CEOs have not only explicit legal authority but also substantial ‘soft’ influence (based on relationships, for example) over what happens in the company. This influence extends to wrongdoing, as revealed in new research by University of Michigan Ross School of Business finance professor E. Han Kim and University of Michigan Law School professor Vikramaditya Khanna. According to Kim and Khanna, CEOs who appoint their top lieutenants (thus increasing their soft influence) are more likely to commit fraud. Their research also shows that fraud is less likely to be discovered when CEOs are ‘connected’ in this way to the other executives on their team.
‘Connected’ CEOs are those who have very close ties to the other top executives in the firm. CEOs are especially connected if they were responsible for appointing the executives to their position. Using the fraction of top executives appointed by the CEO as a proxy for connectedness, Kim and Khanna found through their research that the more closely the CEO is connected to his or her top executives, the more likely that the CEO will be involved in some kind of fraud. Fraud at the CEO level is often a collaborative effort, or at least it involves the acquiescence if not the active participation of other top executives in the organization. When there is a close connection between the CEO and the other executives, it is ‘less costly’ to coordinate the fraud and bypass controls. The cost of the fraud in the eyes of the wrongdoer is the likelihood of detection and the potential penalty.
Working with Yao Lu, associate professor of finance at Tsinghua University School of Economics and Management in China and a research fellow at Ross, Kim and Khanna offer quantitative proof of their conclusions. In a company in which the CEO appointed all four executives, the incidence of fraud was 35 percent higher than for a company in which the CEO had not appointed any of the top four executives. The same correlation occurs for the discovery of the fraud: Companies with the top four executives appointed by the CEO were 25 percent less likely to detect fraud than companies in which the top four executives did not owe their position to the CEO.
The lower incidence of detection is logical; the CEO is protected by his appointees. Thus, the typical monitoring systems by auditors and boards hit a wall; the uncovering of the fraud is going to take much more effort.
And, in the final barrier in the battle against fraud, even when the fraudulent activities of a CEO are discovered, that CEO is less likely to get fired if he or she is closely connected to the firm’s top executives.
A close working relationship between the CEO and the top executives in the company will have its benefits. If top management team members like and respect each other, and work well together, they are more likely to be able to institute significant change or work in unison toward a vision for the future. However, there is a downside to a top executive team too closely aligned.
To increase the detection of fraud, corporate directors and auditors or government specialists — who are on the front lines of detection — must:
‘CEO Connectedness and Corporate Frauds,’ by Vikramaditya S. Khanna, E. Han Kim and Yao Lu, Public Law and Legal Theory Research Paper Series, University of Michigan Law School, June 2012.
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