Saturday, November 6, 2010

CEO-Director Connections and Corporate Fraud

By N.K. Chidambaran, Simi Kedia, and Nagpurnanand Prabhala @ HLS Forum.

We study the propensity of firms to commit financial fraud using a sample of SEC enforcement actions from 2000 to 2006. Controlling for year effects, Fama-French 48-industry effects, and several firm characteristics, we find a significant relation between fraud probability and CEO-board connectedness. The nature of this relation depends on the institutional origin of the connection. While nonprofessional connectedness due to shared educational and non-business antecedents increase fraud probability, professional connections formed due to common prior employment decrease fraud. The positive effects of professional connectedness are pronounced only when individuals share prior service as executives. The impact of professional-connections persist after the 2002 Sarbanes-Oxley Act while nonprofessional connections lose significance after SOX. Our results suggest that social ties matter and they can have very different effects depending on the institutional context in which the ties are formed. The results support a “collaborative board” perspective in which directors are not merely monitors but also provide advice and counsel to CEOs.

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