The (Market) Price of Bad Behavior

By  Brandon N. Cline, PhD, 

To many, the mention of business leaders and Wall Street executives conjures images of corporate greed by day and wild parties by night. Indiscretions do make splashy headlines and generate public outrage. But bad behavior by top businessmen and women in free market systems has larger repercussions than embarrassment and personal  stress.

In fact, new research suggests that the free market provides an effective incentive for business leaders to behave well, contributing to a more ethical  society.

In “The Agency Costs of Managerial Indiscretions: Sex, Lies, and Firm Value,” my coauthors, Professors Adam S. Yore and Ralph R. Walking, and I examine executives accused of indiscretions in their personal lives, unrelated to the operations of their businesses.The evidence shows that activities of violence, substance abuse, dishonesty, and sexual misadventure in personal lives translates into damage to their  companies.

Shareholders respond to news of such activities by selling the stock of companies led by these ill-behaved executives. Thus, while the actions are personal in nature, the data indicates that managerial indiscretions inflict substantial losses to the firm. This is particularly true when the CEO is involved. On average, there is an immediate 4.1% ($226 million) loss in shareholder value at the disclosure of a CEO indiscretion. The firm likewise suffers a one-year decline in value of 10% to  11%.

For example, Best Buy’s stock fell nearly $144 million when it announced CEO Brian Dunn’s alleged affair with a 29-year-old working for the company. When it was uncovered that Raytheon’s CEO, William Swanson, plagiarized his popular booklet Swanson’s Unwritten Rules of Management, the company stock fell $219  million.

Personal misconduct impairs the reputation of the executive and erodes shareholder confidence that other forms of dishonesty are absent at the firm. Maryland U.S. Attorney Thomas DiBiagio, once noted during the prosecution of alleged corporate looter, Nathan Chapman, that “If they are lying to their wives, there’s huge potential they are also lying to their colleagues, their board of directors and potentially their  auditors.”

Shareholders view indiscretions as insight into the business decisions of top executives. They often signal fraud and malfeasance within the company, and shareholders take swift action. For example, when news that Yahoo!’s then-CEO, Scott Thompson, lied about earning a computer science degree from Stonehill College, the company’s market value plunged $390 million! Mr. Thompson was fired the next week. When Veritas Software disclosed that its CFO, Ken Lonchar, also falsified his personal credentials, Merrill Lynch analyst Scott Phillips downgraded the company stating, “Our first concern is that the CFO’s falsification of his educational credentials could suggest the financials are suspect.” The impact was an immediate drop of $906 million in the company’s value and Mr. Lonchar was removed from his  duties.

These heavy costs no doubt deter managers from engaging in such unethical behavior. Interestingly, the research suggests that the punishments the free market can impose are often more painful and effective in promoting ethical behavior than the government’s. In many cases, such as the examples of dishonesty by Yahoo! and Veritas executives, the indiscretions are not punishable by law; however the market provides such  discipline.

We will always see instances of indiscretions, but the evidence suggests that the private sector provides discipline on individual behavior and, in turn, limits the amount of unethical and fraudulent activity. The high price the market places on bad behavior serves as strong deterrent for executives and that’s just one more reason to celebrate the free   market!

Brandon N. Cline is the BancorpSouth Professor of Finance in the Department of Finance and Economics at Mississippi State   University.

All opinions expressed on USDR are those of the author and not necessarily those of US Daily Review.