Board Composition and Corporate Fraud

The study reported here examined how various characteristics of the board of directors and other governance features affected the occurrence of U.S. corporate fraud in the 1978–2001 period. The findings suggest that board composition and the structure of a board's oversight committees are significantly correlated with the incidence of corporate fraud. In the sample, as the number of independent outside directors increased on a board and in the board's audit and compensation committees, the likelihood of corporate wrongdoing decreased. The scandals at numerous high-profile companies have led to public perception of a crisis in corporate governance, to passage of the Sarbanes–Oxley Act, and to establishment by the NYSE and Nasdaq of strengthened governance requirements, including enhanced oversight by independent company directors. We investigated how various characteristics of the board of directors and board committees affect the occurrence of corporate fraud. To conduct our investigation, we constructed a database for a sample of companies that have been accused of committing fraud over the 1978–2001 period from the Wall Street Journal Index. We also constructed an industry- and size-matched control sample of companies that were not accused of committing fraud. For both of these samples, we collected data on the board of directors and other governance attributes from the proxy statements, and we then examined how various characteristics of the board and governance features affect the occurrence of corporate fraud. We found that board composition and the structure of its oversight committees are significantly related to the incidence of corporate fraud. The new NYSE and Nasdaq rules require companies to have a majority of independent directors on their boards so as to enhance the quality of the board and reduce the possibility of damaging conflicts of interest. Our results support this requirement and its underlying motivation. We found that a higher proportion of independent outside directors is associated with less likelihood of corporate wrongdoing. The Sarbanes–Oxley Act of 2002 instructs public corporations to create an independent audit committee from its board of directors. Since 1978, the NYSE has required listed companies to have audit committees also composed of independent directors. The NYSE and Nasdaq now require companies to have a compensation committee and a nominating committee composed solely of independent directors. Our findings support these requirements and the recent tightening of the definition of “independent” by the NYSE and Nasdaq. We found the lack of audit committees and compensation committees and the lack of independent members of these committees to be significantly related tothe occurrence of fraud. In particular, although independent outside directors predominated on the audit and compensation committees, the presence of outside directors who were not independent because they had business or personal ties to the company significantly increased the likelihood of fraud in the sample. 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. The implication is that compensation committees have been inefficient in evaluating and properly rewarding the performance of top executives. They may also have designed compensation packages with dysfunctional incentives, as claimed by many critics. Whatever the reason for our finding, compensation committees deserve more attention from regulators, rule-making bodies (such as the NYSE and Nasdaq), and shareholders.