The Effects of Fraud and Lawsuit Revelation on U.S. Executive Turnover and Compensation Author(s): Obeua S.

Persons Reviewed work(s): Source: Journal of Business Ethics, Vol. 64, No. 4 (Apr., 2006), pp. 405-419 Published by: Springer Stable URL: http://www.jstor.org/stable/25123761 . Accessed: 06/03/2012 21:10
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(2006) 64: 405-419 Journal of Business Ethics DOI 10.1007/sl0551-006-0018-l

Springer 2006

The Effects of Fraud and Lawsuit

Revelation
Turnover

on U.S.

Executive
Obeua S. Persons

and Compensation

ABSTRACT.
fraud/lawsuit and compensation.

This
revelation

study
It also the

investigates
top potential turnover firms. there U.S.

the

impact
turnover explanatory

of

suggests decisions,

that and

ethics

appears

to

play may

no have

part

in

the board's standards

on U.S. examines

executive

that U.S.

firms

ethical

in writing
standards.

but they do not

implement

nor enforce

the

variables sation findings higher lawsuit firms average,

affecting among are U.S.

executive

and

compen important

fraud/lawsuit First, among

Four was firms

documented. turnover

executive revelation without U.S.

significantly with fraud/ than matched although on in cash increase firms.

KEY nance,

WORDS: ethical turnover,

board

of

directors, executive lawsuit

corporate

gover

standards, fraud,

compensation,

in the Wall such top revelation.

Street Journal Second, received an

executive

executives

increase this

One
extraordinary

recent

concern

of most
awarded

investors
to many U.S.

is an
top

after fraud/lawsuit compensation is smaller than that of matched

revelation, non-fraud/lawsuit

compensation

executives. bonus

It's not unusual

Third, fraud/lawsuit firms were more likely to change top executive when chief executive officer (CEO) was not the board chairman and CEO had been on the board for a
short to time. reduce Fourth, their fraud/lawsuit executive cash firms were more likely when

reach literally hundreds awards of this magnitude propriate even when a company consistent

to for this compensation of millions of dollars. Salary and seem grossly inap is profitable and has a

compensation

profitability was
compensation met more often. general, executive were U.S. cash likely than

low, firms were

size was These

involved
small, that not involved executive top

in fraud,
and the although, reduce

the
in their

committee

board

increase in stock price. Such salary and bonus when a company is award is clearly incomprehensible losses and a stock price decline. experiencing study examines a specific situation that causes a to incur substantial expenses which gener company leads to a decline in stock price, and is under the ally This of top management. Such situation is responsibility conse the revelation of fraud and lawsuits. What their companies quences do top executives face when are discovered to be engaged in fraud or are facing lawsuits? In some cases, the allegation of fraud and their jobs. For threatening lawsuits cost top executives example, chairman Columbia/HCA federal in its home and chief executive Corporation (CEO) was fired of the firm's investigations officer Healthcare

indicate findings firms did fraud/lawsuits compensation, to reduce to change nor those their their

in fraud cash com The

more

pensation

executives.

finding, that ethical standards is not a significant factor for

U.S. executive turnover compensation reduction,

Obeua Rider

S.

Persons

is an Associate in Lawrenceville, from Master

University earned her B.A. and

Professor of Accounting New Jersey, U.S.A. University, and

at She

Chulalongkorn

Bangkok, Ph.D in

in 1997 following

Thailand,

of Accountancy

accountingfrom
teaching tional interests accounting.

the University
include financial, Her research compensation,

of Texas
managerial, interests

at Austin. Her
and include interna corporate accounting,

health care business. More billing practices and WorldCom recently, Enron, Global Crossing their CEOs after the revelation of changed shortly financial do not reporting fraud. However, fraud and lawsuits always prompt changes in top management. Reliant Resources, for example, has not changed their chairman and CEO since the financial reporting fraud et al. (1999) find that companies surfaced. Agrawal

governance,

executive

international

andfinancial reporting.Her publications have appeared in Review of Accounting & Finance, Multinational Finance Journal, Managerial Finance, Journal of Business Research,
Research in Accounting Regulation among others.

406Obeua or charged with turnover among ally high This study raises an suspected upon fraud the finding companies did executives, the reduction through fraud did not have unusu senior managers.

S. Persons Fraud and lawsuits decreasefirm value

based important question et al. (1999). If these of Agrawal did not usually change their top their executives they reprimand

and Lott that frauds are report (1993) Karpoff in firm value and earn associated with decreases et al. (1998) find that no matter who ings. Bhagat brought a lawsuit against a firm, experienced statistically lawsuit value the Brunello upon filing. et al. Lausten and Warner (2003), (2002), report that there managerial is a higher probability a firm performs when the defending firm losses in firm significant et al. (1988) of top

in their compensation? To et al.'s finding, this study not only verify Agrawal examines in executive the changes compensation turnover but also investigates the top-executive among fraud firms. In addition to fraud, this study on the impact of lawsuit revelation also examines
executive turnover and compensation. Niehaus and

Roth
turnover class

(1999) find that the probability of CEO

increases lawsuits. from
papers,

change poorly. and Larcker Lambert that (1987) find Similarly, there is greater likelihood of executive-compensa tion reduction when earnings and firm value are These and studies
or

for

firms

subject

to

securities

action

Alexander

that management lawsuits facing

None of these

turnover

(1999) also finds is higher among firms customers and employees.

however, examine the

declining. of fraud
managerial

lawsuits
change

suggest that the revelation can increase the benefits of

executive compensation

reduction
earnings

because
and firm

it corresponds
value.

to a decrease

in

effects
compensation.

of

fraud

and

lawsuits

on

executive Fraud and lawsuits signal lowfirm The value

turnover of higher executive and of fraud lower compensation after the revelation assure stockholders and lawsuits should that the The finding is working corporate governance properly. On the other hand, an opposite finding would suggest that stockholders should try to improve their company's iden help stockholders mechanisms that tify specific corporate governance this study also examines may require improvement, turnover fol the relationship executive between corporate governance. lowing porate fraud/lawsuit revelation and specific cor mechanisms governance and the effectiveness independence the including of the board of To

of fraud and lawsuit can reveal the publicity have been pre firm's unfavorable prospects which hidden from investors (Agrawal et al., 1999). viously Maksimovic and Titman (1991) argue that the costs to committing fraud tend to be lower for financially troubled firms than financially healthy firms. This means trouble are more that firms facing financial revelation of public a signal to investors can provide assessment of the firm's regarding the top executives' unfavorable prospects. The revelation that the firm is fraud and lawsuits performing
changing top

likely to commit fraud which against the firms. Therefore,

likely

leads to lawsuits

directors

and the and compensation committee, the relation ethical standards. Likewise, corporate in executive compensation changes ship between is also and these corporate variables governance

poorly
managers

would
or

increase
reducing

the benefits
their compen

of of

sation,
such

and

therefore,

increasing

the

likelihood

this study's findings should investigated. Therefore, are contem be highly relevant to regulators who a further reform of corporate governance plating
and executive compensation.

changes.

