By Ralph A. Walkling

In 2012, the Wall Street Journal (WSJ) reported that Scott Thompson, Yahoo’s CEO, allegedly lied about obtaining a computer science degree. In 2007, the WSJ reported that Chris Albrecht, the head of Time Warner’s HBO unit, allegedly assaulted his girlfriend outside a Las Vegas casino following the Oscar De La Hoya v. Floyd Mayweather Jr. boxing match. These revelations no doubt were personally embarrassing to Mr. Thompson and Mr. Albrecht, but were they important for Yahoo and Time Warner? Specifically, do these personal indiscretions imply firm-level consequences and are signals of personal integrity important for firm value?

Personal managerial indiscretions are separate from a firm’s business activities. It is therefore possible that there is no link between a manager’s personal indiscretions and the firm’s operations and business relationships. In contrast is the argument that there is spillover from a manager’s personal indiscretions to job performance and firm value, which we term the integrated affairs hypothesis. The theoretical links for spillover effects are reputational losses to the manager and the related impact on counterparty transactions. Erhard and Jensen (2014) and Erhard, Jensen, and Zaffron (2014) argue that management’s reputation for integrity is a factor of production. To the extent that these personal indiscretions signal low integrity, their revelation can impact the firm.

The importance of personal integrity to firm value has received little empirical attention in finance research. One reason for this is the difficulty in measuring the impact of integrity. It is challenging to identify executives with low integrity before corporate misdeeds are committed. In addition, measurements of losses around bad corporate behavior are intertwined with the impact of the acts themselves. An important literature focuses on allegations of fraud, shareholder lawsuits, and earnings management and it generally presumes that executives committing these acts have low integrity. In that literature, the research design defines lack of integrity by the malfeasance, making it difficult to establish a separate market reaction to the personal trait. For example, a firm typically sustains a loss in value when fraud is announced but it is difficult to know how much of the market reaction is due to a realization of low managerial integrity, the lack of firm-wide controls for misdeeds, the fraud itself, or its consequences. Moreover, we do not know the propensity for “low integrity executives” to commit subsequent corporate misdeeds or if personal misdeeds concern their business partners, boards, or shareholders.

We identify low integrity executives as those accused of personal indiscretions, including allegations of dishonesty, substance abuse, sexual misadventure, or violence. Our sample consists of 219 unique indiscretions and 106 related observations. These personal indiscretions are, by construction, distinct from the operations of the firm, thereby permitting us to examine market reactions to the indiscretion separate from the reaction to the corporate malfeasance utilized in other identification strategies.

We explore several research questions regarding the importance of a manager’s personal integrity and its impact on firm value and performance. We find that announcements of managerial indiscretions are associated with a significant decline in firm value and operating performance. At the revelation of an indiscretion, there is an immediate 1.6% loss in shareholder value that translates into an average loss of $110 million in market capitalization. When committed by the CEO, the loss in shareholder value is 4.1% or $226 million. The magnitude of the stock market losses suggests that investors react to more than just the monetary penalties associated with these events. Indeed, losses around the announcement of the indiscretion are consistent with at least two explanations encompassing: 1) the expected litigation, opportunity costs, or severance costs that arise as a direct result of the event and 2) the market value (reputational) adjustments to signals of low integrity. We decompose the investor reactions into the components that reflect the direct monetary costs to shareholders and those that represent reputational damage.

To examine the channels through which the personal affairs of managers could be integrated into firm value, we examine changes in counterparty relationships in the firm’s product markets. The prediction of the integrated affairs hypothesis is a decline in counterparty trust and deterioration of inter-firm relationships, as others are less willing to conduct business with a low integrity executive. Consistent with this, CEO indiscretions are associated with a significant decline in the acquisition of new major customers and joint venture partnerships, and CEO reputational costs are negatively and significantly related to the likelihood of obtaining a new major customer. Our results also indicate that operating performance suffers, as there is an abnormal decline in profit margin and return on assets (ROA). We further find evidence that indiscretion managers exhibit a willingness to expropriate stakeholders. Firms of indiscretion executives are significantly more likely to manipulate earnings or commit unrelated malfeasance that becomes the target of shareholder class action lawsuits or Department of Justice (DOJ) / Securities and Exchange Commission (SEC) fraud charges. Our results suggest that much of the effects we observe are attributable to reputational damage.

Finally, there is a meaningful labor market response to the indiscretion disclosures in our sample. CEOs are disciplined for their personal missteps, particularly for those indiscretions imposing large stock price hits or reputational damage. The probability of CEO turnover rises by 41% following an indiscretion. Boards impose financial discipline on the surviving CEOs, who see an average drop in salary and bonus of around $400k. In keeping with prior work on directors’ career concerns, we find that corporate directors at indiscretion firms lose a small but significant percentage of shareholder votes; the magnitude is comparable to that observed when the firm is targeted by litigation. The effect is heightened for indiscretions committed by a member of the board. Interestingly, the loss in shareholder support is primarily related to the reputational damage associated with the indiscretion.

Our work sheds additional light on the question of how trust facilitates contracting, production, and exchange. While prior work typically focus on activities at the corporate level, our paper contributes by documenting the link between non-business activities, integrity, and firm value. As far as we know, our paper is the first to examine shareholder wealth effects surrounding ex ante signals of low integrity revealed in an executive’s personal life and how these signals impact corporate relationships in the product markets.


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