What leads to CEO wrongdoings?

What are the pressures faced by CEOs and what are the opportunities afforded to CEOs to commit wrongdoing

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What are the pressures faced by CEOs and what are the opportunities afforded to CEOs to commit wrongdoing, and transgress the line separating right from wrong in legal, ethical, and socially responsible behaviour? What are the contributing factors to a CEO’s ability to rationalise wrongdoing?

Over the decades, scholars and business leaders have attempted to answer these questions about CEOs and top management who hold positions of authority and power in an organisation.

An excellent recent article on this subject is titled CEO Wrongdoing: A Review of Pressure, Opportunity, and Rationalisation, published in July 2018 in the Journal of Management. The authors are University of Missouri Professors Karen Schnatterly and Professor K. Ashley Gangloff, and Professor Anja Tuschke from Ludwig-Maximilians-Universität, Munich.

In answering these questions, the authors apply them to the longstanding auditing concept of the Fraud Triangle, which has been around since the 1950s, with pressure (‘have to’), opportunity (‘can’) and rationalisation (‘it’s okay’) as the three elements.

According to the Fraud Triangle, developed by Criminology Researchers Edwin Sutherland and Donald Cressey, criminal behaviour is linked to a person’s association with a criminal environment and to social and political interactions with other people with criminal tendencies. Many people become criminals themselves as a consequence of this association.

The authors explain that pressure reflects the necessity to commit wrongdoing (‘have to’). Opportunity suggests the ability to commit wrongdoing with the expectation that it will not be detected or punished (‘can’; Dorminey et al., 2012).

Rationalisation allows individuals to justify their wrongdoing as morally justifiable or necessary for the business—“we will misstate our inventories this quarter and fix it next quarter” or “we won’t get this deal if we don’t inflate some of these numbers”.

Rationalisation is also possible if “everyone is doing it”.

If all three elements of the Fraud Triangle are present in a company or organisation, it is highly likely that CEO wrongdoing will occur.

The authors highlight 25 potential areas of wrongdoing within the Fraud Triangle, for which there is robust research and analysis from both a quantitative and qualitative assessment.

They make reference to a wide range of activities including financial reporting, fraud, investigations by regulatory authorities, class actions and lawsuits, backdating of share options, illegal loan recovery practices, unethical decision-making and unethical behaviour.

Following an extensive literature review, they came up with the type and measure of wrongdoing for each element of the triangle and divided them into internal forces and external forces.

For example, under pressure, two internal forces are ‘compensation structure’ and ‘board expectations’ and two external forces are ‘competition’ and ‘investor expectations’; under opportunity, two internal forces are the ‘CEO’s power’ and ‘organisational complexity’, while external forces include ‘industry complexity’ and ‘macroeconomic factors’; under rationalisation an internal force is ‘control misalignment’ and ‘social ties’, and an external force is ‘industry culture/norm’.

Internal forces that impose pressure

Internal forces that apply pressure to CEOs include compensation structures and firm performance as well as pressure exerted by the board of directors. The authors write: “Compensation structure can drive the CEO to misbehavior because of the pressure it applies (S. A. Johnson, Ryan, & Tian, 2009; Shi et al., 2016). This constitutes a pressure brought about by greed… This literature argues that the CEO is incentivised to commit wrongdoing to inflate the stock price so as to increase his or her compensation. Research focuses on the role that options play in influencing CEOs’ behavior… and finds that options are associated with a greater likelihood of fraudulent financial reporting.”

The authors explain that even ‘good’ organisations/companies/firms facilitate bad behaviour due to performance pressure: “Firm performance, according to Chen (2010), also has the ability to impact CEO confidence and, in turn, increases the ‘need’ to misreport performance as more positive than it really was to ‘feed an ever-increasing ego’.”

External forces that impose pressure

The authors explain that companies facing below-board competition for customers are associated with greater willingness to use corrupt and unethical practices to attract or retain customers and contracts. The extent of this wrongdoing is being unearthed in the state capture hearings and commissions. This is why state capture can become so corrosive as it permeates the whole fabric of business and becomes the normalised way of doing things.