Replacing managers reestablish the firm's revelation

or reducing their compensation help reputationfollowing fraud and lawsuit

Theoretical There benefits reduction revelation

development The revelation arguments supporting of managerial change following the and the reputation investors its end of an implicit contract with et al., 1999). The of implicit notion (Agrawal contract in Klein and Leffler is discussed (1981). of fraud or lawsuit damages the firm's it indicates that the firm did not because

are four theoretical and likelihood in executive of fraud

uphold

compensation or lawsuits.

Effects of Fraud and Lawsuit Revelation

In particular, when an investor purchases stock or

407 the stockholders their executives. to take disciplinary If no effect is found

bond an implicit The

the firm establishes with the investor to conduct the business legally. fraud and lawsuit revelation serves as a breach of contract

of a firm,

pressure from action against

this implicit contract resulting in investors' lowering the perceived reputation of the firm. The removal of or the reduction in their compensation top managers can be a cost-effective
reputation.

in this setting, it is not likely to be found in any is other. The Wall Street Journal (on microfiche) also read for any clarification the nature regarding and timing of particular fraud and lawsuits. A firm is allowed as long
years Because

to have more as the fraud

executive

than one lawsuits

fraud or lawsuit are at least two

and data about

way

to reestablish

the firm's

and

apart. compensation

the Changing managers or reducing their compensation can limit the firm's liability exposure The revelation of fraud increases the firm's exposure to legal liability because fraud provides the basis for lawsuits. Similarly, the fifing of the first lawsuit can in lawsuit filings, especially pave the way for more the case of product defects, racial discrimination and reporting fraud. If the firm has a policy to for any lawsuit-related top executives indemnify these costs through costs, the firm can minimize and

board ethical

of

in a proxy via the firms identified fraud/lawsuit statement, are required to have electronically filed proxy WSJ statements in the EDGAR database of the U.S. This Commission (SEC). Exchange results in a sample of 277 fraud/lawsuit requirement firm years coming from 224 firms (36 firms have two firm years, seven firms have three firm years and one firm has four firm years). These firms come from 121 different industries based on the four-digit concentration Preparation Commercial SIC code. The the highest industry with of firm is Pharmaceutical years (26 firm years), followed by National Securities

directors, compensation are reported standards

committee

financial

oversaw the quick removal of the executives who fraudulent behavior. More the 1991 importantly, U.S. Commission for corpo Sentencing guidelines the 2002 Sarbanes-Oxley Act, which sharply increased penalties for corporate crimes, offer to leniency to firms that apply "adequate discipline" Under these laws, a firm gets responsible employees. more much (smaller fine or no criminal justice faster if the firm takes "immediate charge) much or reduce their to fire or demote employees, steps"
compensation.

rations

and

(12 firm years), Motor Vehicles and Passenger Car Bodies years), (eight firm Securities Brokers firm years) and Dealers (eight and

Banks

software firm Services-Prepackaged (eight Out of these 277 firm years, fraud revelation years). accounts for 106 firm years of 97 different firms (nine firms had two fraud-revelation years). as the This study defines executive compensation sum of annual salary and bonus of the highest paid executive the CEO and/or chair officer, normally man of the board of directors. This study uses only any cash compensation (salary and bonus) and excludes stock compensation because, unlike long-term
long-term stock compensation, salary and bonus are

Sample U.S.

selection the revelation from 1992 of fraud and law

firms with Index

suits were (WSJ)

collected from

the Wall

through topics of the Index were lowing fraud and lawsuits: "Accounting", "Class Action
up", "Fraud",

Street Journal 2000. The fol

Lawsuits",
"Insurance

to identify "Bank Fraud", "Environmental Clean used

Fraud", "Liability",

commit annually by the compensation tee and approved by the board of directors (BOD). the committee can easily and the BOD Therefore, reduce salary and bonus fraud/lawsuit revelation. Firms must have of the top executive after

determined

"Litigation",

"Mail

"Pyramid Operations", "White Collar Crime". WSJ is that firms in the WSJ

"Product Fraud", Liability", "Securities Fraud" and The are reason to fraud/lawsuit likely for using the revelation face greater

salary and bonus data before and after fraud/lawsuit revelation. Therefore, the earliest year in the sample period can only be 1992 because the electronic filing started in 1994. A proxy state ment 1993, filed in 1994 contains compensation data for data 1992 and 1991. All corporate governance

with

reported

408Obeua were collected from the proxy revelation. statement for the year

S. Persons Stone and Rasp (1991) and Maddala state that the logit regression is appropriate for (1991) this type of study. Because is on the the emphasis
impact of corporate governance on executive turn

lawsuit firms.

of fraud/lawsuit

Methodology This had study conducts four analyses. The first analysis firms which identifies the number of fraud/lawsuit turnover other than death of of chairman

over,

this study includes variables which and the effectiveness of the BOD independence and the firm's potentially included.

measure

the and

the compensation committee, standards. Two other variables executive whether change The decision turnover are also the firm was

ethical to are a

relevant

top-executive executive. The top executives include chief executive the board of directors, of a company. The

involved

They in fraud, and is crucial The

president any of the persons holding one or more of the top revelation held three positions before fraud/lawsuit none of these positions at anytime during two years after the revelation of fraud or lawsuits.2 The second
analysis compares top executive's cash compensation

turnover

officer, and if occurred

in firm's profitability. of the BOD independence to terminate is measured top

for its BOD

executives.

by independence on the BOD, tenure of CEO directors, is also the chairman of BOD. ther CEO director has because less or director independence he/she has a financial a personal (1988) finds than

the number

of inside and whe An an inside outside

before

and

after

fraud/lawsuit

revelation.

