Governance and Performance Changes after Accusations of Corporate Fraud

Using a sample of companies charged with government, financial reporting, or stakeholder fraud or regulatory violation in the United States during the 1978–2001 period, this study found that after the accusation of fraud, companies increased the proportion of outsider directors on their boards of directors and on the monitoring committees of the boards. Furthermore, the results show comparable long-run stock price and operating performance between companies charged with fraud and a matching sample of companies not accused of fraud. Collectively, these results suggest that improvements in internal control systems following accusations of fraud help repair a company’s damaged reputation and reinstate confidence in the company. The commission of corporate fraud is a glaring failure of a company’s internal control system. In previous studies, such failures have been shown to impose significant costs on shareholders. We examine whether the costs of corporate fraud are sufficiently high to motivate changes in internal control systems that may lower the likelihood of future commissions of fraud. We focus on changes in the structure of the board of directors and its committees after the accusation or revelation of fraud because the board stands at the apex of the company’s internal control system. Using press announcements of corporate frauds, we constructed a sample consisting of 133 pairs of “fraud” and “no-fraud” companies matched by industry and size. We found that companies increase the percentage of outside directors on their boards following accusations of corporate fraud and increase the proportion of independent outside directors on the boards’ oversight committees. These changes result in board and committee structures that are comparable to those of no-fraud companies, suggesting that fraud companies attempt to reduce further incidents of fraud. We also examined changes in corporate board structures before and following the 1991 corporate sentencing guidelines instituted by the U.S. Sentencing Commission and present evidence that market-imposed reputational costs alone are sufficient to induce positive changes in the boards of directors of fraud companies. Finally, we examined the long-term financial and operating performance of fraud companies. We found that the postfraud performance of fraud companies is comparable to that of the matched no-fraud companies, indicating that changes in internal control systems following accusations of fraud work toward restoration of the company’s reputation in financial and product markets. Our study has important implications for the ongoing debate on the appropriate size of penalties imposed on companies because our evidence suggests that civil and criminal penalties can be set at low levels. The evidence we present also has implications for recent reforms to reduce the occurrence of corporate fraud, including the Sarbanes–Oxley Act of 2002 and reforms initiated by the NYSE and NASDAQ. These reforms impose several governance provisions on publicly traded companies in the United States that increase the independence of corporate boards and their committees. Our study reinforces the reasoning underlying these reforms because our results indicate that the markets induce companies that have committed or been accused of committing fraud to alter their board structures in a manner consistent with these reforms. But this market-imposed transformation of board structure is largely reactive in nature. Sarbanes–Oxley and the NYSE and NASDAQ rules achieve the same by being proactive.