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Rules are made to be followed, right? But often in the corporate world, governance isn’t always a fraud deterrent. In fact, it can have quite the opposite effect.
Brian Connelly, Luck Eminent Scholar of Management at the Harbert College of Business, co-authored an award-winning paper that reveals that top managers may be more likely to engage in financial misconduct when facing more stringent external control mechanisms in the form of activist shareholders, the threat of a takeover, or zealous securities analysts.
Connelly, Wei Shi of Indiana University’s Kelley School of Business, and Robert E. Hoskisson of Rice University’s Jesse H. Jones Graduate School of Business, used cognitive evaluation theory to describe how external controls could have the opposite of their intended impacts on top managers. The paper, “External Corporate Governance and Financial Fraud: Cognitive Evaluation Theory Insights on Agency Theory Prescriptions,” earned the 2017 Fraud Impact Award presented by the Houston Chapter of the Association of Certified Fraud Examiners.
The paper is due to be published in the Strategic Management Journal.
“Cognitive evaluation theory revolves around the principle of our intrinsic motivation to behave in certain ways,” Connelly said. “When people trust us, we are intrinsically motivated to behave appropriately toward them. The problem comes when people trust us, but then monitor us closely. This sends conflicting messages about trust, and robs us of our intrinsic motivation to behave appropriately. As a result, too much monitoring backfires because we resent the monitoring and we feel like we are not being trusted.
“This is what makes the job of a director, or parent, so challenging – finding the right balance between monitoring and autonomy.”
For the paper, researchers collected top manager compensation and governance data of all S&P 1500 firms from 1999-2012 using a variety of accounting, auditing, and securities agencies.
Connelly said he once asked Andy Fastow, former Chief Financial Officer at Enron, whether he found it surprising that increased monitoring can lead to increased fraud. “He said that as monitoring increases they find more cases of fraud, but that doesn’t mean that more fraud is occurring – they are just finding what they are looking for,” Connelly said.
“Pick up the Wall Street Journal any day of the week and you will read about tremendously powerful shareholders. People like Carl Icahn, Warren Buffet, and Ralph Whitworth. These institutional investors have CEOs shaking in their boots. Over the past two decades or so, institutional investors have become the most powerful people on the planet. We wanted to examine some of the fallout of having these people looking over the shoulders of CEOs.”