Is there a pattern to be found in the actions of managers trying to cover up their firm’s wrongdoings? According to this Idea, yes there is: they all tend to engage in the same sort of behaviours, such as exercising stock options more frequently, rarely changing the firm’s auditors, and more. An understanding and awareness of these behaviours can assist shareholders, regulators and other stakeholders notice failures and wrongdoings early and help address problems before disaster hits.
In recent years, the trust afforded to senior management has eroded significantly, particularly for those executives in finance-related positions. The demise of certain companies sent shockwaves across industries; successful covering up of the actual financial situation a company was in meant regulators, employees and the general public remained unaware till it was too late. Going forward, people want to know how to spot such covering up beforehand, and what the telltale signs are that companies have something to hide.
Addressing these concerns, researchers from the University of St. Gallen and New York University’s Stern School of Business looked at 216 US companies accused of illegal cartel activity (price fixing) by antitrust authorities. They describe a ‘cartel’ as an association of independent firms aiming to raise their joint profits through explicit agreements to, for example, control prices and restrict supply; such agreements are almost always at the direction of middle or top managers. They found a pattern amongst these firms: they frequently engaged in a range of practices designed to obscure their behaviour to internal and external audiences.
Take the case of the pharmaceutical company Bristol-Myers Squibb Co. Between 1999–2004, Bristol-Myers was charged with participating in cartels in three different countries. During this period, three new outside directors joined the company’s board, one of whom was based in a foreign country and all three being classified as "busy" (i.e., holding three or more board seats); five years’ of earnings results were restated; and, the company’s auditors were not changed until the end of the cartel period.
Through their analyses, the researchers found that these activities were not unique to just Bristol-Myers; in fact, these are just some of the tell-tale signs that a company may be trying to cover up an increasing amount of wrongdoing. Other warning signs include stock options being exercised more rapidly, consistent with the interpretation that managers may wish to withdraw their equity compensation before some future date at which the illegal activity might be exposed and the firm’s stock price could drop.
Though in this particular research cartels and, specifically, price-fixing was examined, the researchers believe their findings should apply to many scenarios in which managers seek to hide information from inside and from outside parties.
Broadly, the warning signs to look out for are as follows:
These signs provide a template for understanding how companies can behave when they wish to conceal aspects of their financial performance. Such an understanding can ensure serious problems become apparent earlier to shareholders, analysts, and regulators.
Smokescreen: How Managers Behave When They Have Something to Hide “González, Tanja Artiga”, “Schmid, Markus” and “Yermack, David”, NBER Working Paper No. 18886 (2013)
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