Why boards should worry about executives' off-the-job behaviour

In the mid 2000s the United States was reeling from a wave of corporate scandals: Think of WorldCom, Enron, Tyco and AIG. For Aiyesha Dey, then an assistant professor of accounting at the University of Chicago, those episodes fueled a question: Did leaders' lifestyles affect outcomes for their firms, and if so, how? "There were all these articles about how executives at those companies were throwing parties for millions of dollars," Dey recalls. So she and colleagues embarked on a series of studies linking leaders' off-the-job behaviour with their actions at work.

In deciding what behaviours to focus on, the researchers drew on findings in psychology and criminology. They settled on two: a propensity to break the law, which is tied to an overall lack of self-control and a disregard for rules, and materialism, which is associated with an insensitivity to how one's actions affect others and the environment.

Across four studies, Dey — now an associate professor at Harvard Business School — and her co-authors examined correlations between one or both of those behaviours and five on-the-job issues.

Insider trading

In their most recent paper, the researchers looked at whether executives' personal legal records — everything from traffic tickets to driving under the influence and assault — had any relation to their tendency to execute trades on the basis of confidential inside information. Using US federal and state crime databases, criminal background checks and private investigators, they identified firms that had simultaneously employed at least one executive with a record and at least one without a record during the period from 1986 to 2017. This yielded a sample of nearly 1,500 executives, including 503 CEOs. Examining executive trades of company stock, they found that those were more profitable for executives with a record than for others, suggesting that the former had made use of privileged information. The effect was greatest among executives with multiple offenses and those with serious violations (anything worse than a traffic ticket).

Could governance measures curb such activity? Many firms have "blackout" policies to deter improper trading. Because the existence of those policies is hard to determine (few companies publish data on them), the researchers used a common proxy: whether the bulk of trades by a firm's officers occurred within 21 days after an earnings announcement (generally considered an allowable window). They compared the trades of executives with a record at companies with and without blackout policies, with sobering results: Although the policies mitigated abnormally profitable trades among traffic violators, they had no effect on the trades of serious offenders. The latter were likelier than others to trade during blackouts and to miss SEC reporting deadlines. They were also likelier to buy or sell before major announcements, such as of earnings or M&A, and in the three years before their companies went bankrupt — evidence similarly suggesting they had profited from inside information. "While strong governance can discipline minor offenders, it appears to be largely ineffective for executives with more-serious criminal infractions," the researchers write.

All this led Dey and her co-authors to wonder: Why do boards hire — or fail to fire — executives who have broken the law? To that end, they more closely analyzed the CEOs in their sample. It didn't appear that companies where the CEO had a record had fewer independent directors, or that the directors had legal records themselves. Nor did those CEOs generate superior returns. Noting that most committed their first offense after taking office, Dey says, "It could be they're not monitored as much if they came up from within the firm and are doing an OK job — not better than average, but not worse." In informal conversations, some senior executives and directors told her, "I don't care what they did, especially if it was a long time ago."

Fraudulent reporting

In an earlier study, Dey and her co-authors identified 109 firms that had submitted fraudulent financial statements to the Securities and Exchange Commission. Comparing those companies' CEOs with the heads of comparable firms that had clean reporting slates, they found that far more leaders in the fraud group had a legal record: 20.2 per cent, versus just 4.6 per cent of those in the control group.

Firmwide reporting

The same study looked at whether executives other than the CEO submitted fraudulent financial statements or made unintentional reporting errors. It turned out that CEOs' legal histories had no effect on this measure — but their materialism did. Leaders with lavish personal consumption habits (the researchers used property and tax records to identify CEOs who, relative to their peers, owned unusually expensive homes, cars or boats) ran lax operations in which reporting errors of both kinds were prevalent. This often worsened during their tenures, as they made cultural changes associated with higher fraud risk: appointing materialistic chief financial officers, increasing equity-based incentives and relaxing board monitoring.