For

if a calendar-year firm had fraud/lawsuit example, inMay revelation 1998, the change in salary is 1999 salary less 1998 salary, and the change in bonus is 1998 bonus less 1997 bonus. This is because salary is set before
mined around

the company executive. Weisbach CEO A

relation

relation with a top with of

that turnover

firms for poorly performing the BOD has low percentage of director
of

is highest when inside directors. is a current or or a family who are activ

the year
the

starts whereas

bonus

is deter

is an insider
executives.

if he/she of

year-end.

former
member

officer/employee
top

the firm,
Corporate

turnover the executive study also compares of fraud/lawsuit and the changes in cash compensation This firms with fraud/lawsuit those of matched revelation as fraud/lawsuit firms, which did not have in theWSJ during the same

governance

becomes not

less effective

when

individuals

firms. For each fraud/ time period lawsuit firm, this study identifies amatched firm which is in the same industry (based on the four-digit SIC has the closest size based on revenue amount, code), and has the proxy statement for the same time period used to collect third data of the related analysis,
analysis,

independent ities of management is also CEO When executive board,

from management (Beasley, the BOD

monitor

sample firm. explanation-for

firm-specific

could exert to supervise is supposed which top man on behalf of the firm's stockholders agement (Jen could influence sen, 1993). The CEO/Chairman of setting board the process the BOD through the flow who would

1996; Jensen, 1993). this top chairman, on the an undue influence

The

called
examines

executive-turnover

variables which fraud/lawsuit identifies reduction

affect top executive fourth firms. The variables

turnover analysis, influencing

among called
analysis,

controlling agenda, managing meetings, and handpicking directors information not seriously challenge them. Dechow find likely board been likely CEO that firms to have chairman. on manipulating the CEO who

of

explanation-for-change-in-compensation

et al. (1996) are more earnings serves as the also

among compensation discussions of the third and lawsuit firms. Detailed the fourth analyses are as follows.

firm-specific in executive

the fraud/

has the longer a CEO Likewise, entrenched the board, the more they are a to become the influence and the higher over CEO the board and Weisbach (Hill and Phan, (1988) also note

can exercise

1991). Hermalin that an established

Explanation-for-executive-turnover analysis

than a new dence directors CEO

has relatively more power the BOD Therefore, indepen if the number of inside is compromised CEO. is long, and

This

a logit regression to identify analysis employs influence the turnover among fraud/ variables which

is large, the tenure of CEO is also the chairman of BOD.

Effects of Fraud and Lawsuit Revelation committee's independence also plays a major role in its can make suggestion decision because the committee to the BOD the termination of top regarding from compensation top executives executives. and Peck (1991) and Conyon Crystal committee under (1998) found that compensation of insid the CEOs influence (i.e., partly composed to favor management ers) was more likely by CEO of com salary. The inflating independence there by whether relations between The "insider" committee earlier). The
compensation

409 listed firms ethics that to have a code of business

The

which conduct officers

to all directors, applies This the employees. study measures standards by whether ethical is a specific there to oversee executives' committee ethical designated and and whether the BOD and the compen conduct, sation committee consider ethical conduct of exec

require and

committee is measured pensation are any "insider" and "interlocks" committee relation member
"interlocks"

or deciding in setting their compensation their termination. The lack of such ethical-standard measure could lead to no negative impact of fraud utives
and lawsuit on executive turnover and compensa

members

and

the firm.

tion. This ethical

governance.

a compensation exists when is an inside director (defined

relation exists when a

study standards

is the first to examine the role of on the effectiveness of corporate

Different differential turnover

committee officer officer

member

of Entity-B, serving as a member

is an of Entity-A which has Entity-A's

executive executive

have types of revelation can potentially on the possibility of executive impact and

committee. compensation "insider" relations compromise

compensation committee.

or BOD of Entity-B's "interlocks" and These the independence of

in executive the change cash com In particular, is likely fraud revelation pensation. a longer lasting and more negative associated with than impact on stock price and the public confidence lawsuit revelations Lott, 1993). There (Karpoffand fore, firms with fraud revelation are expected to have turnover or greater reduction in higher executive executive than any other sample firms. compensation The financial reporting bank fraud, securities fraud fraud, fraud, contracts. and fraudulent billings of government A firm's profit also plays an important role in insurance
executive turnover and compensation

board

effectiveness of BOD is measured by the size (the number of members) and the number of meetings in a year. Large board is less likely to to function and is easier for the CEO effectively The control et al., 1996; Jensen, (Beasley, also suggests that a 1993). Organizational theory to make takes more time decisions larger group a larger BOD (Steiner, 1972). Therefore, likely has 1996; Dechow
time reaching a consensus on controversial

fraud

revelation

includes

determining

harder

issues

such

as termination reduction.

of The

compensation in a year reflects how is. Conger time

diligent et al. (1998) suggests resource is an important

a top executive or number of meetings and vigilant the BOD that board meeting in improving the

1994; Kim and Ryu, (Gibson, 2003; Kaplan, 1998). statements of all sample firms indicate that they Proxy use profitability to assess top executives' performance The most and determine the executives' cash compensation. common measure of profitability among firms is earnings per share (EPS) which is sample typically
Therefore,

of BOD. effectiveness the effectiveness Similarly, of a compensation committee ismeasured by its size
and the number of its meetings in a year. In sum,

compared with
to measure

the previous
the change

year's number.
in firm's profit

ability,

BOD

if the size of could be compromised and compensation committee is large and the is small. number of meetings The ethical standards have increasingly become an feature of recent Sarbanes-Oxley regulatory requirements. Act of 2002 (also known

the effectiveness

this study uses the percentage change in EPS, as (EPS, ? t is where computed EPSf_i)/EPS?_i, the year of fraud/lawsuit revelation. potential explanatory below. logit regression model These variables are in the

important The U.S.

as the Corporate traded companies

Bill) requires publicly Oversight to disclose whether they have

adopted a code of ethics for senior financial officers. In addition, the New York Stock Exchange and have new rules NASDAQ corporate governance

FIRECEO = a 4- ^INTLOC + ^INSIDE + &3CEOCHAIR+ fc4COMSIZE + ?5COMMEET + 66BODSIZE + t7BODMET + ?>8ETHIC + ?9CEOTEN + i>10FRAUD + fcnEPSCHG

410Obeua FIRECEO = 1 if a firm has executive within INTLOC INSIDE = = revelation turnover

S. Persons changes among sample fraud/lawsuit compensation firms. It is based upon a smaller sample because the turnover had executive study excluded firms which of and no longer pay nor report cash compensation the executive turnover after
variables

two years of fraud/lawsuit and 0 otherwise. or "in 1 if there are "interlocks" and 0 otherwise. of inside direc all directors value is and chair

sider" relations

the
are

turnover.
the same as

The
those

potential
in exec

1 if the percentage tors relative to higher 0 otherwise. than

explanatory

utive

its median is also

sion model

analysis. The following is used in this analysis.

logit regres

CEOCHAIR COMSIZE

= =

1 if CEO
man and 0

the BOD

otherwise.

