Scoundrels In The C-Suite: How Should The Board Respond When A CEO’s Bad Behavior Makes The News?

David F. Larcker
Stanford University – Graduate School of Business

Brian Tayan
Stanford University – Graduate School of Business

May 10, 2016

Rock Center for Corporate Governance at Stanford University Closer Look Series: Topics, Issues and Controversies in Corporate Governance No. CGRP-57
Stanford University Graduate School of Business Research Paper No. 16-23

Abstract:

The board of director has a responsibility to investigate credible allegations that management has engaged in activity that is not in the interest of the company or its shareholders. In the case of illegal activity, the appropriate response is likely to be very clear. Less obvious are the actions directors should take when the CEO engages in behavior that is questionable but not illegal — such as making controversial public statements, having relations with an employee or contractor, or developing a reputation for overbearing or verbally abusive behavior.

In this Closer Look, we examine the actions that board’s take in response to CEO “bad behavior.” We ask:

• When are allegations serious enough or credible enough to merit boardroom attention?
• How can the board assess the impact of CEO misconduct on the organization broadly?
• Should the board be proactive in employing information gathering tools to detect early signs of CEO or employee misconduct?

The Stanford Closer Look series is a collection of short case studies through which we explore topics, issues, and controversies in corporate governance and executive leadership. In each study, we take a targeted look at a specific issue that is relevant to the current debate on governance and explain why it is so important. Larcker and Tayan are co-authors of the books Corporate Governance Matters and A Real Look at Real World Corporate Governance.

Scoundrels In The C-Suite: How Should The Board Respond When A CEO’s Bad Behavior Makes The News? – Introduction

The board of directors has a duty to monitor the corporation on behalf of shareholders. This includes the obligation to investigate credible allegations that management has engaged in activity that is not in the interest of the company or its shareholders. If verified, the board should (and normally will) take corrective action, including termination, required leave of absence, reduction in pay, and changes to policies or procedures for executive conduct.

Although the appropriate response to illegal activity is likely to be very clear, it is less obvious what actions directors should take when the CEO engages in behavior that is questionable but not illegal—for example, a CEO making controversial public statements, having relations with an employee or contractor, or developing a reputation for being rude, overbearing, or verbally abusive. The decision becomes more important when these actions are picked up by the news media, bringing public attention to the executive behavior. In this case, the board must decide whether and how to investigate, and whether or not to address the matter publicly or privately. Equally important is the board’s assessment of whether CEO misbehavior will impact the broader organization and shareholder value. This includes determining the scope of the CEO’s actions, and whether the actions are indicative of systemic or potentially widespread cultural problems that adversely impact shareholders.

Concerns about the potential for bad behavior to spread are explored in many research disciplines. Studies of corporate illegality suggest that companies that engage in misbehavior tend to exhibit repeated violations over time, implying that corporate misbehavior can become persistent.1 Research also finds that the behavior of individuals within an organization is influenced by the “tone at the top” and that, when left uncorrected, misbehavior can spread.

CEO Misbehavior

It is difficult to accurately determine the frequency with which CEOs misbehave or the steps that boards take in response to CEO misconduct. First, it is not clear what percentage of misconduct is reported publicly and what remains private. For example, in recent years, news stories have highlighted multiple incidents of CEOs who have misrepresented educational credentials on their resumes or biographies.3 However, it is unknown how many times similar incidents occur that remain unreported and presumably dealt with in a private fashion at other corporations. Second, clear parameters do not exist to identify questionable behavior that should be of concern to board members. For example, should the board investigate allegations that a CEO is “abrasive” or engages in “tirades”?4 What about allegations of “arrogance” or “hubris”?

Still, pressure on a board to act increases when stories of CEO conduct are picked up by the media. Valid or not, allegations can spread virally, and references to prior occurrences can resonate in news stories years after they initially occurred—with a lingering effect on corporate reputation.

