HOW DOES–AND SHOULD–THE MARKET RESPOND TO PERSONAL INDISCRETIONS BY COMPANY LEADERSHIP?
Brant E. Christensen, Brandon N. Cline, Nathan G. Lundstrom, Adam S. Yore. (Sept. 2024). Do Auditors View Off-the-Clock Misbehavior by Company Leadership as a Signal of Tone at the Top? The Accounting Review, 99 (5): 171–196. https://doi.org/10.2308/TAR-2021-0026
Brandon N. Cline, Ralph A. Walkling, Adam S. Yore (2018). The Consequences of Managerial Indiscretions: Sex, lies, and firm value, Journal of Financial Economics, Vol. 127, Issue 2, 389-415. https://doi.org/10.1016/j.jfineco.2017.11.008
Brandon N. Cline, Ralph A. Walkling, Adam S. Yore. (Dec. 2018). The Market Price of Managerial Indiscretions Journal of Applied Corporate Finance, Morgan Stanley, Vol. 30(4), 78-88. business.msstate.edu
What does an executive’s personal life say ABOUT THE COMPANY?
Scandals involving the personal lives of company leadership are nothing new. An executive is arrested on drug charges. A high-profile divorce case brings out allegations of a CEO’s affairs and domestic violence. A director is fired for falsifying his academic record.
While these types of events may have consequences for the executive from embarrassment to incarceration, what do they say about the companies that hire these leaders?
What happens off the job stays off the job…
Not much, some argue. Executive skills and talent are what matters. As long as he or she is performing on the job, what happens off the clock is irrelevant. This position is supported by accounting standards that exclude personal misconduct from the category of noncompliance that an auditor must consider.
…Or does it?
Others argue that indiscretions from assault to dishonesty and everything in between impact company culture, corporate relationships, and, ultimately, the bottom line. Indiscretions can distract executives from doing their jobs and damage company morale. Disciplining and firing executives for these incidents can undermine continuity. The entire company can suffer from poor public image. Employees may feel more free to also engage in questionable behavior if they see their bosses doing so.
The impact of company culture
A series of articles co-authored by Brandon Cline PhD, the Mississippi State University John “Nutie” and Edie Dowdle Professor of Finance, demonstrates that there is a decline in company value and heightened auditor attention in light of public allegations of non-business related indiscretions by corporate management. In other words, the so-called “tone at the top” of a company matters.
“Shareholders view these allegations of personal misconduct as insight into the business decisions of the executives,” notes Cline, who holds a doctorate and serves as MSU’s coordinator of graduate programs in finance and as director of the university’s Institute for Marketing Studies. “These indiscretions signal other events that may be likely to occur at the firm.… What we find is that these companies are significantly more likely to be named in class action lawsuits, they have a much higher likelihood of being indicted by the DOJ for fraud, they have higher incidences of earnings management and earnings manipulation.”
Tone at the Top
The component of companies’ internal controls framework that demonstrates commitment to integrity and ethical values.
“The link between personal integrity and behavior at the firm is intuitive. Without the appropriate ‘tone at the top,’ even the bestdesigned corporate controls can be ineffective.”
– Brandon Cline et al.
Article: The Market Price of Managerial Indiscretions
Does executive integrity MATTER?
Best Buy’s stock fell nearly $144 million when the company announced CEO Brian Dunn’s alleged affair with a 29-year-old working for the company. When it was revealed that Raytheon’s CEO, William Swanson, plagiarized his self-titled booklet “Swanson’s Unwritten Rules of Management,” the company stock fell $219 million.
Anecdotally, incidents like these are bad for business. What effect do they have on the executive’s company? Some of the potential costs include:
BOTTOM LINE: While there has been an increased emphasis in recent years on corporate responsibility outside the balance sheet, in many cases money talks. Stock losses like those to Best Buy may be the most easily quantifiable consequences of managerial indiscretion.
MINIMIZE THE DAMAGE: The costs of managing the fallout may not be as direct as a decreased stock price, but still may cause financial damage. This can be everything from public relations efforts after a scandal to legal costs undertaken by a company in relations to the executive’s behavior.
LOSS OF TRUST: If key business relationships are undermined by the lack of trust in a manager, this can lead to decreased business opportunities.
UPHEAVAL: If a manager is replaced, business relationships he or she created may be in jeopardy. Company culture may also feel less stable in the wake of a scandal involving an executive.
Measuring THE IMPACT
While it may seem like common sense that a boss’s behavior trickles down to the entire company culture, that effect is difficult to measure.
Cline and his co-authors were the first to quantify declines in value to shareholders following revelations of breaches of integrity in executives’ personal lives.
Researchers reviewed managerial indiscretions over approximately 35 years. They reviewed 219 unique cases of indiscretions involving 195 different executives. Executive indiscretions were divided into four broad categories: sexual misadventure, substance abuse, violence, and dishonesty.
Companies with accused executives see consequences including:
LOSS OF SHAREHOLDER VALUE: The research found a 4.1% decrease in firm value (averaging around $226 million) when CEO indiscretions were announced.
LOST OPPORTUNITIES: Indiscretions also were followed by a significant decline in acquisition of new major customers and joint venture partnerships. CEO indiscretion is associated with a 2.1% lower likelihood of obtaining a major new customer in the following fiscal year and a 5.1% lower likelihood of a new joint venture.
