In the mid-2000s the United States was reeling from a wave of corporate scandals: Think of WorldCom, Enron, Tyco, and AIG. For Aiyesha Dey, then an assistant professor of accounting at the University of Chicago, those episodes fueled a question: Did leaders’ lifestyles affect outcomes for their firms, and if so, how? “There were all these articles about how executives at those companies were throwing parties for millions of dollars,” Dey recalls. So she and colleagues embarked on a series of studies linking leaders’ off-the-job behaviour with their actions at work.
In deciding what behaviours to focus on, the researchers drew on findings in psychology and criminology. They settled on two: a propensity to break the law, which is tied to an overall lack of self-control and a disregard for rules, and materialism, which is associated with insensitivity to how one’s actions affect others and the environment.
Across four studies, Dey—now an associate professor at Harvard Business School—and her coauthors examined correlations between one or both of those behaviours and five on-the-job issues.
In their most recent paper, the researchers looked at whether executives’ personal legal records—everything from traffic tickets to driving under the influence and assault—had any relation to their tendency to execute trades on the basis of confidential inside information. Using U.S. federal and state crime databases, criminal background checks, and private investigators, they identified firms that had simultaneously employed at least one executive with a record and at least one without a record during the period from 1986 to 2017. This yielded a sample of nearly 1,500 executives, including 503 CEOs.
Examining executive trades of company stock, they found that those were more profitable for executives with a record than for others, suggesting that the former had made use of privileged information. The effect was greatest among executives with multiple offences and those with serious violations (anything worse than a traffic ticket).
Could governance measures curb such activity? Many firms have “blackout” policies to deter improper trading. Because the existence of those policies is hard to determine (few companies publish data on them), the researchers used a common proxy: whether the bulk of trades by a firm’s officers occurred within 21 days after an earnings announcement (generally considered an allowable window).
They compared the trades of executives with a record at companies with and without blackout policies, with sobering results: Although the policies mitigated abnormally profitable trades among traffic violators, they had no effect on the trades of serious offenders. The latter were likelier than others to trade during blackouts and to miss SEC reporting deadlines. They were also likelier to buy or sell before major announcements, such as of earnings or M&A, and in the three years before their companies went bankrupt—evidence similarly suggesting they had profited from inside information. “While strong governance can discipline minor offenders, it appears to be largely ineffective for executives with more-serious criminal infractions,” the researchers write.
All this led Dey and her coauthors to wonder: Why do boards hire—or fail to fire—executives who have broken the law? To that end, they more closely analyzed the CEOs in their sample. It didn’t appear that companies, where the CEO had a record, had fewer independent directors, or that the directors had legal records themselves. Nor did those CEOs generate superior returns. Noting that most committed their first offence after taking office, Dey says, “It could be they’re not monitored as much if they came up from within the firm and are doing an OK job—not better than average, but not worse.” In informal conversations, some senior executives and directors told her, “I don’t care what they did, especially if it was a long time ago.”
In an earlier study, Dey and her coauthors identified 109 firms that had submitted fraudulent financial statements to the SEC. Comparing those companies’ CEOs with the heads of comparable firms that had clean reporting slates, they found that far more leaders in the fraud group had a legal record: 20.2%, versus just 4.6% of those in the control group.
Firmwide reporting risk.
The same study looked at whether executives other than the CEO submitted fraudulent financial statements or made unintentional reporting errors. It turned out that CEOs’ legal histories had no effect on this measure—but their materialism did. Leaders with lavish personal consumption habits (the researchers used property and tax records to identify CEOs who, relative to their peers, owned unusually expensive homes, cars, or boats) ran lax operations in which reporting errors of both kinds were prevalent. This often worsened during their tenures, as they made cultural changes associated with higher fraud risk: appointing materialistic CFOs, increasing equity-based incentives, and relaxing board monitoring.
A propensity to take chances.
In a study focused on banks, Dey and her coauthors found that materialistic CEOs took more risks: Their institutions had higher outstanding loans, more noninterest income (which could reflect greater trading activity), and more mortgage-backed securities (known for their riskiness) as a proportion of assets. Using a standard index composed of factors such as whether the firm had a chief risk officer, they found that banks helmed by materialistic CEOs had weaker risk management than others. And cultural indicators, such as whether other executives in the firm reaped abnormally high returns from trades during the Great Recession’s bank bailouts, indicated that materialistic CEOs were likelier than others to run loose ships in this regard, too.
Corporate social responsibility.
Psychologists have shown that people who prioritize material goods are less concerned about others and less likely to engage in environmentally responsible behaviours. The researchers expected this to be true of materialistic CEOs, and they were right: Those leaders got lower overall CSR scores than other chief executives and had fewer CSR strengths and more weaknesses.
The researchers hope their findings will alert boards to the perils of ignoring red flags raised by executives’ lifestyles—and of trusting that governance mechanisms will avert any potential problems. “Prior researchers have assumed that deterrence policies will have the same effect on all executives in a firm,” Dey says, but this work shows that individuals have very different appetites for taking chances and breaking rules. “Simply having governance structures in place may not be enough. One size does not fit all, even within the same firm.” She and her coauthors recognize that their work has looked only at downsides and that these executives might also bring unusual strengths to the table—a topic they are investigating in their current research.
About the Research: “Executives’ Legal Records and the Deterrent Effect of Corporate Governance” (Contemporary Accounting Research, forthcoming), “CEO Materialism and Corporate Social Responsibility” (Accounting Review, 2019), and “Executives’ ‘Off-the-Job’ Behavior, Corporate Culture, and Financial Reporting Risk” (Journal of Financial Economics, 2015), all by Robert Davidson, Aiyesha Dey, and Abbie Smith; and “Bank CEO Materialism: Risk Controls, Culture and Tail Risk,” by Robert M. Bushman et al. (Journal of Accounting and Economics, 2018)