Bad Business: Where Unethical Corporate Cultures Come From

Information asymmetries are meant to be exploited - legally - in the knowledge economy. The ability of one enterprise to recognize value, then take advantage of the guidance it provides is the key to the power of information.

Big Data is simply an aggregation of accumulated asymmetries that may, eventually, add up to an even more significant and possibly strategic advantage.

The problem comes when organizations and, especially, their leaders use such information to mislead investors, customers, suppliers and employees.

Research shows that executives inclined to abuse their knowledge in order to shade financial reports, compensation calculations or other forms of contractual and sometimes regulated data flows will do so not just in one case, but generally. As the following article explains, such behavior invariably permeates the institution. Economic dependency makes for intensive signal interpretation by those on the value chain. The result is that at culture of ethically dubious activity tends to flow from the signal being sent by the organization's leadership cadre.  This leads to the 'few bad apples' fallacy, in which managers claim that the enterprise usually does the right thing but that a few individuals have gone rogue. The disconnect flows from the fact that very few people act without hope of some sort of cover. Most will behave in a manner they think is sanctioned by their superiors.

The issue is exacerbated in a global economy which must, by its nature, interact with a variety of cultural norms, not all of which regard certain actions in the same moral, ethical or legal light. Those determined to sustain a successful but ethical culture must remember that everyone affected by an organization looks to its leaders for signs of what is acceptable - and what is not. JL

Lee Bickerstaff, David Cicero and Andy Puckett report in VoxEu:

The ethics of corporate leaders is an important determinant of the ethical cultures of the firms they manage.
One of the great features of the modern economy is that firms can be owned by a diverse group of outside investors while day-to-day business operations are delegated to full-time managers. Such ownership arrangements allow for immense economic gains since capital is allocated to its highest use and risk is borne more efficiently.

• This modern 'separation of ownership and control' introduces potential problems in that managers do not always invest the resources delegated to them as the owners would like (Fama and Jensen 1983).

In addition, mangers sometimes fail to accurately inform investors about how business is going – especially when it is not going as well as was hoped.

• The costs that can result when managers exploit information asymmetries to intentionally mislead investors can be quite dramatic.

This can be seen in the market losses associated with financial statement frauds uncovered at firms such as Enron, WorldCom, Tyco, and HealthSouth.
As a result of these frauds and others, the US Federal Government passed the Sarbanes-Oxley Act in 2002 in order to help restore investor confidence in the modern corporate structure.

Business ethics and Sarbanes-Oxley

The subject of business ethics and the refinement of provisions in the Sarbanes-Oxley Act continue to occupy a prominent role in on-going public policy debates. Of particular importance in the current dialogue is an understanding of (and potential means to mitigate) the forces that drive firms to mislead investors and cause the misallocation and destruction of scarce societal resources. In short:

• Where does an unethical culture originate?

Anecdotal evidence suggests that these fraudulent firms were often characterised by an unethical culture that permeated a nexus of employees, whose cooperation was necessary to perpetrate extensive corporate malfeasance. For instance, approximately 30 employees at Heathsouth and Peregrine Systems were convicted or pleaded guilty to charges related to financial statement fraud.
Our recent research suggests that it may be driven by the actions and attitudes of those at the very top level of corporate leadership – in particular the CEO (Biggerstaff, Cicero and Puckett 2013). Our findings are consistent with a growing literature that emphasises the influence of those in the upper echelons of corporate leadership (Chatterjee and Hambrick 2007, Hambrick 2007).

Research challenges

The challenge when exploring the influence of an executive’s character on corporate culture is that the character of top executives is inherently difficult to measure.

• We propose a novel way to identify an unethical pattern of behaviour, based on an executive’s systematic participation in options backdating.

Options backdating refers to the manipulation of stock option grant or exercise dates (and therefore grant or exercise prices) in order to maximise 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 minimise 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 2006.¹ Options backdating for top executives likely indicates stealth (nefarious) activity undertaken for personal gain and to the detriment of shareholders and taxpayers.²
In a nutshell, we assume systematic participation in options backdating serves as a reasonable indicator of unethical behaviour on behalf of the chief officer. This allows us to test whether this behaviour is associated with an unethical corporate culture.
We use a largely data-driven approach to identifying CEOs who personally benefitted 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 identify 249 suspect CEOs using this rule, and augment this list with 12 additional CEOs who were specifically named in enforcement actions or backdating settlements.

Findings

Our results indicate a strong association between the identified executives and other forms of corporate misbehaviour.

• 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 (Hayn 1995, Degeorge et al 1999).
• 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:

• Firms with backdating CEOs make significantly more acquisitions and that their acquisition announcements are met with a significantly lower market response.

Prior studies (Jensen 1986) 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 penalise 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 behaviour 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.