To examine how corporations handle allegations of CEO misbehavior, we conducted an extensive review of the news media between 2000 and 2015. We identified 38 incidents where a CEO’s “bad behavior” garnered a meaningful level of media coverage (defined as more than 10 unique news references). These incidents can be categorized as follows (see Exhibit 1):

• 34 percent involve reports of a CEO lying to the board or shareholders over personal matters—such as a drunken driving offense, prior undisclosed criminal record, falsification of credentials, or other behavior or actions.
• 21 percent involve a sexual affair or relations with a subordinate, contractor, or consultant.
• 16 percent involve CEOs making use of corporate funds in a manner that is questionable but not strictly illegal.
• 16 percent involve CEOs engaging in objectionable personal behavior or using abusive language.
• 13 percent involve CEOs making controversial statements to the public that were offensive to customers or social groups.

Media coverage of CEO misconduct is significant. Reports of these actions were included in over 250 news stories each, on average. Furthermore, reports were persistent, with references made to the CEO’s actions 4.9 years on average after initial occurrence. For example, news stories continue to make reference today to former American Apparel CEO Dov Charney’s odd behavior of walking around the company’s offices in his underwear, even though it was first reported over 10 years ago.

Shareholders react negatively to news of CEO misconduct, with share prices declining by a market-adjusted 3.1 percent (1.1 percent median) over the 3-day trading period before, including, and after the initial news story.8 For example, Hewlett Packard stock fell almost 9 percent over a 3-day period following reports that former CEO Mark Hurd had a personal relationship with a female contractor. However, stock price reactions are not uniformly negative. Eleven out of the 38 companies in our sample exhibited positive abnormal stock price returns when CEO misbehavior made the news. Perhaps unexpectedly, there is no discernable relationship between the type of behavior and stock price reaction. (However, a small sample size makes it difficult to reliably measure this association.)

Corporations engage in a variety of responses to allegations of CEO misconduct. The most common is a press release or formal statement on the matter. This occurred 84 percent of the time. In 71 percent of cases, a spokesperson provided direct commentary to the press. Board members were much less likely to speak to the media, making direct comments only 37 percent of the time.9 In over half of cases (55 percent), the board of directors was known to initiate an independent review or investigation. The board is most likely to announce an independent review in cases of potential financial misconduct. However, the willingness of an individual director to discuss the matter directly with the press does not appear to be associated with the type of behavior involved or the “severity” of the CEO’s actions.

Among the sample, it was more likely than not that the CEO was eventually terminated for his or her actions: 58 percent of incidents resulted in termination.10 Terminations occurred across all categories of alleged behavior. Questionable financial practices was the only category of behavior that almost uniformly resulted in termination; all other behaviors—including allegations of lying to the board or shareholders, expressing controversial views, personal relations with employees, and exhibiting objectionable language or behavior—resulted in both outcomes (termination and retention) across our sample. Even behavior as straightforward as falsifying information on a resume was treated differently by different boards.

Among CEOs who were eventually fired for their actions, the time to termination varied widely, ranging from 9 years following initial media coverage to 20 days prior. (The CEO of Stryker was terminated before reports of his extramarital affair with a former employee made the news; the company initially announced that the CEO stepped down “for family reasons”). Eleven CEOs were terminated the same day that the CEO’s behavior made the news. Shareholder reaction to termination is muted, with a mean 0.8 percent decline and median 0.1 percent increase in stock price.

In one-third of cases (32 percent), the board took actions other than termination in response to CEO misconduct. These actions included stripping the CEO of the chairman title, removing the CEO from the board, amending the corporate code of conduct, reducing or eliminating the CEO bonus, other director resignation, and other changes to board structure or composition.

Finally, corporations experience a wide range of ramifications as a result of CEO misconduct. Approximately one-third (34 percent) faced additional fallout including a change in marketing, loss of a major client, federal investigation, shareholder or federal lawsuit, or shareholder action such as a proxy battle. It is unclear whether CEO misbehavior was symptomatic of broader cultural or organizational deficiencies, although it is worth noting that 45 percent of companies in the sample experienced a significant unrelated governance issue following the event, such as an accounting restatement, unrelated lawsuit, shareholder action, or bankruptcy.

The implications for the executive are also unclear. Three CEOs in the sample were reported to resign from other boards because of their actions. Two CEOs who were terminated were subsequently rehired by the same company.11 Many continued in their position, were hired by other corporations or investment groups, or there is no notable news of what happened to them professionally.

As for whether CEOs who misbehave are recidivists, 21 percent of individuals in the sample were reported to have engaged in previous or subsequent questionable behavior, including allegations of sexual harassment, insider trading, and other infractions, felonies, or misdemeanors.

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