1 if the number committee than its median

wise.

members

of compensation is higher and 0 other

value

COMPCHG = a + MNTLOC + MNSIDE + &3CEOCHAIR + fc4COMSIZE + 65COMMEET+ fc6BODSIZE + fe7BODMET + fc8ETHIC+ ?9CEOTEN + ?10FRAUD + ?nEPSCHG
COMPCHG = after fraud/lawsuit All the other variables 1 if cash compensation decreases revelation and 0 otherwise. are defined earlier. Similar to

COMMEET

1 if the number committee its median value

of compensation is higher than meetings and 0 otherwise. of BOD mem va

BODSIZE

1 if the number bers

is higher than its median lue and 0 otherwise. of BOD

BODMET

1 if the number is higher than and 0 otherwise.

meetings its median value the ethical-stan

COMMEET, analysis, are expected to and FRAUD ETHIC BODMET, and the other estimated have positive coefficients are expected to have negative estimated variables coefficients.

executive

turnover

ETHIC CEOTEN

= =

1 if the firm dard measure 1 if CEO higher

otherwise.

has

and 0 otherwise. tenure on the BOD value is and 0

Results An indicates that 105 out of 277 firm

than its median revelation

investigation

FRAUD EPSCHG

= =

1 if fraud
wise.

and 0 other in EPS is

years (37.9%) changed top executives during two years after fraud/lawsuit revelation. This turn non over is significantly higher than that of matched their firms during the same time period (67 out of 277 or 24.2%, %2 = 12.1754 with significance level <0.005). Out of these 105 firms, 86 firms (82%) one year after fraud/ changed top executives within fraud/lawsuit lawsuit revelation in the There chief two and are 19 firms executives revelation. changed officer, Seventy
their top

1 if percentage change positive and 0 otherwise.

This

study uses 1/0 variables because of two reasons. First, the use of binary variables helps retain the same the effect of obser neutralizing sample size while extreme value. Second, for this sample, to a better-fit model with than continuous variables. The esti

second

vations with

top (18%) changed year after fraud/lawsuit 134 firms (48.2%) which such as chief financial or vice 134 firms
other

binary variables contribute better explanatory power

some other executives operating (53.73%) investigation,

as well

officer of these
as some

president. changed
executives.

COMMEET, BODMET, ETHIC and FRAUD are

to have positive estimated coefficients. expected to have negative other variables are expected mated coefficients.
analysis

executives

Another Table

which

Explanation-for-change-in-compensation

This

to analysis attempts explain the cross-sectional

identify variables which in executive difference

I, employs non-parametric of cash compensation (CHG changes significance because these change data are not normally COMP) in I reports Table that the change distributed. of has the mean executive cash compensation and the of $35,400, and the median $53,867

in is summarized to test the statistics

Effects of Fraud and Lawsuit Revelation TABLE

Changes in executive cash compensation

411

I
after fraud/lawsuit revelation

Minimum

Mean

Median 35,400 68,000

-31,000

Maximum 3,237,500 1,118,800 2,456,500 384.47% 220.0 384.47 1,289,600 542,000 1,210,500 80.08% 65.29 66.12 4,000,000 994,400 3,567,600 11,385% 4865 11,382

Signed rank stat. 1923 5093 -1320 1908.5 4953

-1707.5

Significance 0.0018***
0.0001***

level

CHGCOMP $
MATCH DIFFERENCE

-4,175,000 -2,280,300 -3,806,300 -67.24% -69.51 -271.81

53,867 119,682
-65,354

CHGCOMP %
MATCH DIFFERENCE

10.75% 15.80
-4.96

4.46%
8.74 -4.13

0.0350** 0.0019***
0.0001***

CHGSAL $
MATCH

-950,000 -235,600
-1,012,500 -41.18% -55.93 -52.99 -4,375,000 -2,280,300 -4,006,300

DIFFERENCE CHGSAL%
MATCH DIFFERENCE

43,911 40,051 3661 6.14%

7.13 -1.02

27,700 30,000
-200

4687

4.33%
5.76 -0.82 0

6193 5 4688 6150

-1429 719.5 4053.5 -1785 703.5 3615
-2003.5

CHGBONUS $
MATCH DIFFEPJENCE CHGBONUS % MATCH DIFFERENCE CHGCOMP
is the

9736 81,379
-71,495

0.0094*** 0.0001*** 0.0001* 0.4974 0.0001* 0.0001*** 0.0339** 0.1506

0.0001***

24,900
-15,700 0% 6.78 -6.91

-100%
-100

-4890

62.19% 47.54 14.76

0.0151** 0.1559
0.0001***

0.0067*** revelation. CHGSAL

represents SIC code, a corre revenue

is the change in cash compensation

salary. CHGBONUS of non-fraud/lawsuit is the firms

(salary and bonus) before versus after fraud/lawsuit

in bonus. with Negative sample firms means on reduction. the basis of MATCH four-digit

in change statistic sponding

change matched

amount and time period. DIFFERENCE

non-fraud/lawsuit test since executive firm. All percentage compensation at p <

is cash compensation
changes are relative to decline after

($ and %) of a fraud/lawsuit
before. The significance fraud/lawsuit revelation.

firm less that of itsmatched

level is based sizes on one-tailed for CHGCOMP,

to the year

is expected

Sample

CHGSAL

and CHGBONUS
significant

are 186, 202 and 212 firm years, respectively.

0.05 and p < 0.01, respectively.

