CEO Connectedness and Corporate Fraud

Abstract

We find that connections CEOs develop with top executives and directors through their appointment decisions increase the risk of corporate fraud. Appointment-based CEO connectedness in executive suites and boardrooms increases the likelihood of committing fraud and decreases the likelihood of detection. Additionally, it decreases the expected costs of fraud by helping conceal fraudulent activity, making CEO dismissal less likely upon discovery, and lowering the coordination costs of carrying out illegal activity. Connections based on network ties through past employment, education, or social organization memberships have insignificant effects on fraud. Appointment-based CEO connectedness warrants attention from regulators, investors, and corporate governance specialists.ALLEGATIONS OF CORPORATE and securities fraud have dominated headlines over the last decade. Corporate wrongdoing damages investor confidence, decreases shareholder value, causes misallocation of capital, and increases financial market instability, leading a number of scholars to examine factors affecting the likelihood of fraud and its detection. 1 Largely absent from these inquiries, however, is an analysis of the role played by the CEO's connections with other * Khanna is at 1203 1204The Journal of Finance R leaders within the firm. 2 CEOs have substantial "soft" influence in addition to explicit legal authority to direct corporate behavior, 3 of which wrongdoing is but one potential outcome. This soft influence is likely to be strengthened by the CEO's internal connections.CEO connections with other top executives and directors could increase or decrease the incidence of corporate fraud. As with other corporate activities, corporate wrongdoing often requires coordination between, or acquiescence by, top executives and/or board members. Such coordination and acquiescence can take the form of direct involvement in criminal activities, or a reluctance to "blow the whistle." A CEO's close connections may facilitate wrongdoing by providing the necessary support. However, CEO connections may also help deter fraud. The CEO's familiarity with other top executives may enable him to detect early signs of fraudulent activity. Further, when a CEO is not aware that a certain activity is illegal, a common problem in some areas of white collar crime, closer interpersonal relationships could make it easier for other executives and board members to help the CEO avoid wrongdoing. Thus, CEO connectedness can cut both ways. Which effect prevails is an empirical question.We consider CEO connectedness to top executives and directors through two sources: appointment decisions and prior network ties. Our results indicate that appointment-based connectedness warrants attention. In particular, it is significantly associated with not only greater likelihood of fraud, but also lower expected costs of engaging in fraud: it decreases the likelihood of fraud detection, lengthens the time from fraud commission to detection, reduces the likelihood of forced CEO turnover upon ...

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