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Dividend Spring 2013 : Page 15

Connected CEOs and Fraud . New study shows that CEOs with close ties to their top executives are more likely to commit fraud Corporate frauds have dominated financial news in the past decade, hurting public and investor confidence. Plenty of studies have worked to predict fraud – probing board structure, the regulatory environment, executive compensation, and business conditions. But few have examined the connectedness of the company’s topmost executive to its other top executives. After all, the CEO has legal authority and immense “soft” influence over the top lieutenants. Professor E. Han Kim and Professor Vikramaditya Khanna of U-M’s Law School wondered: How does CEO connectedness affect the likelihood of wrongdoing and its detection? It turns out to have a big effect. The more top executives the CEO appoints, the higher the probability of fraud. Also, that fraud has a lower likelihood of detection. “CEOs who commit fraud don’t act alone,” says Kim, the Everett E. Berg Professor of Business Administration. “We wanted to focus on white collar crime and the soft influence CEOs have over their top executives. We found the more closely they are connected, the easier it is to bypass controls.” Their paper, “CEO Connectedness and Corporate Frauds,” was co-authored by Yao Lu , associate professor of finance at China’s Tsinghua University School of Economics and Management, and a fellow at the Ross School’s Mitsui Life Financial Research Center. Connectedness: A Double-Edged Sword Having a CEO closely connected with top executives has major benefits. A close-knit executive suite generally reacts faster to changing business conditions and is more efficient, Kim says. But the researchers wondered if there was a downside. Could a close-knit executive team help deter fraud? Could the CEO’s familiarity with the other executives enable him or her to detect early signs of fraud? Or, if a CEO is unsure whether an activity crosses the line, would executives with close relationships be more comfortable steering the CEO in the right direction? The researchers examined a sample of publicly traded companies from 1996-2006. To determine connectedness, they looked at the top four executives under the CEO and whether they were hired from the outside or promoted during the CEO’s tenure. The observation problem — they only could count detected frauds, not the entire population of frauds — was resolved by using a statistical tool called the bivariate probit model. They found a significant positive association between CEOs’ connections with their top executives and the likelihood of wrongdoing, as well as a decrease in the likelihood of the deception being detected. E. Han Kim Kim’s estimate found that a firm with all four executives appointed by the CEO has a 34.5 percent higher incidence of fraud and a 20.3 percent lower likelihood of detection than a firm with none of the executives appointed by the CEO. “Committing fraud and keeping it from view requires coordination,” Kim says. “When the CEO and the top executives are closely connected, coordination costs go down and it’s easier to get support to override control mechanisms. It’s also easier to influence others to obfuscate. This is what social scientists call social influence. It relies on norms of liking and social consensus to shape decision making.” Finding the Fraud and Implications for Boards Kim and his co-authors also found that standard internal and external monitoring systems aren’t successful at detecting fraud by a connected CEO. If a board is overseeing a connected CEO, uncovering possible fraud will take more effort. Even when fraud is discovered, the connected CEO is less likely to be fired. Unless the chief executive is jailed, dismissal is a company-level decision. Better connected CEOs can gather more support from other executives than non-connected ones, Kim says. The study found that the probability of a CEO’s firing following fraud discovery is 29.6 percent lower when all four top executives were appointed by him or her than at a firm where none of the top lieutenants have that connection. “Boards, regulators, and investors need to be aware of this,” says Kim, who has served on a number of boards. “Corporate directors and auditors aren’t finding the wrongdoing, and they are the first line of defense. Hopefully we can change their perspective.” –Terry Kosdrosky SPRING 2013 DIVIDEND 15

| - Faculty Research // Connected CEOs and Fraud.

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