Walking Away Rather Than Blowing the Whistle

Higher turnover among boards of directors is linked to corporate fraud, a new study proves

Over the past two decades, a number of high-profile cases of financial reporting fraud among large firms (Enron, XEROX, and AOL, among others) have led governments and regulators to question how effective existing oversight structures—including boards of directors—are at preventing fraud. If directors serve to provide oversight, how does fraud go unchecked? Do directors with certain characteristics react differently to fraudulent activity?

Some observers have suggested that, in many cases, outside directors lack the time to familiarize themselves adequately with the firms on whose boards they serve. Perhaps they don’t have access to enough quality information to alert them of mismanagement, should any be taking place, or enough incentive to really get to know the company’s inner workings.

A new study by Desmond Tsang, an Associate Professor of Accounting at McGill University, and co-authors Yanmin Gao (City University of Hong Kong), Jeong-Bon Kim (University of Waterloo), and Haibin Wu (City University of Hong Kong), presents evidence suggesting that some directors actually know more than perhaps they’ve been given credit for.

Their study is the first to look at director turnover during fraudulent periods—rather than after the activity was discovered and reported to the public—and examines director turnover rates for clues to whether members of boards of directors are aware of the deceit as it unfolds.

They compare director turnover rates at fraudulent firms during periods of known fraud with those at non-fraud firms. “In doing so, we found that the fraudulent firms’ director rates of departure were abnormally high during fraudulent periods,” says Tsang.

This finding suggests that, in some cases, directors are aware of fraud while it’s being committed and are either unable or unwilling to assume the role of whistleblower. “This seems to imply that, instead of fixing the problem, [the directors in question] would just elect to walk away,” says Tsang.

If director departures are more common than average during periods of fraud, the researchers also noted three shared characteristics among the cases considered.

More meetings, more information

First, members of boards that met more regularly during fraudulent periods were more likely to depart, indicating that it’s not the absence of information, but perhaps the nature of information itself, that compels directors to resign during fraudulent activity.

More departures among women

Women were slightly more likely to resign their directorships during fraudulent periods than men, reinforcing existing scholarship that has demonstrated that female directors are slightly more risk-averse than their male counterparts and have a tendency to focus more rigorously on ethical standards. Likewise, directors with a higher ownership stake in a company were more likely to depart during fraudulent periods, perhaps indicating a link between these departures and a higher risk of reputational damage.

Degrees of severity

The final characteristic considered was whether the seriousness of the fraudulent activity corresponded with an abnormally high turnover rate. They found positive correlations there, too, indicating that directors are more likely to resign when fraud is more egregious (fictitious transactions, for example) than in less egregious cases, such as incomplete financial reporting.

“We don’t know how much these specific reasons would compel directors to leave,” remarks Tsang, noting that they did not interview directors about their motivations for leaving. However, he added, there are hard-to-ignore implications as to why a director would be more likely to resign in cases of severe fraud. “If it’s a big fraud, they may lose everything. They might not be a director again down the road.”

Weighing the effectiveness of boards

The risk of reputational damage and the threat of litigation have been cited in existing literature as factors that can inhibit directors from taking on the role of whistleblower. Despite recent regulatory changes made by the American Security and Exchange Commission (for example, the Sarbanes-Oxley Act) that reinforce the importance of outside boards of directors, this new research reinforces the alternative view that outside constraints might be inhibiting boards from functioning the way they’re intended.

It would appear that, in many cases, directors would prefer to resign from their role rather than address fraudulent practices head-on.

It would appear that, in many cases, directors would prefer to resign from their role rather than address fraudulent practices head-on. This raises some important questions about the general effectiveness of boards of directors. If litigation and reputational damage loom so large, are boards of directors really the most effective oversight instruments?

Conversely, perhaps it’s unrealistic in today’s highly competitive, post-industrial economic landscape to expect individual directors to be capable of changing a company’s fraudulent course. Perhaps a new approach to external corporate governance is needed, one that allows observers to make crucial interventions without putting their careers and reputations in the crosshairs.

Reputational damage is a significant motivator behind director departure. Perhaps, by protecting directors from the threat of litigation, they would be freer to intervene in cases of fraud rather than simply to depart.

The evidence that abnormal director departures may suggest possible cases of fraud might help regulators develop alternative oversight instruments. Should boards of directors continue to function according to the status quo, perhaps attention paid to the boards themselves could prove useful in preventing fraud in the future.

“There has been a lot of research which is beyond the scope of our paper, about the inefficiencies of a board. There have been many proposals about improving board governance. Obviously, there needs to be better board monitoring and better board functioning. Our research is adding empirical evidence to an existing call for reform,” says Tsang.