**,***StatisticaUy

in the compensation has the percentage change mean of 10.75% and the median of 4.46%. Both of the dollar and percentage increases in cash com are highly significant at 0.002 level based rank statistics. However,
smaller than the

those fore,
in

of matched
cash

non-fraud/lawsuit contributes
after

firms.
the

There

it is the salary which

compensation

to the increase
revelation

executive

pensation on the signed

creases are

of fraud and lawsuits. The BOD and

these
compensa

in

significantly

the compensation lawsuit firms are more likely

bonus than the salary.

results also imply that the committee of fraud/ to curb the top exec

of matched firms non-fraud/lawsuit < 0.05 p (DIFFERENCE, level). The table also presents a separate analysis for salary and bonus of fraud/lawsuit the dollar firms. Both and percentage highly increases at 0.0001 are in salary (CHGSAL) level. However, only the in salary is signifi increase non-fraud/law

tion

increases

utive's

Results

of the first

fraud/lawsuit average, their top executives turnover or compensation

suit firms.

two analyses suggest that, on seems to reprimand firms executive by having higher

significant not dollar, percentage, cantly smaller than that of matched suit firms. The dollar

in cash smaller increase providing than that of matched non-fraud/law

corporate governance seems to

Therefore,

work

in and percentage changes are not statistically significant bonus (CHGBONUS) with zero median value. Both the percentage and the dollar changes in bonus are significantly smaller than

for many of these fraud/lawsuit firms. How of these firms did not change ever, a large proportion their executive (172 out of 277 firm years or 62.1%) nor reduce their executive (120 out compensation of 186 firm years or 64.5%). Further analyses

412Obeua variables (Tables VI and VII) provide explanatory some fraud/lawsuit execu for why firms changed
tives or reduced their executive compensation, and

S. Persons served from as the BOD 0 to 12 with chairman. the median COMSIZE

ranges of 4. COMMEET

why Table

the other

did not.

the median of 4. Both ranges from 0 to 18 with COMSIZE and COMMEET have the minimum value of 0 because there are five The firms with size of no committee. BOD

II reports descriptive statistics of explana in their original values before being tory variables converted into binary variables based upon their a original value of INTLOC makes the relations of insider (INT between = 2) and interlocks (INTLOC 1) because insider relation may have greater adverse impact on The

compensation

medians.

distinction LOC =

the median ranges from 4 to 29 with (BODSIZE) of 11. The number of BOD meetings (BODMET) the median of 8. For ranges from 1 to 50 with ETHIC, committee conduct
mining

there

are

12 firm

the independence of compensation committee than INTLOC is also equal 1 if a interlocks relation. member in a committee is involved compensation relationship 93 firm insider relation, years (8.3%) with interlocks relation and 161 firm years (33.6%) with no insider or interlocks rela years (58.1%) with firm tions. For comprised with BOD the BOD INSIDE, of all insiders whereas there is one firm with there BOD is no firm business with the firm. There are 23

designated and also using

executive

a years (4.3%) with to oversee employees' ethical ethical conduct

or

in deter
termination

years only (ETHIC =1), none of the above ethical standards (84.1%) with measures. tenure on the board The shortest CEO is one year, the longest is 50 years, and is 10 years. For FRAUD, there are 106 For EP firm years (38.3%) with fraud revelation. a the majority of firm years experienced SCHG, (CEOTEN) the median decline revelation several in the year of fraud/lawsuit in profitability value = -2.60%). The fact that (median variables such as EPSCHG, BODMET,

(ETHIC committee

compensation

2),

32

firm

years

(11.6%) with and 233 firm

such

of all outsiders. On average, comprised of sample firms had 25% insiders. For of 216 the overwhelmingly CEOCHAIR, majority out of 277 firm years had the CEO who also (78%)

TABLE Descriptive Variables INTLOC

Min.

II into 0/1 variables

statistics of explanatory variables before being converted

25%
0 16.67% 1 3 3 8 6 0 5 0
-99.55%

Median
0

75%
1

Max.

0
6.25% 0 0 0 4 1 0 1 0 -4285.71%

INSIDE
CEOCHAIR COMSIZE COMMEET BODSIZE BODMET

ETHIC
CEOTEN FRAUD

25% 1 4 4 11 8 0 10 0
-2.60%

36.84% 1 5 6 13 10 0 15 1 25.20%

100% 1 12 18 29 50 2 50 1
10,980%

EPSCHG
There

are 277 firm years. INTLOC = 2 for insider relation, 1 for interlock relation and 0 if no insider and interlock = 1 if CEO is also the BOD relations. INSIDE = Percentage of inside directors relative to all directors. CEOCHAIR
and 0 otherwise. = COMSIZE = The number of

chairman

number of compensation
of BOD conduct meetings. ETHIC in determining

committee meetings.
2 if a firm has executive compensation means

BODSIZE
a committee or

= The number of BOD members.

to oversee employees' 1 if a firm has ethical such conduct committee

compensation

committee

members.

COMMEET

The

BODMET
and only, also and

= The number
considers 0 if none ethical of the

termination,

above. CEOTEN
Percentage change

= CEO
in EPS

tenure on
where minus

the BOD.

FPJVUD = 1 if fraud

revelation

and 0 otherwise.

EPSCHG

a decrease.

Effects of Fraud and Lawsuit Revelation INSIDE values

neutralize

413

and CEOTEN supports the use

the effect of

have

extreme

maximum which
observations

interlocks committee percentage 51.2%). Table tics

of binary
extreme-value

variables

in compensation relations insider versus 45.3%), and (5) lower (35.2% of positive change in EPS (42.9% versus

or

without Table

the sample size. reducing tests on characteris III presents univariate firms with versus This executive table turnover executive years) (172 firm those without

tics of fraud/lawsuit (105 turnover firm

percentage its original xon Rank-Sum binary

reports the years). of firm years with variable value =1 (i.e., value is higher than its median). Wilco test, which indicates five is appropriate for testing are variables which CEOTEN, In particular,

tests on characteris IV presents univariate firms with fraud/lawsuit compensation the reduction (66 firm years) versus those without firm years). Similar to Table III, this reduction (120 of table reports iable value=1 the percentage of firm years with var its original value is higher than its (i.e., test indicates five Rank-Sum Wilcoxon

median).

variables,

statistically BODSIZE, firms which lower chairman

significant: INTLOC

CEOCHAIR, and EPSCHG.

their changed of CEO percentage

had: (1) top executives as the board serving

significant variables (in the order of their EPSCHG, COMSIZE, FRAUD, significance): In other words, firms BODSIZE and BODMET. had: which reduced their executive compensation statistically in EPS of positive percentage change (31.8% versus 59.2%), (2) smaller size of compen sation committee (3) more (24.2% versus 47.5%), versus 29.2%), fraud revelation (50% (4) smaller (1) lower

(2) lower percent (66.7% versus 84.3%), versus 52.3%), (3) CEO of long-tenure age (33.3% smaller board size (35.2% versus 47.1%), (4) less

TABLE
Univariate tests on characteristics of fraud/lawsuit

III
firms ? with versus without executive turnover

Variables

of

Firm

years

with

variable

value

Wilcoxon Z-value

rank-sum

test Prob. > Z

FIRECEO INTLOC INSIDE CEOCHAIR COMSIZE COMMEET BODSIZE BODMET ETHIC CEOTEN FRAUD EPSCHG There
CEO = 0).

