Abstract
We track the fortunes of all 2,206 individuals identified as responsible parties for all 788 Securities and Exchange Commission (SEC) and Department of Justice (DOJ) enforcement actions for financial misrepresentation from January 1, 1978 through September 30, 2006. A total of 93 % lose their jobs by the end of the regulatory enforcement period. Most are explicitly fired. The likelihood of ouster increases with the cost of the misconduct to shareholders and the quality of the firm’s governance. Culpable managers also bear substantial financial losses through restrictions on their future employment, their shareholdings in the firm, and SEC fines. A sizeable minority (28 %) face criminal charges and penalties, including jail sentences that average 4.3 years. These results indicate that the individual perpetrators of financial misconduct face significant disciplinary action.
This chapter includes a reprinted article first published under the title “The Consequences to Manager for Financial Misrepresentation” in Journal of Financial Economics in 2008, which is followed by the author’s comments by way of a post script on further developments on the Financial Misrepresentation based on the original paper presented at the Fourth International Workshop on Accounting and Regulation in 2007. We thank Jennifer Arlen, John Armour, Chris Anderson, Jennifer Bethel, Sam Buell, Laurie Krigman, Geoffrey Miller, an anonymous referee, and participants at the Harvard Law School Conference on “The Enforcement of Corporate Governance Rules” the Duke Law School/ILEP Roundtable Discussion on “Recent Reform Proposals for Securities Litigation, Corporate Governance, and Reporting Practices” and at seminars at Arizona State University, Babson College, the University of Arizona, the University of Kansas, and the University of Nevada at Las Vegas for helpful comments. We thank Texas A&M University’s Private Enterprise Research Center and the University of Washington’s CFO Forum and Foster School of Business for support.
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Notes
- 1.
Fortune magazine, March 18, 2002 cover and accompanying story headline.
- 2.
- 3.
Summaries of such arguments are found in Arlen (2007) and Jackson and Roe (2007). See Atkins (2005) for an SEC Commissioner’s argument for a greater reliance on individual penalties rather than firm-level penalties, and La Porta et al. (2006) for evidence on enforcement regimes around the world. For an overview of the debate over the optimal mix of individual and firm-level penalties, see Arlen and Carney (1992), Polinsky and Shavell (1993), and Arlen and Kraakman (1997). This literature implies that firm- level penalties, i.e., those paid by shareholders, can be efficient if internal mechanisms work to discipline culpable managers, because firm-level monitoring and control can be less costly than direct monitoring by regulators.
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- 5.
Alexander (1999, Table 4) also reports evidence of employee or managerial turnover in a large fraction of firms accused of a federal crime (see also Alexander 2007). In a new working paper, Agrawal and Cooper (2007) examine turnover among top executives in firms that announce earnings-decreasing restatements. The empirical method in this paper is similar to those of the papers discussed in this section. Helland (2006), Fich and Shivdasani (2007) examine turnover among directors and officers of firms targeted by securities class actions for fraudulent activities.
- 6.
To repeat, our criticism is of the data available to prior researchers, not of their research design or execution. We highlight the approach taken by Desai et al. (2006) because it is the most recent of these papers. Desai et al. (page 90) explicitly recognize that their approach will miss some relevant turnovers, i.e., have a positive Type I error.
- 7.
Even tests that focus exclusively on the CEO position have this problem, because some firms have more than one CEO over the observation period. Yet another problem arises when researchers erroneously assume that all AAERs represent actions taken against perpetrators of misconduct. Some AAERs are issued to forewarn firms of practices that may lead to disciplinary actions. For example, the SEC initiated an administrative proceeding relating to a material overstatement by a Japanese subsidiary of Boston Scientific. (See Securities Exchange Act Release 34-43183, also assigned AAER-1295.) Upon discovery, the firm promptly undertook remedial actions, made appropriate public disclosures, and cooperated with the SEC investigation. The SEC undertook no disciplinary action against the firm or any individual, but issued the AAER to put firms on notice to adjust their internal controls to avert similar problems. A post-event method using AAERs erroneously would count the turnover of Peter M. Nicholas (founder, CEO, Chairman, and President), who relinquished the titles of CEO and President to James Tobin approximately 4 months after the GAO date. We can find no evidence that Nicholas’ departure was related to the SEC’s administrative proceeding.
- 8.
- 9.
These include, but are not limited to, such actions as an Initial Decision, Supplemental Initial Decision, Administrative Proceedings Ruling, Opinions, Order Denying Motions for Reconsideration, Order for Summary Affirmance and Filing Opposing Petition for Review, Order Remanding Proceeding, Order Denying Disqualification of Commission, Modifying Order, and Finality Order.
- 10.
See Accounting and Auditing Enforcement Release No. AAER-1, 1982 SEC LEXIS 2565, May 17, 1982.
- 11.
A total of 402 (28 %) of the 1,433 executive respondents joined the firm after the financial misrepresentation was underway. For these executives, the risk of turnover begins from the date the individual joined the firm.
- 12.
- 13.
We adopt a cutoff 90 days after the final regulatory proceeding because quarterly reports reveal an executive’s absence up to 90 days after the actual departure. Using the calendar date of the final regulatory date has no noticeable effect on the results, as only five executives move to the ousted category during this interval.
- 14.
Fortune magazine, March 18, 2002 cover and accompanying story headline.
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Karpoff, J.M., Lee, D.S., Martin, G.S. (2014). The Consequences to Managers for Financial Misrepresentation. In: Di Pietra, R., McLeay, S., Ronen, J. (eds) Accounting and Regulation. Springer, New York, NY. https://doi.org/10.1007/978-1-4614-8097-6_14
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