Based on Research By Shi, W., Connelly B., Hoskisson, R.

Strong External Governance Makes Top Managers More Prone To Cheat.

  • It’s commonly thought that external corporate governance measures, such as a threatened takeover, naturally curb financial fraud.
  • It seems logical that managers would toe the line under intense scrutiny – but external corporate governance can have a surprising psychological effect.
  • In fact, when top level managers find governance mechanisms too coercive, they’re more likely to commit fraud.

Ever since the 2008 financial crisis, investors have been highly touchy about company managers committing fraud. And rightly so: misdeeds ranging from improperly stating revenue to inaccurately valuing assets undermine stakeholders’ ability to judge a firm. The Securities and Exchange Commission takes such transgressions just as seriously, penalizing numerous publicly traded firms for misconduct every year.

Scholars, policy makers and regulators also brood about corporate ethics and governance, in the process creating a vast literature on how to fight financial fraud. External governance, they largely agree, is best. Yet most of this research is based on one framework known as agency theory. What if a different theory explained human behavior just as well, or better?

Agency theory argues that we are driven by self-interest. According to this line of thought, the presence of external governance mechanisms should make managers less likely to enrich themselves via financial fraud. After all, the added scrutiny boosts the chance of getting caught: obviously, not in any manager’s self-interest.

However, Robert Hoskisson, a Rice Business professor, tackled the question of financial fraud a different way. In a recent paper, Hoskisson and two colleagues built on a theory called cognitive evaluation theory, which looks at the psychological effect of external governance mechanisms. How, the researchers asked, might this theory predict financial fraud?

According to cognitive evaluation theory, humans need to feel a certain level of self-determination. Impose too many outside restrictions, the theory goes, and you “crowd out” the wish to act in the very ways the controls were meant to encourage.

To test if this theory applies to top managers, the scholars studied institutional and regulatory data from 1999 to 2012. They focused on three kinds of external governance mechanisms: 1) dedicated institutional investors; 2) the threat of corporate takeover; and 3) ratings agencies.

The results were surprising.

The first group the scholars looked at were dedicated institutional investors. These investors have access to key data because they hold stock over longer than average periods of time, and closely watch the senior management’s actions. Under that kind of spotlight, traditional agency theory suggests, financial fraud by managers should shrink. But the data suggested the opposite. Higher levels of dedicated institutional ownership were linked to higher levels of fraud.

A looming corporate takeover also pressures firms. Lackluster management quickly gets ousted; poorly performing firms get acquired. To study the effects of this external pressure, the researchers analyzed how financial fraud differed if managers were shielded from this pressure by takeover defense provisions (e.g., poison pills, golden parachutes and staggered board appointments). Traditional agency theory predicts that fraud should increase when more of these shields are in place. But according to the data, when takeover defenses increased, financial fraud dwindled.

Finally, ratings agencies also exert pressure. Securities analysts are privy to troves of information, and thus serve as a second pair of eyes on a firm and its performance. Their reviews can send a stock price plummeting or soaring. So according to traditional agency theory, more analyst scrutiny should equal less financial fraud. Au contraire. According to the scholars’ findings, higher analyst pressure correlated to higher levels of fraud.

The findings create a real conundrum. Too little external control leaves managers with no accountability. But too much actually threatens their feelings of agency – emotions that cascade into lower motivation to protect shareholders, and higher chances of committing fraud. The answer seems to lie in proportions. You catch more flies with honey than with vinegar, as the adage goes. In corporate governance, the recipe has been heavy on the vinegar. Regulators might find better results with just a little more honey.

Robert E. Hoskisson is a strategy professor in the Jones Graduate School of Business at Rice University. Wei Shi was a doctoral student in the strategy department in the Jones Graduate School of Business at Rice University, and now is an assistant professor at Indiana University.

To learn more, please see: Wei Shi, Brian Connelly, Robert E. Hoskisson. External corporate governance and financial fraud: Cognitive evaluation theory insights on agency theory prescriptions. Forthcoming, Strategic Management Journal.