= 1

FIRECEO 45.35% 44.19 84.30 36.05 48.84 47.09 42.44

16.86

= 0

35.23% 51.43 66.67 28.57 47.62 35.24 47.62

14.29

-1.6529

1.1688
-3.4092 -1.2783 -0.1956 -1.9314

0.0491** 0.1212
0.0004***

0.8389
-0.5665 -3.0753

0.1006 0.4225 0.0267** 0.2008 0.2855

0.0011***

33.33 41.90 42.86 executive

are

52.33 36.05 51.16 turnover

or

0.9706
-1.3390

0.1659 0.0903* no turnover ifCEO is higher (FIRE

of

are 105 firm years with

INTLOC=l if there

(FIRECEO
"insider''

1) and 172 firm years with

and 0 otherwise. INSIDE=1

"interlocks"

relations

if the percentage

inside directors relative to all directors is higher than itsmedian value and 0 otherwise. CEOCHAIR=l the number of compensation committee members BOD chairman and 0 otherwise. COMSIZE=l
median median value value and and 0 otherwise. 0 otherwise. COMMEET=l BODSIZE=l if the if the number number compensation of BOD members of committee is higher meetings than

is also the than its

than and its 0

is higher its median value

otherwise. BODMET=l
the firm has a committee executive

if the number of BOD meetings

to or oversee termination, ethical employees' and 0 otherwise.

is higher
conduct CEOTEN=l

than itsmedian
and/or considers if CEO

value and 0 otherwise. ETHIC=1

ethical on conduct the BOD in determining than tenure is higher

if
its

compensation

median

value and 0 otherwise.

and 0 otherwise. significant

FRAUD=1
<

iffraud revelation and 0 otherwise. EPSCHG=1

0.10, p < 0.05 and p < 0.01,

if percentage

change in EPS

is positive *** *, **,

Statistically

atj?

respectively.

414

Obeua

S. Persons IV
versus without executive-compensation reduction

TABLE
Univariate tests on characteristics of fraud/lawsuit firms with

Variables

of

Firm

years

with

variable

value

Wilcoxon

rank-sum Prob.

test > Z

COMPCHG INTLOC INSIDE CEOCHAIR COMSIZE COMMEET BODSIZE BODMET ETHIC 46.97% 45.45 83.33 24.24 46.97 34.85 50.00 13.64 50.00 50.00 31.82

= 1

COMPCHG 42.50% 45.00 80.00 47.50 51.67 53.33 40.00 15.83 50.83 29.17 59.17 reduction
or "insider"

= 0

Z-value

0.5842 0.0578 0.5529

-3.0980 -0.6097 -2.4093

0.2795 0.4769 0.2902

0.0010***

0.2711
0.0080***

1.3109
-0.3975 -0.1068

CEOTEN
FRAUD EPSCHG There
CHG=0).

2.8135
-3.5581

0.0950* 0.3455 0.4575 0.0049***

0.0002***

are 186 firm years: 66 with

INTLOC=l if there are

compensation
"interlocks"

(COMPCHG=l)
relations and

and 120 without

0 otherwise. INSIDE=1

the reduction
if the

(COMP
of

percentage

inside directors relative to all directors is higher than itsmedian

BOD median chairman value and and 0 otherwise. COMSIZE=l COMMEET=l the if the number number 0 otherwise.

value and 0 otherwise. CEOCHAIR=l

of of compensation compensation committee committee members meetings

if CEO
is higher is higher

is also the
than than its its

is higher than its median value and 0 if the number of BOD members median value and 0 otherwise. BODSIZE=l is higher than itsmedian value and 0 otherwise. ETHIC=1 if if the number of BOD meetings otherwise. BODMET=l
the firm has a committee or to oversee employees' and ethical conduct CEOTEN=l and/or considers tenure ethical on conduct the BOD executive compensation termination, 0 otherwise. if CEO in determining is higher than its

median
is positive *,***

value and 0 otherwise.

and 0 otherwise. significant

FFJ\UD=1
and

if fraud revelation and 0 otherwise. EPSCHG=1

if percentage

change in EPS

Statistically

at^<0.10

jKO.01,

respectively.

size (34.8% versus 53.3%), (50% versus 40%). meetings board Table V

and (5) more

BOD

for a short pendence

time.

which

is crucial

In other words, the board inde for effective corporate

correlations among the reports Pearson are below variables. All correlations independent are below 0.25. These gen 0.50, and 93% of them erally modest earity is not
regression

is greatly compromised when CEO is governance also the board chairman and when CEO has a long to exert an tenure on the board enabling the CEO undue influence over other board members. logit regression results of the Table VII based upon reports

correlations likely presents

suggest that multicollin to be a problem in the logit logit regression results results
analysis

analyses.

explanation-for-change-in-compensation

analysis

Table VI 277

of

the two

explanation-for-executive-turnover

based

upon

firm

years.

