurement of a CEO’s character/ethics. This new study proposes a novel way to measure an unethical pattern of behavior by looking at CEOs participation in options backdating.

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For a decade plus in the late 1990s and early 2000s, many executives and directors of public firms enriched themselves by backdating either the grant or exercise dates of their stock options, often secretively and at a notable cost to shareholders (Lie, 2005; Heron and Lie, 2007; Cicero, 2009). The authors review of the facts in a number of cases “suggests the practice was often best characterized as inappropriate.” The study defines a CEO as as “suspect” if he or she engaged in systematic options backdating for their own benefit.

Based on data from 1992 to 2009, the academics identify 249 “suspect” CEOs. Of note, this number is close to five times more than we should find by random chance. The empirical analysis undertaken in the study compares the corporate decisions and financial reporting quality of firms run by suspect CEOs with those of control firms of around the same size in the same industry.

CEOs with poor ethics create problems

The research demonstrates that firms managed by suspect CEOs are nearly three times as likely as control firms to engage in fraud (8.82% compared to 2.94%). Further statistical analyses support a conclusion that firms run by suspect CEOs also overstate their profitability more frequently than average.

CEOs with poor ethics

For example, firms with backdating CEOs are 14.55% more likely than control firms to just meet or barely beat analysts’ quarterly earnings forecasts, a tendency other researchers have suggested is evidence of accounting manipulations to support stock prices (Hayn, 1995; Degeorge et al, 1999). The current study also found that companies with suspect management use significantly more positive discretionary accruals in quarters when they barely meet their quarterly “numbers”.

The dubious decisions made by “suspect firms” is also reflected in their investment policies. Suspect firms make more acquisitions than average and the market is also typically less excited about their acquisition announcements. Frequent nonstrategic M&A could reflect “selfish empire building” (Jensen, 1986; Lang, Stultz, and Walkling, 1991; and Morck, Shleifer, and Vishny, 1990) or may be designed for “earnings management” purposes.

Consistent with the this interpretation, the authors note the results are even stronger if you consider the acquisition of private targets, whose less transparent assets are often much easier to manipulate to “manage” earnings.

See full PDF below.

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