DECLINE OVER TIME: The effects of indiscretions were felt well after they were revealed. The research found that median shareholders experienced 10% performance below benchmarks over the next year following an announcement, but the loss within the following month was only 1.6%. In other words, the companies experienced losses immediately after the revelation of management indiscretion, which also continued throughout the following year.
A SIGN OF THINGS TO COME: Research also suggests that off-the-clock leadership misdeeds can be a canary in a coal mine, indicating future problems for the company. For example, the companies studied were more likely to be sued in shareholder class actions or targeted in Department of Justice and Securities and Exchange Commission enforcement actions for fraud following the announcement of leader indiscretion.
Research found that company shareholders suffered an immediate loss averaging 4.1% ($226 million) when a CEO’s indiscretion was announced.
Audit quality and poor tone AT THE TOP
Today, the now-defunct accounting firm Arthur Andersen is nearly synonymous with the Enron scandal of the early 2000s. Arthur Andersen was convicted of obstruction of justice in Enron’s fraudulent activities. The Supreme Court overturned the conviction in 2005, but by then, the firm had already folded.
The Arthur Andersen case underscores the role that accounting firms can take in exacerbating a toxic corporate culture. On the other hand, audit firms may be in position to detect a negative company culture before it becomes an issue.
Auditors react to management indiscretion
The most recent research by Cline’s team explores this relationship between corporations and auditors, including how auditors respond to negative tone at the top. Researchers measured the amount of time spent on audits as well as the rare instances in which firms sever ties with the companies they are auditing. The results indicate that auditors might take a closer look at a company’s books if there are signals of a lack of integrity.
The study considered 139 observations of indiscretions over a period of about 11 years. As with the prior study, researchers categorized leadership indiscretions based on the type of conduct.
The team concluded that auditors respond to signals of poor tone at the top:
Auditors spend more time on audits with companies whose leadership is publicly accused of personal indiscretions.
Auditors also charge higher fees to companies led by individuals mired in personal indiscretion.
While rare, auditors are somewhat more likely to resign from engagements with troublesome executive behavior.
The study also showed some differences among auditor response to specific types of leadership misdeeds. For example, auditors reacted with greater audit effort and more willingness to walk away from work with companies whose leaders are accused of extramarital affairs. Cline’s article suggests that events associated with dishonesty, like lying to a partner, may generate stronger reaction than activities like substance abuse or violence, which indicate poor choices but not necessarily dishonesty.
“Business is all about trust.”
– Brandon Cline
The market KEEPS SCORE
The personal indiscretions of company leadership impact their companies financially and reputationally. Even if not directly related to business functions, an executive’s personal indiscretions can impact company performance.
Executives set the tone
Company scandals over the years show how a culture of dishonesty can ultimately lead to devastating consequences. For example, over a period of eight years, Toshiba went from disclosing multiple accounting malpractices involving top management in 2015 to being delisted from the Tokyo Stock Exchange in December 2023.
An investigation determined that the misreporting of profits began in 2008 when senior management began imposing unattainable performance targets. The investigation states that, “Within Toshiba, there was a corporate culture in which one could not go against the wishes of superiors.” “… when top management presented ‘challenges’, division presidents, line managers and employees below them continually carried out inappropriate accounting practices to meet targets in line with the wishes of their superiors.”
The decline of Toshiba demonstrates the tone that company leadership can set. In light of Cline’s research, companies should take note of the message leaders send even through off-the-clock activity.
Disciplining leadership
In some cases, companies do take action to discipline their management. Cline’s study indicates that there was a turnover of 36% of all executives measured. When CEOs are singled out, there is around a 41% incidence of forced turnover. Of course, this is not a majority. In many instances, it may be difficult to discipline an executive, such as when he or she has a major influence on the board, in family companies, and where the CEO is also the founder. However, the research findings do indicate some willingness to take action following leadership indiscretion.
Even if executives keep their jobs, there is a decline in CEO pay for around $388,000 in the fiscal year following disclosure of indiscretion.
Further, Cline notes that when executives are disciplined, the market value of the company often rebounds. This may indicate that investors are concerned not simply about indiscretion but also what action a company takes in the wake of scandal.
“In a 24/7 news world, everything a CEO says and does is no longer personal. It is attributed to the company.”
–Shelly Lazarus, Chairman Emerita of Ogilvy & Mather
WATCH FOR THE TONE AT THE TOP
Many companies have codes of ethics and corporate handbooks that set forth how they should do business. And yet, time after time, companies engage in fraud and other deceptive practices. Investors lose confidence in the market and in the information that many of these same companies present to the public.
The tone at the top can provide a window into how a company conducts itself. While it is only one factor in a company’s risk, the conduct of company leadership can provide an early and important snapshot.
Research reveals that the market responds to leadership indiscretions, particularly those that indicate dishonesty.
“Shareholders view these allegations of personal misconduct as insight into the business decisions of the executives,” says Cline. “And so these indiscretions then signal other events that may be likely to occur at the firm.”
If, as Cline’s research indicates, executive behavior – even off the clock – is a signal of overall corporate culture, then shareholders, employees, and the public should take note.
“CEO indiscretions are associated with a significant decline in the acquisition of new major customers and joint venture partnerships, and CEO reputational costs are negatively and significantly related to the likelihood of obtaining a new major customer.”
– Brandon Cline et al.
Article: The Consequences of Managerial Indiscretions: Sex, lies, and firm value