These

indicate affect

statistically significant firms: (1) whe tive turnover among fraud/lawsuit is also the board chairman and (2) ther the CEO CEO measure CEO. tenure the on the board. of These two variables from the independence In particular, fraud/lawsuit firms are likely to is not the chair change top executive when CEO man of the board and CEO has been on the board the BOD

variables which

execu

among fraud/ compensation of the the change in profitability (1) whether the firm had fraud revelation, firm, (2) (3) and (4) the number size of compensation committee, firms are likely to Fraud/lawsuit of board meetings. lawsuit firms: reduce their executive declines, committee compensation ' meets more often. The profitability cash compensation when firms are involved in fraud, the size is small, and the board of fact that the effectiveness

statistically in executive reduction

186 firm years. These results present four influence the significant variables which

cu

s:

h-* en

0.04 0.01 0.01 0.10 0.05 0.11

0.06 -0.07-0.00 -0.04

0.08 0.05 0.02

-0.100.00 -0.11-0.13

0.03 -0.12

0.16 0.06 0.21 0.01

-0.180.06 -0.05-0.16

-0.05 0.02 -0.09

0.20 0.09

0.05 0.05

0.04 0.02 0.13 0.27 -0.01

0.16

INSIDE CEOCHAIR COMSIZE COMMEET BODSIZE BODMET ETHIC CEOTEN FRAUD EPSCHG 0.03 -0.20 Correlations independent of variables 0.46 0.31

C=l there are "interlocks" or "insider" relations 0.15 if and 0 otherwise.

V TABLE

ifmedian higher COMMEET=l its than 0value median members and higher otherwise. value than is of number its meetings committee compensation if CEOCHAIR=l percentage of inside directors relative theifandisthe BOD CEO 0otherwise. its is median and COMSIZE=l 0 otherwise. also value chairman the compensation number committee of EPSCHG=1 its BOD FPJ\UD=1 otherwise. and positive revelation otherwise. 0 in is and BODSIZE=l BOD 0membersvalue ifof and higher higher the BODMET=l of otherwise.EPS if is number fraud BOD ifpercentage 0 its the median isand than otherwise.change value than and meetingsmedian number 00 firm has ifif 0ethical than its ETHIC=1 median isand otherwise. value and the the CEOTEN=l tenure CEO 0 standards otherwise. on measure INSIDE=1 higher

-0.17 -0.14 0.09 0.22

0.08 0.07 -0.31

-0.04-0.12

0.15

COMSIZE COMMEET BODSIZE CEOCHAIR BODMET CEOTEN FRAUD INSIDE ETHIC INTLOC

otherwise.

416

Obeua

S. Persons

TABLE VI
Logistic regression results for executive turnover (FIRECEO)

Variables
Intercept

Expected
n/a

sign

Est.

coeff

Wald

Chi-Square 1.8934 2.6083 0.6207 6.9590 0.0154 0.0615 0.7962 0.9361 0.9638 4.9315 0.8717 0.6670

Prob.

>

Chi-Square

0.5606
-0.4498

INTLOC INSIDE CEOCHAIR COMSIZE COMMEET BODSIZE BODMET ETHIC

0.2223
-0.8361

0.1688 0.1063 0.4308

0.0083***

0.0415
-0.0735 -0.2809 + +

0.2679
-0.3718 -0.6232

CEOTEN
FRAUD

0.2610
-0.2177

EPSCHG
Chi-Square

0.9013 0.8042 0.3722 0.3333 0.3262 0.0264** 0.3505 0.4141

26.16 level executive

or "insider" 0.0061***

Probability There

are 277 firm years: 105 with

if there are "interlocks"

turnover
relations

(FIRECEO=l)
and 0

and 172 with

INSIDE=1

no turnover
if the

(FIRECEO=0).
of inside

INTLOC=l

otherwise.

percentage

directors relative to all directors is higher than itsmedian

chairman value and and 0 otherwise. COMSIZE=l COMMEET=l the if the number number 0 otherwise.

value and 0 otherwise. CEOCHAIR=l

of of compensation compensation committee committee members meetings

ifCEO
is higher is higher

is also the BOD

than than its median its median

if the number of BOD members value and 0 otherwise. BODSIZE=l if the number of BOD meetings is higher than itsmedian BODMET=l
the ethical standards measure and 0 otherwise. CEOTEN=l if CEO

is higher than itsmedian value and 0 otherwise. value and 0 otherwise. ETHIC=1 if the firm has
on the BOD is higher than its median value

tenure

and 0 otherwise.
0 otherwise. **,*** Coefficient

FRAUD=1

iffraud revelation and 0 otherwise. EPSCHG=1

< 0.05 and p < 0.01,

if percentage

change in EPS is positive and

statistically

significant

atp

respectively.

both tically
to

compensation significant
the

committee variables
of

and BOD

are statis with most

Conclusions This

and

discussion

is consistent authorizes
executive cash

companies'
suggest

policy which
amount

the committee
compensa

the impact of the revelation study investigates turnover and of fraud and lawsuits on U.S. executive changes
recent

tion

to the board which

has

the final

authority

to

in executive
accounting

cash compensation.
scandals at several U.S.

Given
corpora

the

adjust and/or approve the compensation. turnover In sum, the variables affecting executive are not the same as those affecting the reduction in executive dence that The board indepen cash compensation. factor in executive is the most important turnover firms. The finding among fraud/lawsuit the revelation of fraud does not turnover is consistent with significantly the result the other it was

relevant to all investors tions, this project is definitely and regulators. Prior studies find that companies, or lawsuits, which reveal fraud incidences suffer in stock prices, decline substantial i.e., significant financial losses for stockholders. The question here is: did these companies penalize their top executives for the wealth losses of stockholders by changing or reducing their top executive their top executives compensation? To address

affect executive of Agrawal, the hand, involved the

(1999). On Jaffe and Karpoff whether firm's profitability,

in fraud, and the effectiveness of the BOD are crucial factors for committee and compensation reduction in executive firms. cash compensation of fraud/lawsuit

this question, this study uses 277 firm which had fraud/lawsuit in the Wall revelation years Street Journal between 1992 and 2000. Four analyses are conducted. The first analysis the identifies

Effects of Fraud and Lawsuit Revelation TABLE VII

Logistic regression results for executive cash compensation (COMPCHG)

417

Variables
Intercept

Expected
n/a

sign

Est.

coeff.

Wald

Chi-Square 0.4332 0.4807 1.5941 0.3486 5.2338 0.0447 0.3755 3.2779 0.1182 0.0154 4.3581 6.5167

Prob.

