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
Ralph
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.