A propensity to take chances

In a study focused on banks, Dey and her co-authors found that materialistic CEOs took more risks: Their institutions had higher outstanding loans, more noninterest income (which could reflect greater trading activity) and more mortgage-backed securities (known for their riskiness) as a proportion of assets. Using a standard index composed of factors such as whether the firm had a chief risk officer, they found that banks helmed by materialistic CEOs had weaker risk management than others. And cultural indicators, such as whether other executives in the firm reaped abnormally high returns from trades during the Great Recession's bank bailouts, indicated that materialistic CEOs were likelier than others to run loose ships in this regard, too.

Corporate social responsibility

Psychologists have shown that people who prioritise material goods are less concerned about others and less likely to engage in environmentally responsible behaviours. The researchers expected this to be true of materialistic CEOs, and they were right: Those leaders got lower overall CSR scores than other chief executives and had fewer CSR strengths and more weaknesses.

The researchers hope their findings will alert boards to the perils of ignoring red flags raised by executives' lifestyles — and of trusting that governance mechanisms will avert any potential problems. "Prior researchers have assumed that deterrence policies will have the same effect on all executives in a firm," Dey says, but this work shows that individuals have very different appetites for taking chances and breaking rules. "Simply having governance structures in place may not be enough. One size does not fit all, even within the same firm." She and her co-authors recognize that their work has looked only at downsides and that these executives might also bring unusual strengths to the table — a topic they are investigating in their current research.

"Everything is scrutinised"

Justus O'Brien coleads Board and CEO Advisory Partners at Russell Reynolds Associates, a global leadership advisory and search firm. He recently spoke with HBR about how he and his clients assess CEO candidates' off-the-job behaviour. Edited excerpts follow.

Q: How do boards conduct due diligence on candidates' personal lives?

A: We urge companies to have a specialized third-party firm do a full legal background check. You need the candidate's consent, and it's not cheap — it averages $10,000. About 85% of clients do this as a final step before making an offer; the others have an in-house process.

Q: What typically comes up?

A: Past or pending legal matters. Issues with credit. Traffic violations. Restraining orders. Securities and Exchange Commission investigations. Everything is scrutinised. If you find an issue, you can ask the investigators to do a deep dive.

Q: How do boards respond?

A: If something complicated or nuanced arises, we'll often put directors on a call with the investigators. Let's say the background check on a candidate shows a DUI within the past few years. Those come up from time to time. During the ensuing board discussion, directors might discuss the DUI, determine whether there are other incidents that establish a pattern of risky behavior, and explore the candidate's judgment and truthfulness in explaining the situation.

Q: Do boards really care about traffic violations?

A: Sometimes they do. A pattern of speeding violations suggests risky behavior. The investigators also pay attention to the circumstances. If someone gets several speeding tickets at 2 a.m., that raises questions.

Q: This research suggests that many violations occur after the CEO has been hired. Do companies have a way of tracking those?

A: Many require directors and officers to update a form each year in which they must note convictions. And when corporate executives get involved in anything criminal, it tends to become public pretty quickly.

Q: What about #MeToo issues?

A: Those often aren't in the legal record, so we ask specific questions during reference checks — and we don't limit ourselves to the people whose names the candidate provides. At the end of every reference interview I ask, "Is there anything else that would cause concern?" In one case I talked with 10 references, all glowing — but when I asked that question of the 11th reference, what I heard was disturbing enough that I told the client, "I don't see how we can move forward with this candidate." And we didn't.

Q: The researchers also looked at whether CEOs' ownership of fancy homes, cars or boats affects risk-taking. Do you worry about conspicuous consumption?

A: We certainly see that, but it's not necessarily a red flag. We're more concerned about egregious spending on the job — if someone spends a lot to redecorate the executive suite, say, or makes a habit of taking a large corporate aircraft even when traveling alone. Those behaviours can be damaging to a company's culture and might give a board pause. I'll say this, though: More often than not, if executives have an extensive track record of value creation and no ethical issues come up in the background check, how they spend money probably isn't going to matter.

Written by: Harvard Business Review
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