Internal forces that provide opportunity

The authors explain: “The more power the CEO has, the more opportunity to misbehave by overruling the board or ignoring organisational controls. A CEO’s power can come from his or her role in the organisational structure (e.g. duality), a sizable ownership stake, or an information advantage over other stakeholders. Ramdani and van Witteloostuijn (2012) find that CEOs who have a significant ownership stake are more likely to engage in wrongdoing than their counterparts without this ownership stake.”

This is what happened in Steinhoff and it raises the question of how much skin in the game should a CEO have, as research reveals that CEOs with too much skin in the game are more likely to engage in wrongdoing.

External forces that provide opportunity

Organisational complexities can increase the potential for wrongdoing, hence, if we look at Eskom, SAA, the SABC, Steinhoff, Bosasa, KPMG, VBS, McKinsey and many others, we see very complex organisational dynamics at stake. This requires aggressive (in the sense of robust) monitoring by the board and of the board, and relentless vigilance of what is being done, how it is being done, who sits on the board and the kind of reporting that needs to be undertaken.

At the end of the day, everything is fixable if the appropriate conduct, monitoring and vigilance are in place, which is what Public Enterprises Minister Pravin Gordhan is working on implementing throughout the SEOs.

Rationalisation

In some of the studies, the authors found that younger CEOs are more likely to rationalise fraud, as are CEOs with less functional experience and without a business degree (Troy et al., 2011). However, other studies contradict this and found that a business-related education may be related to fraudulent tendencies (e.g., Ferraro, Pfeffer, and Sutton, 2005; Frank, Gilovich, and Regan, 1993; Kelly, Ferrell, and Skinner, 1990). Of interest is that all the reviews found that male CEOs and executives are more likely to engage in wrongdoing than female executives, and whistleblowers, more often than not, are female. The whole question of board diversity is so important from this perspective.

Internal forces that foster rationalisation

The authors explain that well-intentioned companies with formal controls, but which fail to apply equally strong controls to budgets and budget reporting as they do to monitoring budgets as a control mechanism to evaluate spending behaviours, are dropping the ball as this can facilitate fraudulent reporting.

Our SOEs have suffered from this. When the Auditor-General issues a qualified report but nothing is done about it, you send the wrong signal because then CEOs are able to exploit this gap when there is no follow-up.

External forces that foster rationalisation

The authors write: “External forces may also foster bad behavior by nurturing rationalisation. For instance, attorneys or accountants outside of the firm could promote or support misconduct, thus enabling a CEO to rationalise the act (Trompeter et al., 2013).”

We need to make sure the CEO is not put in a position where the attorney or accountant helps them to rationalise their fraudulent behaviour.

Then, there is the whole issue around cultural practice—where, in some cultures, it is regarded as the right thing to do to ‘look after’ your family while, in other cultures, this is seen as nepotism. The cultural practice of a country and its CEOs and businesses in this regard needs to be clearly articulated and regulated.

It has become imperative for boards to ask and investigate all these questions, and more, otherwise, CEOs can easily rationalise their wrongdoings on the basis that none of the board members asked them about this.

Companies and organisations need to be cautious of running ‘rookie’ boards because inexperienced board members are not going to ask the right questions.

While it is important to include people with fresh ideas, at the same time, you need to ensure that knowledge, experience, expertise and strong ethics prevail on any board. This degree of depth ensures that CEOs are questioned and monitored appropriately and that the board expects their own behaviour to be monitored with equal rigour to guard against pluralistic ignorance at every level.

South Africa is at a crucial crossroads in terms of CEO, top management and board behaviour. The direction we take for organisations and companies needs to be rigorously preventative and it is imperative that anyone who sits on a board minimises the possibility of wrongdoing occurring. This is the only way to nurture a culture of ethical behaviour, accountability and right-doing. 

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