Monday, February 11, 2013

Sex, Lies, and Firm Value

Today, two of my coauthors, Brandon Cline and Adam Yore, are featured as guest bloggers today talking about a recent paper of ours entitled, The Agency Costs of Managerial Indiscretions: Sex, Lies, and Firm Value.

All the best


The Agency Costs of Managerial Indiscretions: Sex, Lies, and Firm Value

 Ethics and codes of conduct are frequently placed at the forefront of corporate policy. Recently, many have even argued that the integrity of management is a factor of production. The notion is that mutual trust between two economic agents reduces transactions costs as it mitigates the need for excessive contracting. However, when trust among economic agents is breached, the offending agent’s reputation is damaged. The penalties resulting from the damaged reputation are often a multiple of the actual harm associated with the offending event.

Many executives face ethical charges in their personal lives unrelated to the firm’s financial or operating decisions. Boeing’s Harry Stonecipher, RadioShack’s David Edmonson, Staples’ Martin Hanika, and Raytheon’s William Swanson were all placed under the spotlight for engaging in alleged extramarital affairs, substance abuse, domestic violence, or public displays of dishonesty.

In a paper just released we examine a sample of executives accused of indiscretions in their personal lives for actions explicitly unrelated to the operations of their firm. These include allegations of violence, substance abuse, dishonesty, and sexual misadventure. The objective of this research is to examine the corporate agency costs associated with alleged indiscretions in executive’s personal life.

The existence of alleged improprieties in an executive’s personal life raises important questions for corporate governance. First, what is the impact of these allegations (if any) on the valuation and operations of the firm, and do these allegations have the potential to signal important managerial qualities to the market? A second set of questions asks whether an executive’s alleged personal indiscretions relate to subsequent questionable or even illegal activities at the firm level including earnings management, actions provoking shareholder lawsuits, or fraud. In essence, are signals suggested by personal indiscretions borne out by successive actions in the corporate setting?

While these actions are personal in nature, we find that they signal significant agency costs for the firm. The data indicates that managerial indiscretions pose a significant risk to the company and inflict substantial agency costs upon shareholders, particularly when the CEO is involved. On average, there is an immediate 3.8% loss in shareholder value at the disclosure of a CEO indiscretion and operating performance suffers an abnormal decline of 1.5% during the same fiscal year. In addition, the firms of these executives experience a long-run abnormal decline in value of 9% to 12% during the year of an indiscretion. These firms are also more likely to be involved in shareholder-initiated lawsuits, DOJ/SEC investigations, and are significantly more likely to manage their earnings. Notably, only 25% of executives face disciplinary turnover for these offenses, despite the fact that a significant fraction of these executives are repeat offenders. In fact, the turnover rate for repeat offenders is almost identical to that of first time offenders. At best, this implies that the typical firm’s board does not feel that that management’s behavior poses a problem. At worst, it implies that boards are ineffective at preventing these events or are simply apathetic to their consequences.

The paper contains many other results. It is authored by Brandon N. Cline of Mississippi State University, Ralph Walkling of Drexel University, and Adam Yore of Northern Illinois. It can be downloaded here.

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