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Scarlet Letter: Are the CEOs and Directors of Failed Companies "Tainted"?

Scarlet Letter: Are the CEOs and Directors of Failed Companies "Tainted"?

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Published by: Brian Tayan on Sep 01, 2011
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Topics, Issues, and Controversies in Corporate Governance and Leadership
stanord closer look series 1
Scarlet Letter: Are the CEOs andDirectors of Failed Companies“Tainted”?
Tere is a vast research literature that chroniclesthe impact when a company suers a major gover-nance ailure (which might be due to an ethical oraccounting violation or to insucient risk manage-ment and oversight). First, stock prices all aroundthe initial announcement period, with the magni-tude o the decline commensurate with the sever-ity o the ailure.
Second, stock price underperor-mance tends to persist well past the announcementperiod, suggesting that the damage to the company is o potential long-term consequence.
Tird, thecompanies (and their ocers and directors) otenace lawsuits rom shareholders and regulators, whoseek to be compensated or their losses.
And nal-ly, there is elevated turnover in both the executivesuite and the boardroom, as companies signal to themarket that they are serious about reorm.
Te impact on the long-term careers o the or-mer executives and directors o these companies,however, is less clear. Recent experience suggeststhat many CEOs and directors o ailed companiesare able to retain outside directorships—and evenobtain new ones—ollowing their orced depar-tures. For example, ater resigning rom Citigroupin 2007, ormer chairman and CEO Charles Prince was elected to the board o Xerox. Stanley O’Neill,ormer chairman and CEO o Merrill Lynch, wasnot only named a director o Alcoa but was alsoappointed to that company’s audit committee.Nonexecutive directors at Lehman Brothers, Wa-chovia, Washington Mutual, Bear Stearns, and AIGall gained new directorships ater their companiesailed (see Exhibit 1).
 Clearly, circumstance plays a role in determining  whether leaders o ailed companies are t to serveas directors o other organizations. For example, the
By dv . l  B tyspmb 1, 2011
assessment might be based on the degree to whichthese individuals were associated with wrongdoing.Tey might also depend on the individual’s capacity to learn rom error. In these cases, companies mightbenet rom the knowledge and experience gainedrsthand by individuals who have been involved with a crisis or ailure.On the other hand, there are reasons why theexecutives and directors o ailed companies mightnot be t to hold uture directorships. First, gov-ernance ailures are not the same as managerialailures. Executives are hired with the express pur-pose o taking strategic risk to increase shareholdervalue, some o which might not work out as hoped.Corporate monitors, by contrast, are hired with theexpress purpose o detecting maleasance. While“ailure” is an expected part o a managerial job, it isnot an expected part o a monitoring job.
Second,governance ailure might reveal underlying char-acter faws in the leaders themselves. I executivesand directors were not suciently engaged in theirduties (or, worse, i they exhibited low levels o in-tegrity), these shortcomings might maniest them-selves again in other settings. Tird, companiesthat retain such individuals in the uture might besubject to heightened scrutiny. Rightly or wrongly,these individuals have incurred reputational dam-age simply through their association with a ailedrm. Companies that subsequently employ themare likely to ace pushback rom shareholders andstakeholders.
 Tere is some evidence that the executives o ailed companies are treated more strictly than thedirectors o those same companies. According to a recent survey o executives and directors, only 37percent believe that the ormer CEO o a company 
stanord closer look series 2
Scarlet letter: are the ceOS and directOrS Of failed cOmpanieS “tainted”?
that experienced substantial accounting and ethi-cal problems can be a good board member at an-other company. By contrast, 67 percent o respon-dents believe that directors o such a company canbe a good board member elsewhere. When askedto elaborate, respondents tend to suggest that theCEO is held to a higher standard o accountability,given his or her position o leadership. By contrast,directors are presumed to have less involvement inpotential violations and are also seen as able to learnrom mistakes o this nature. However, these opin-ions are not universal (see Exhibit 2).
Why This MaTTers
1. In recent years, there have been many large- andsmall-scale corporate ailures, driven in part by ethical, accounting, or risk management impro-prieties. However, the executives and directorso these companies have in many cases gainedemployment as directors o other rms. Shouldthis be a concern or shareholders o these rms?2. Executives and directors oten suer reputation-al damage rom their association with a ailedcompany. What is the standard by which their“culpability” should be judged? When are theseindividuals t to hold uture directorships, and when are they “too tainted” by their experience?3. How plausible is the argument that an oceror director involved in an accounting or ethicalproblem “should have learned valuable lessonsrom the experience” that makes them a valuableboard member or other companies?
Zoe-Vonna Palmrose, Vernon J. Richardson, and Susan Scholz, “De-terminants o Market Reactions to Restatement Announcements,”
 Journal of Accounting & Economics 
Mark Grothe and Poonam Goyal, “rend Report Restatements: Re-statement Dust Settles,” Glass Lewis (March 19, 2009).
Approximately 200 class-action lawsuits are led each year againstpublic companies or ederal securities violations. See StanordLaw School and Cornerstone Research, “Securities Class ActionClearinghouse.” Available at:http://securities.stanord.edu/.
Marne L. Arthaud-Day, S. revis Certo, Catherine M. Dalton, andDan R. Dalton, “A Changing o the Guard: Executive and Directorurnover Following Corporate Financial Restatements,”
 Academy of   Management Journal 
Suzanne Craig and Peter Lattman, “Companies May Fail, but Di-rectors Are in Demand,”
Te New York imes 
(Sep. 14, 2010); and Joann Lublin, “Staying on Boards ater Humble Exit,”
Te Wall Street Journal 
(Jun. 6, 2011).
For this reason, the cause o a corporate ailure must be clearly diag-nosed and managerial ailures distinguished rom governanceailures.
For example, in 2002, the AFL-CIO circulated a letter urging allpublic companies to remove rom their board any directors who hadalso served on the board o Enron. See Reed Abelson, “Endgame?Some Enron Board Members Quit or Face Ouster at Other Compa-nies,”
Te New York imes 
(Feb. 9, 2002).
Heidrick & Struggles and the Rock Center or Corporate Gover-nance at Stanord University, “2011 Corporate Board o DirectorsSurvey,” (2011).
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Corporate Governance Matters.
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stanord closer look series 3
Scarlet letter: are the ceOS and directOrS Of failed cOmpanieS “tainted”?
exhibiT 1 — ForMer and CurrenT direCTorships (seleCTed)
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