Executives Acting in Bad Faith and the Role of the Board
By Thomas Fox ,The Compliance Evangelist, Author
A piece by Dick Cassin in the FCPA Blog had some very stark language. He quoted from the Telefonaktiebolaget LM Ericsson (Ericsson) 6-K filing for the following,
“While the Company had a compliance program and a supporting control framework, they were not adequately implemented. Specifically, certain employees in some markets, some of whom were executives in those markets, acted in bad faith and knowingly failed to implement sufficient controls. They were able to enter into transactions for illegitimate purposes and, together with people under their influence, used sophisticated schemes in order to hide their wrongdoing.” [Emphasis supplied]
This language caused me to consider why would an executive engage in bad faith?
There are a number of reasons; it could be they simply were greedy, they wanted the additional income; it could be that they had no moral compass, so they may well know right from wrong but could not give two whits about it. Of course, there are lots of other reasons, including the legs of the Fraud Triangle and the Fraud Pentagon.
How can a company monitor such executives?
I thought about that question when reading a recent Harvard Business Review (HBR) article, entitled “Why Boards Should Worry about Executives’ Off-the-Job Behavior”, by Tim Bower. He looked at research by Aiyesha Dey, then an assistant professor of accounting at the University of Chicago. Dey was interested in the question of the failures of Enron Corporation, Tyco International Ltd., and WorldCom and posed the following: “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 and colleagues embarked on a series of studies linking leaders’ off-the-job behavior with their actions at work.
I found this next point insightful for the compliance practitioner. In deciding what behaviors to focus on, Dey and her colleagues
“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 an insensitivity to how one’s actions affect others and the environment.”
This insight is significant because it could enable a compliance function to bring insight into which corporate executives might well be willing to “act in bad”, in the parlance of the Ericsson 6-K. It also has significant implications for Boards of Directors about when it could well be time to cut an executive before things get really out of hand and the legal violations start flying.
The most recent work Dey (now at Harvard) and her team has done is around insider trading. They “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…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 offenses and those with serious violations (anything worse than a traffic ticket).”
The results were, as Dey called them, “sobering”. Executives with multiple offenses were likelier than others to trade stocks “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.”
The researchers specifically noted “While strong governance can discipline minor offenders, it appears to be largely ineffective for executives with more-serious criminal infractions.”
It was similarly alarming in prior studies conducted by Dey. In one study, Dey and her coauthors identified 109 firms that had submitted fraudulent financial statements to the Securities and Exchange Commission (SEC). Comparing those companies’ Chief Executive Officers (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.” This same study also considered “whether executives other than the CEO submitted fraudulent financial statements or made unintentional reporting errors.” Here the key indicator was not prior legal problems but simple greed. She noted, “Leaders with lavish personal consumption habits 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.” Once again this is akin to the actions in bad faith admitted to by Ericsson.
The question you might pose after reading all this is “Where was the Board?”
Indeed, that is a question around every corporate scandal, including recent ones involving The Boeing Company, Wells Fargo and a host of other companies. Dey and her team 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 offense 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.”
But it is more than simply the Board’s responsibility to fire such executives who act in bad faith. The, clearly, better approach is not to hire them in the first place. These findings should alert Boards, as well as compliance professionals,
“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.”
- Core Investigative Due Diligence - June 3, 2021
- Preparing for the Next Crisis - May 14, 2021
- Using Data in Compliance - March 29, 2021
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