CEO Connectedness and Corporate Fraud

• Author: E. HAN KIM,YAO LU,VIKRAMADITYA KHANNA
• DOI: http://doi.org/10.1111/jofi.12243
• Published date: 01 June 2015
• Date: 01 June 2015

THE JOURNAL OF FINANCE •VOL. LXX, NO. 3 •JUNE 2015

CEO Connectedness and Corporate Fraud

VIKRAMADITYA KHANNA, E. HAN KIM, and YAO LU∗

ABSTRACT

We find that connections CEOs develop with top executives and directors through

their appointment decisions increase the risk of corporate fraud. Appointment-based

CEO connectedness in executive suites and boardrooms increases the likelihood

of committing fraud and decreases the likelihood of detection. Additionally, it de-

creases the expected costs of fraud by helping conceal fraudulent activity, making

CEO dismissal less likely upon discovery, and lowering the coordination costs of

carrying out illegal activity.Connections based on network ties through past employ-

ment, education, or social organization memberships have insignificant effects on

fraud. Appointment-based CEO connectedness warrants attention from regulators,

investors, and corporate governance specialists.

ALLEGATIONS OF CORPORATE and securities fraud have dominated headlines over

the last decade. Corporate wrongdoing damages investor confidence, decreases

shareholder value, causes misallocation of capital, and increases financial mar-

ket instability, leading a number of scholars to examine factors affecting the

likelihood of fraud and its detection.1Largely absent from these inquiries,

however, is an analysis of the role played by the CEO’s connections with other

∗Khanna is at the University of Michigan Law School; Kim is at the University of Michigan Ross

School of Business; and Lu is at Tsinghua University School of Economics and Management. We

are grateful for helpful comments and suggestions by Campbell Harvey (the Editor), the Associate

Editor, an anonymous referee, Cindy Alexander, Jennifer Arlen, John Coates, Simon Johnson,

Jeffrey Smith, David Wilkins, and participants at business and/or law school seminars/roundtables

at Boston University, Central University of Finance and Economics, Harvard University, Indian

School of Business, Renmin University,Shanghai University of Finance and Economics, University

of Miami, University of Michigan, University of Southern California, and Yale University, as well

as participants at the 2013 American Finance Association Meetings, the 2013 American Law and

Economics Association Annual Meeting, the 7th Conference on Empirical Legal Studies, and the

2014 NASDAQ OMX Conference on Capital Markets. We are indebted to Jonathan Karpoff and

Gerald Martin for generously sharing their Federal Securities Regulation (FSR) database. We also

thank Joseph Rewoldt, Satoko Kikuta, Guodong Chen, Paul A. Sandy,Alex Pierson, Melan A. Patel,

Rudresh Singh, Tamar Groswald Ozery, Shinwoo Kang, and Robert Powell for excellent research

assistance. This project received generous financial support from Mitsui Life Financial Research

Center at the University of Michigan. Yao Lu acknowledges support from Project 71202020 of the

National Natural Science Foundation of China.

1See Karpoff and Lott (1993), Beatty, Bunsis, and Hand (1998), Bhagat, Bizjak, and Coles

(1998), Karpoff, Lee, and Vendrzyk (1999), Bar-Gill and Bebchuk (2002), Karpoff, Lee, and Martin

(2008a, 2008b), Gande and Lewis (2009), Murphy,Shrieves, and Tibbs (2009), and Karpoff, Lee, and

Martin (2014). Yu(2013) surveys this literature, highlighting the enormous welfare loss stemming

from corporate fraud.

DOI: 10.1111/jofi.12243

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1204 The Journal of Finance R

leaders within the firm.2CEOs have substantial “soft” influence in addition to

explicit legal authority to direct corporate behavior,3of which wrongdoing is

but one potential outcome. This soft influence is likely to be strengthened by

the CEO’s internal connections.

CEO connections with other top executives and directors could increase or

decrease the incidence of corporate fraud. As with other corporate activities,

corporate wrongdoing often requires coordination between, or acquiescence by,

top executives and/or board members. Such coordination and acquiescence can

take the form of direct involvement in criminal activities, or a reluctance to

“blow the whistle.” A CEO’s close connections may facilitate wrongdoing by

providing the necessary support. However, CEO connections may also help

deter fraud. The CEO’s familiarity with other top executives may enable him

to detect early signs of fraudulent activity. Further, when a CEO is not aware

that a certain activity is illegal, a common problem in some areas of white

collar crime, closer interpersonal relationships could make it easier for other

executives and board members to help the CEO avoid wrongdoing. Thus, CEO

connectedness can cut both ways. Which effect prevails is an empirical question.

