Minding the corporate store

Corporate fraud and malfeasance have made headlines the past few years. Now, a researcher in the Alfred Lerner College of Business and Economics is drawing widespread attention of his own, with a study that directly links the composition of boards of directors to the incidence of corporate wrongdoing.

Raj Varma, professor of finance in the Lerner College, with co-authors Samuel H. Szewczyk of Drexel University and Hatice Uzun of Long Island University, examined 133 companies that had been accused of fraud between 1978 and 2001. They compared them with a similar sample that had not been accused of wrongdoing. Their results support recent corporate reform measures that require boards of directors to have a majority of independent members.

“When the three of us decided to collaborate on this project, we looked at companies that have been accused of fraud, and the first question that came to mind was, ‘Who is minding the store?’ in terms of oversight by boards of directors,” Varma says.

“We decided to do a comparison study to find out what characteristics of the boards of directors affect the occurrence of corporate fraud. In essence, we put the boards of directors under a microscope in terms of their oversight role and the boards’ oversight committees, such as audit, compensation and nominating committees.”

The researchers looked at various types of wrongdoing, including defrauding such nongovernmental stakeholders as employees, customers, suppliers or franchisees; defrauding the government; financial reporting fraud; and regulatory violations. In analyzing the makeup of the companies’ boards, they categorized members as “inside directors,” who are current employees of the company; “affiliated,” sometimes termed “gray,” directors not currently employed by the company but with other business or personal ties to it; and “independent” directors, with no former or current links to the company.

They concluded that “board composition and the structure of its oversight committees are significantly related to the incidence of corporate fraud” and that “a higher proportion of independent, outside directors is associated with less likelihood of corporate wrongdoing.”

“The key is to have directors who are independent of the CEO,” Varma says. “We need to have more of these independent directors, to stop CEOs from committing the kinds of shenanigans so many of them have been accused of recently.”

Published in the Financial Analysts Journal, the study’s findings have been covered by a variety of print media, including The Wall Street Journal, Business Week, Forbes, Christian Science Monitor, Accounting Today, CFA Digest and CFO: The Magazine for Senior Financial Executives, as well as by Reuters, Business Wire, Dow Jones Newswires, CFO.com and Associated Press Online.

The researchers wrote that the “presence of [an] audit committee and compensation committee and the independence of these committees are significantly related to the occurrence of fraud.” However, they noted that “a troubling finding of our study is that, in general, the presence of a compensation committee increased the likelihood of corporate fraud in the sample.” To address that finding, they recommend that shareholders and regulators, such as the New York Stock Exchange and Nasdaq, pay more attention to compensation committees.

Varma says he and his colleagues are continuing and expanding their research into corporate governance and now are seeking to answer the question of why companies commit fraud in the first place. Although they have only recently begun analyzing this issue, Varma says a primary reason for fraud may be that companies often don’t suffer any long-term consequences from wrongdoing.

“People want to believe that if you commit fraud, you’ll get caught and pay a big penalty,” he says. “Our preliminary evidence, however, indicates that what really happens is that firms might suffer in the short term but not in the long term. The company pays a fine and stock prices fall at first, but then shareholders forget—or forgive—and the prices bounce back for at least some types of fraud.”

But, Varma says he believes the situation is changing as Congress and regulators implement reform measures. The Sarbanes-Oxley Act, passed in 2002 in the wake of the Enron and WorldCom scandals, calls for sweeping reforms that seek to make corporate accounting more open and boards of directors more independent. Despite complaints from some in the business community that the requirements of the legislation are costly and difficult to implement, Varma says his research backs up the benefits of such reforms.

“Research like ours should remind businesses that these reforms are worth pursuing,” he says.

Other independent studies have found widespread changes in corporate governance since 2002. Eighty percent of companies now provide training for their directors, compared with 14 percent that did so in 2002, and 95 percent of companies have a qualified financial expert on their audit committees, up from 65 percent in 2002.

Varma, who has been a member of the UD faculty since 1987, says this is the right time and the right place for the type of research he conducts.

“The area of corporate governance is of special interest to me, and it’s of growing interest nationally right now,” he says. “And, it’s very exciting to be in Delaware, with so many companies incorporated here and the state’s Chancery Court making major decisions that affect corporate governance throughout the United States. When you factor in the research and other opportunities offered by the College’s Weinberg Center for Corporate Governance, this is an excellent location to carry out this kind of work.”

—Sue Moncure