The agency cost of managerial indiscretions: Sex, lies, and firm value

Personal managerial discretions are separate from business activities of the firm, but signal the value executives place on their reputation.  We examine whether these signals are related to changes in firm value and subsequent corporate misdeeds.  We identify ‘low-integrity executives’ as those accused of personal indiscretions including allegations of dishonesty, substance abuse, sexual misadventure or violence.  We test three hypotheses currently considered in the literature.  These are: the pure skills hypothesis, in which technical skills and experience are the only relevant factors in an executive’s contribution to firm value, making personal indiscretions irrelevant; the distraction or disruption hypothesis, in which accused executives reallocate their time to address private-life activities and away from more productive endeavors at the firm; and the managerial character hypothesis, in which personal indiscretions credibly signal an executive’s lack of regard for own reputation, eroding reputation and trust, an importance basis for economic exchange.  We find that companies of accused executives experience significant short- and long-term wealth losses, reduced operating performance, and increased probability of unrelated shareholder-initiated lawsuits, SEC/DOJ investigations, and managed earnings.  CEOs and boards face significant labor market consequences for indiscretions.  However, approximately sixty-five percent of accused executives retain their positions even among repeat offenders.  Indiscretions are more likely in poorly governed firms where disciplinary turnover is less likely. The objective of our research is to examine the financial and labor market consequences to signals of low managerial integrity

JEL classification: G34, G39 Keywords: managerial indiscretions, management quality, integrity, class action lawsuits, fraud, earnings management, corporate governance, managerial labor markets