We consider CEO connectedness to top executives and directors through two

sources: appointment decisions and prior network ties. Our results indicate

that appointment-based connectedness warrants attention. In particular, it

is significantly associated with not only greater likelihood of fraud, but also

lower expected costs of engaging in fraud: it decreases the likelihood of fraud

detection, lengthens the time from fraud commission to detection, reduces the

likelihood of forced CEO turnover upon discovery of fraud, and lowers the

coordination costs needed to carry out illegal activity.

Appointment-based CEO connectedness is measured by the fraction of top

corporate leaders—top executives and directors—appointed during the current

CEO’s tenure. Such connections increase what social psychologists refer to

as “social influence,” which relies on norms of reciprocity, liking, and social

consensus to shape group decision-making processes (Cialdini (1984)). Social

influence facilitates the acquiescence or coordination required to engage in

fraud and keep it from view. When more top executives are appointed during

a CEO’s tenure, the CEO’s social influence increases because CEOs are heav-

ily involved in recruiting, nominating, and appointing top executives. Those

2A notable exception is Chidambaran, Kedia, and Prabhala (2012), who study how CEO-board

network ties are related to the likelihood of fraud.

3The importance of CEO influence on firm behavior and performance is well documented. Gra-

ham, Harvey, and Puri (2013) show that CEO behavioral traits, such as optimism, risk-aversion,

and time preference are related to corporate financial policies and managerial compensation;

Bertrand and Schoar (2003) find that CEO characteristics matter for a wide range of firm poli-

cies; Bennedsen, Perez-Gonzalez, and Wolfenzon (2006) document that CEO deaths are strongly

negatively correlated with firm profitability and growth; Cronqvist, Makhija, and Yonker (2012)

show that differences in corporate financial leverage can be traced to CEOs’ personal leverage; and

Jenter and Lewellen (2014) find that CEOs’ age approaching retirement has an important impact

on the likelihood of their firms being taken over and the takeover premiums their shareholders

receive. Also see Allen, Kraakman, and Subramanian (2012) for discussion of CEOs’ legal authority

to contractually bind the firm for ordinary transactions.

CEO Connectedness and Corporate Fraud 1205

executives are more likely to share similar beliefs and visions with, and may

be more beholden to, the CEO who hired or promoted them to their current

position than executives appointed during a previous CEO’s tenure (Landier

et al. (2013), Kim and Lu (2014)). CEOs also tend to be involved in appointing

board members either directly or indirectly through consultation with the nom-

inating committee. Consequently, directors recruited during a CEO’s tenure

may be similarly beholden to the CEO (Morse, Nanda, and Seru (2011), Coles,

Daniel, and Naveen (2014)). In other words, appointment-based CEO connect-

edness with corporate leaders may weaken the checks and balances required

for prevention of corporate wrongdoing and detection. Inadequate checks and

balances in the executive suite and boardroom breed fraud, make detection

difficult, and reduce the expected costs of wrongdoing.

In contrast to appointment-based connectedness, CEO connectedness based

on sharing prior education, employment, or social network ties with top execu-

tives or directors has insignificant effects on both fraud and the expected costs

of wrongdoing. The insignificant effects may be attributed to a weaker sense of

loyalty. When one is appointed to a top executive position or is recommended

to the board by a CEO, she may feel a sense of loyalty to the CEO. Such loyalty

is likely to be weaker or absent when the connection is through network ties.

One may even argue that sharing similar education or work experiences can

breed a sense of competition within the firm that may not fit as comfortably

with loyalty.

Our sample covers 17,797 firm-year observations for 2,736 unique firms dur-

ing the 1996 through 2006 period. We identify 309 cases of fraud, with 873

firm-year observations, in which the CEO is a named respondent and data

are available to construct appointment-based CEO connectedness variables.

Our primary source of fraud data is the Federal Securities Regulation (FSR)

database (Karpoff et al. (2014)), generously provided by Karpoff and Martin.

FSR provides the most comprehensive and accurate data on financial mis-

statements. We add other types of fraud by supplementing FSR with fraud

allegations contained in the Securities and Exchange Commission’s (SEC’s)

Litigation Releases and in the Stanford Securities Class Action Clearinghouse

(SSCAC).

Inherent in any fraud sample is a partial observability problem: we observe

detected fraud, not the population of fraudulent activity. Since observed fraud

depends on two distinct but latent processes—the commission of fraud and the

detection of fraud—we follow Wang, Winton, and Yu (2010) and Wang (2013)

and employ a bivariate probit model. CEO connectedness with top executives

is measured by the fraction of top-four non-CEO executives appointed during

the current CEO’s tenure, the fraction of executives appointed (FTA); CEO con-

nectedness with directors is measured by the fraction of directors appointed

during a CEO’s tenure, the fraction of directors appointed (FDA). These frac-

tions at a particular point in time depend on how long the CEO has been in the

office. Thus, our analyses control for CEO tenure throughout the paper.

Both measures of CEO connectedness are positively related to the likeli-

hood of wrongdoing and negatively related to the likelihood of detection given