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Study: Rotten Corporations Stink From the Head Down

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A typical "suspect" CEO the authors use to illustrate their findings is none other than former HealthSouth CEO Richard Scrushy and his amazing luck concerning options.

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A new working paper by finance professors Lee Biggerstaff, David C. Cicero, and Andy Puckett appears to prove once and for all, that the rotten corporate fish does indeed stink from the head down.

From the abstract:

We show that firms with CEOs who personally benefitted from options backdating were more likely to engage in other forms of corporate misbehavior, suggestive of an unethical corporate culture. These firms were more likely to overstate firm profitability and to engage in less profitable acquisition strategies.

The increased level of corporate misbehaviors is concentrated in firms with suspect CEOs who were outside hires, consistent with adverse selection in the market for chief executives. Difference-in-differences tests confirm that the propensity to engage in these activities is significantly increased following the arrival of an outside-hire 'suspect' CEO, suggesting that causation flows from the top executives to the firm.

The "dearth of empirical work in this area," the authors write, "may stem from the fact that the ethical values of executives and corporations are difficult to empirically quantify. In this paper, we propose a novel way to identify an unethical pattern of behavior, based on systematic participation in options backdating."

One particularly interesting insight that emerged from Biggerstaff, et al.'s research: "[W]hile these suspect CEOs appear to have avoided market discipline when the market was optimistic, they were more likely to lose their jobs and their firms were more likely to experience dramatic declines in value during the ensuing market correction."

A typical "suspect" CEO the authors use to illustrate their findings is none other than former HealthSouth (NYSE:HLS) CEO Richard Scrushy and his amazing luck concerning options.

The data strongly suggests Scrushy was involved in backdating: of the ten option grants to Scrushy before the Sarbanes-Oxley Act was implemented, improbably six of them occurred on the most favorable day of the month. HealthSouth's story is now familiar – the company grew rapidly throughout the 1990s fueled, in part, by a spree of acquisitions. During this time, Healthsouth displayed a remarkable ability to meet analysts' earnings expectations as highlighted in the company's 2001 annual report to shareholders, where Scrushy stated "we…celebrated another year of fulfilling Wall Street expectations, maintaining our record as the second-longest streak for meeting or exceeding analysts' expectations."

However, in 2002 it became apparent that the success of HealthSouth was largely fictional and built upon one of the largest financial statement frauds in history. The details that emerged in the aftermath of HealthSouth's fraud suggest Scrushy broke the rules to increase his direct compensation at the expense of shareholders, broke reporting rules on behalf of the company to mislead investors, and used corporate resources to further his own interests. HealthSouth's earnings were falsely inflated by a total of $1.4B over the period 1997 to 2002. On a single day in March 2003 when the SEC charges against HealthSouth were revealed, the stock went from $20 to $0.45 per share, and, needless to say, Scrushy was relieved of his duties as CEO.

The moral? Morality matters.
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No positions in stocks mentioned.
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