By Steve Treagus
EverFi Legal Editor
In the era of 24/7 news coverage, viral social media posts, exposure to global compliance risks, and an increasingly skeptical public make it hard to hide serious leadership misconduct.
As Part I of this series discussed, CEOs face termination more frequently than ever for ethical lapses ranging from shady business dealings to personal indiscretions.
Global companies are increasingly penalizing leaders for reported misconduct:
- Interest rate manipulation and money laundering
- Abusive sales practices
- Sexual harassment
- Improper relations with employees
- Résumé fraud
Sometimes it’s hard to draw the line between personal and business-related misconduct. For example, an inflated (but not fraudulent) résumé, or a relationship between a supervisor and their employee.
But when the line is clear, does a leader’s personal misconduct have a detrimental effect on business?
Researchers at three U.S. universities asked this same question, and, after reviewing a sample of 219 unique instances of personal indiscretions, concluded that it does.
How Does a CEO’s Personal Integrity Impact Business Integrity?
The resulting study, published in the Journal of Financial Economics (JEF) (and summarized in the Harvard Law School Forum on Corporate Governance and Financial Regulation) crunches the numbers to determine whether leadership misconduct is also bad for business.
Specifically, the authors wanted to know whether a CEO’s personal indiscretions (as opposed to wrongdoing directly connected with the company) negatively impacted businesses in a measurable way.
The underlying assumption was that personal indiscretions signaled a lack of personal integrity. Building from there, the study sought to discover whether there’s a link between a CEO’s personal integrity and a firm’s value.
How Researchers Defined Personal Indiscretions
The study defined personal indiscretions to include “allegations of dishonesty, substance abuse, sexual misadventure, or violence.” Because personal indiscretions don’t generally expose firms to the same level of legal liability that firm-related misconduct does, some scholars have claimed that personal indiscretions have no significant economic impact on corporations.
But the scholars who conducted the JEF study thought that personal indiscretions could cause significant enough reputational harm to the firm that market forces would “discipline personal misconduct.”
Ethical Indiscretions Cost Millions of Dollars
It turns out that when an incident of CEO personal indiscretion comes to light, shareholder value declines $266 million (4.1 percent). These indiscretions also resulted in:
- The acquisition of fewer customers and joint partnerships
- A decline in profit margins and return on assets
- An increase in CEO malfeasance related to the business, such as manipulating earnings.
Following an indiscretion, CEOs are 41 percent more likely to be fired; those who still hold the reins face an average cut of $400,000 in salary and bonuses as punishment.
But it’s not just the CEO who suffers. When a manager other than the CEO commits an ethical indiscretion, shareholder value declines 1.6 percent ($110 million). The study also found that corporate directors at firms with unethical managers lose shareholder votes at a comparable magnitude to votes lost at firms targeted by litigation. The damage increases when the wrongdoer is a board member.
Unethical Leadership Negatively Affects Company Culture
Not only does unethical leadership cost millions of dollars, but it also signifies a dysfunctional corporate culture. This increases the risk of litigation and enforcement actions as well as loss of reputation and trust in the business community.
The study’s authors observe that a leader’s “indiscretion could signal a shift in the firm’s culture to one that now implicitly condones opportunistic behavior.” Business partners, they continue, “might infer from a managerial indiscretion that the firm does not penalize opportunistic behavior as strictly as previously anticipated and re-evaluate their business relationship with the company.”
Firms are Holding Leaders Accountable for Ethics
CEOs are often evaluated on hard data, such as the economic performance of the business and shareholder value. But some firms have also begun to pay CEOs based on “soft factors” related to ethics, according to the Harvard Business Review.
Some skepticism may come from a belief that ethical conduct cannot be measured by hard data. But as my colleague Karen Peterson observes, the effectiveness of ethics and compliance programs can be measured by triangulating multiple data sources, including:
- Culture surveys
- Internal audits
- Ethics hotline use and response data
- Investigations completed
- Outcomes of ethics complaints
Many firms are learning that profit is inextricably linked with ethical conduct, and that there’s no need to sacrifice the bottom line for an ethical CEO and business. In fact, studies show that good ethics are good for business.
On the flip side, the most recent studies show that CEO misconduct is in no one’s interest (for example, see Part I of this series). Companies that fail to see the link between ethically bad and economically bad business decisions need only look to the data.
Note: This is Part II of a three-part series on the consequences of leadership misconduct. Part I discussed the implications of research showing that the world’s largest publicly held companies have been terminating CEOs more frequently for ethical lapses. Part III will wrap up by looking at situations in which leaders and workers are more likely to cheat, through the lens of recent enforcement actions and empirical data.
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