>

Chi-Square

-0.3661

INTLOC INSIDE

0.2477
-0.4590

CEOCHAIR COMSIZE COMMEET BODSIZE BODMET ETHIC CEOTEN

FRAUD EPSCHG
Chi-Square

0.2760
-1.0045 -0.0837 -0.2540 + +

0.6789
-0.1790 -0.0451

0.5104 0.4881 0.2067 0.5549 0.0222** 0.8325 0.5400 0.0702* 0.7310 0.9012 0.0368**
0.0107***

0.7620
-0.8963

30.984
0.0011***

Probability Level There

are 186 firm years: 66 with compensation reduction (COMPCHG=l) and 120 without the reduction (COMP if there are "interlocks" or "insider" relations and 0 otherwise. INSIDE=1 if the percentage of INTLOC=l CHG=0). if CEO is also the inside directors relative to all directors is higher than itsmedian value and 0 otherwise. CEOCHAIR=l is higher than its the number of compensation committee members BOD chairman and 0 otherwise. COMSIZE=l if the number of compensation committee meetings is higher than its median value and 0 otherwise. COMMEET=l if the number of BOD members is higher than its median value and 0 median value and 0 otherwise. BODSIZE=l if if the number of BOD meetings is higher than itsmedian value and 0 otherwise. ETHIC=1 otherwise. BODMET=l 1 if CEO tenure on the BOD is higher than its the firm has the ethical standards measure and 0 otherwise. CEOTEN= if fraud revelation and 0 otherwise. EPSCHG=1 if percentage change in EPS median value and 0 otherwise. FRAUD=1
is positive *,**,*** and 0 otherwise. statistically significant at p < 0.10, p < 0.05 and^ < 0.01, respectively. Coefficient

number

of firms which changed their top executives two years after fraud/lawsuit revelation. The during second analysis examines whether there was any in executive reduction cash compensation (salary and bonus) before versus after the revelation of fraud third analysis examines firm-specific turnover. These affect top executive are whether the firm was involved in fraud, the independence and compensation and effec committee

non-fraud/ significantly higher than that of matched lawsuit firms during the same time period. The sec ond analysis suggests that after the revelation of fraud a significant increase in exec utive cash compensation, mainly due to an increase in this increase is significantly smaller However, salary. non than the compensation increase of matched on average, fraud/ firms. Therefore, fraud/lawsuit lawsuit firms seems to reprimand their top executives turnover or providing by having higher executive smaller matched The affects firms: two increase non-fraud/lawsuit in cash compensation firms. than that of or lawsuits there was

or lawsuits. The variables which variables

the firm's profitability, tiveness of the BOD in monitoring ethical

and the company's top management, standards. The fourth analysis identifies firm

in variables the reduction specific influencing are the executive These variables compensation. same as those in the third analysis. Both the third and analyses utilize logit regression. The first analysis indicates that 105 out of 277 firm years (38%) changed their top executives during two revelation. This turnover is years after fraud/lawsuit the fourth

third analysis identifies two variables which turnover executive fraud/lawsuit among whether CEO is also chairman of (1) variables and (2) CEO measure executive tenure on the board. These the when independence firms were CEO was of the likely to not the

the board

board of directors. change top

Fraud/lawsuit

418Obeua chairman board four of the board which and CEO fourth influence had been on the in

S. Persons the WSJ tively reported

examine

for a short time. The variables

analysis the reduction

identifies

in the firms reported study uses fraud/lawsuit Because tends to cover rela the WSJ only. larger not be the findings firms, might to smaller not fraud/lawsuit firms Future
turnover

executive

firms: among fraud/lawsuit compensation of the firm, (2) whether the firm was (1) profitability com in fraud, (3) size of compensation involved and (4) the number of BOD meetings. Firms to reduce their executive cash com likely when

generalized

in the WSJ.
executive

research may want

and compensation

to

mittee, were

among fruitful examine

these avenue

smaller of

fraud/lawsuit future research on A this

firms. is

Another to further decisions

firms were declined, pensation profitability involved in fraud, the compensation committee size was small, and the board met more often. These U.S. in general, indicate that although, findings fraud/lawsuits firms did not reduce their cash more compensation, likely to reduce than to change important
executive turnover

the role of ethics top executives. from seem

the BOD highly

concerning

question stemming ethics does not why

decisions.

study's to affect

interesting is findings such BOD

executive fraud were

those

involved executive

in

their

cash compensation tives. The most

factor affecting

their top execu governance

among U.S.

Notes
1 Turnover here due is to to death the is excluded because of corporate the

corporate board

fraud/lawsuit whereas

significant

influencing committee tiveness of compensation and the BOD. securities exchanges and regu national Therefore, to further lators may want the independence regarding BOD and compensation suggestion as the BOD
turnover

independence factors governance corporate reduction is the effec compensation

firms

is

the

emphasis governance.

assess

effectiveness

Most
position occurs relevance the most firm

public firms have the same person holding

of chairman of this and firing, CEO. resigning The Whether or the retiring assumption which because to will bears

the
no

turnover

strengthen requirements and the effectiveness of

pursue

analysis. study's a turnover

is that is the

alternative

firms. One

serving ethical standards

executive

committee of their listed is to prohibit the CEO from chairman. The finding, that is not a significant factor for U.S.
nor compensation reduction,

cost-effective. the a business supplier, relationships a debtor and include a customer. con

of Examples a creditor, sulting,

Both
are are

logistic models
statistical significant also significant

(Tables VI
of <0.01 level the

and VII)
level. in the

have
Variables univariate

an

overall which tests

significance at <0.01 in

suggests decision U.S.

that: (1) ethics of BOD with

tives or reducing firms may have ethical standards in writing nor enforce implement they do not effectively
standards. Therefore, regulators should not only

appears to play no part in the respect to firing top execu and (2) their cash compensation, but the
re

logistic

models.

The

exception to this is BODSIZE which has 0.46 correla tion with COMSIZE. Both variables likely capture simi
lar information and, therefore, only one of them

(COMSIZE)
Logistic inferences

is significant in Table VII model.

regression results the original produce values virtually (0, the 1, 2) same of

to adopt a code of ethics but quire public companies also examine whether they actually enforce the code. has two limitations. This study, however, First, the control direct forces exogenous beyond can have a major of BOD impact on the board in making public
study

when

INTLOC and ETHIC values (0, 1).

are used

instead of their binary

the decisions. attention may

not

on

the degree example, the fraud and the structure the board's
or control

For

of of

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Department of Accounting, School of Business Administration, Rider University, 2083 Lawrence Road, Lawrenceville,

NJ, 08648,
U.S.A.

Kim, Y.
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E-mail:

persons@rider.edu

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