The Market Price of Managerial Indiscretions

To what extent should investors be concerned about the personal behavior of the top managers of the companies they invest in? In a study published recently in the Journal of Financial Economics, the authors shed light on this question by examining the market responses to revelations of over 300 cases of personal misconduct by senior executives and directors, including episodes of domestic violence, DUIs, extramarital affairs, and public dishonesty. In so doing, they provide suggestive evidence of how “tone at the top” can affect corporate policy by way of its culture and how a manager's reputation spills over to that of the firm. The authors' findings show that the companies employing these executives experienced meaningful financial and product market penalties following the disclosure of their unethical behavior. Following the revelation of an indiscretion, investors suffered immediate losses in shareholder wealth—on the order of 4% in cases involving CEOs—and the company's stock continued to underperform during the ensuing year, with total losses amounting to 12 %–14% of firm value. Such companies also tended to lose joint venture partnerships and major customers following these scandals, thereby forcing them into lower‐margin lines of business. The authors also find that such companies were more likely later to commit fraud and be targeted in shareholder class‐action lawsuits. The offending managers themselves were disciplined by the labor market for their missteps in that they faced a higher likelihood of dismissal, and those who were retained earned around $400,000 less pay following the indiscretion. Nevertheless, it is notable that a majority of these executives were not fired, implying that their supervising boards felt they contributed more value to the firm than the damage they caused through their off‐the‐job behavior. Interestingly, the board members supervising these executives were also held accountable for managerial indiscretions in that they received less shareholder support in director elections following the scandals.