In the wake of numerous corporate scandals in recent years, many factors have been suggested as possible indicators of fraud, including outsized compensation, questionable accounting and failed oversight. But a recent paper by three Canadian academics proposes a surprising alternative indicator of fraudulent misconduct they suggest is more reliable – the size of the CEO’s ego.

 

The authors suggest that egotistical managers, stoked by media attention and analyst praise, gain a "feeling of invincibility" that leads them to "take more risks in fraudulent activities," akin to the "moths attracted to the flames that ultimately kill them."

 

In their paper, "Like Moths Attracted to Flames: Managerial Hubris and Financial Reporting Frauds" (here), Michel Magnan of Concordia University in Montreal, Denis Cormier of UQAM and Pascale Lapointe-Antunes of Brock University report on their analysis of financial reporting frauds or improprieties committed at Canadian publicly traded firms between 1995 and 2005 and that led to the imposition of penalties or fines by securities regulators.

 

At the outset, the authors observed that while the "fraud triangle" of incentives, opportunity and rationalization are "red flags" indicating possible fraud, the fact is that many companies exhibit one or more of these characteristics but very few of them are actually engaged in fraud. Because these "red flags" may not actually indicate fraud, the "red flags morph into red herrings, that may lead to numerous and unfruitful wild investigation chases."

 

The authors contend, based on their review of the 15 companies in their sample, that the missing element in the analysis is the factor that explains why some companies become involved in fraud. The missing element, they contend, is "managerial hubris", which they say "ignites and accelerates the propensity of senior executives to commit or to be oblivious to fraud." The authors define "managerial hubris" as "exaggerated pride or self-confidence often resulting in retribution," deriving the meaning from the concept in Greek tragedy for "man’s fatal flaw."

 

The authors propose that:

 

Hubris actually ignites and accelerates the sequence of incentives, opportunities and attitudes (rationalization) that bring CEOs to engage in financial reporting frauds or to be oblivious to such frauds being committed in their own entourage.

 

Interestingly, the authors noted that many of the firms studied were not completely unrestricted; to the contrary, many seemed to exhibit governance mechanisms that appeared to be functioning. Thus, for example, 12 of the 15 firms had a majority of independent directors, and "at least 7 out of the 15 had ‘star’ directors who brought considerable credibility." In addition, "most of the sample firms were supposedly screened or watched by some of Canada’s leading intermediaries."

 

The authors noted that the firms "were subjected to what would appear to be appropriate oversight and scrutiny." The authors’ view is that "for fraud or impropriety to be committed, governance and markets monitoring conditions need to be present, as they provide additional cover."

 

The authors’ most striking observation is that all of the sample firms or their top executives "were the objects of glowing media, society or stock market reports," which "may have either enhanced the willingness of perpetrators of fraudulent activities to pursue their actions or removed successful CEOs from carefully monitoring their executive team." The authors observed that "hubris can be fed and magnified when there is too much self-reflection of success and achievements." This managerial hubris, stoked by the fawning attention of the media and analysts "ignites and accelerates the propensity of senior executives to commit or to be oblivious to fraud."

 

The authors suggest that awareness of these factors can aid fraud detection, because this element of hubris is "more likely to be transparent" when executives are asked about "plans realizations, future strategies." The authors suggest that "inconsistencies between executives’ statements and observable facts or realities, outlandish claims, and a lack of concern for operational detail can be signals that managerial hubris has set in."

 

Thought the authors’ study is limited to Canadian companies, the authors note that "it is highly likely that managerial hubris is present in U.S. cases of fraudulent financial reporting as well" (citing the example of Scott Sullivan, the former CFO of WorldCom).

 

But while the authors refer to the possible applicability of their analysis to financial fraud in the U.S., they also acknowledge the potential limitations of their analysis as well. Among other things, they note the small size of their sample, which they acknowledge represents a "limitation" even though it also afforded them the opportunity for a more detailed study of each case.

 

The authors note that there may be factors unique to Canada at work as well. For example, they note that due to the relatively small size of Canada’s business environment and the relatively fewer number of media outlets there, "it is probably easier for someone to attain ‘star" status in Canada."

 

The authors also note that many Canadian firms have a CEO who is also a controlling shareholder or member of a control group, which may both give the CEO a stronger personal incentive to commit fraud and great opportunities to overcome internal controls. This fact may explain much about the cases the authors studied; in 13 of the 15 cases, the firm’s CEO was "an important shareholder, if not the controlling shareholder."

 

These somewhat distinctly Canadian factors may limit the extent to which the authors’ analysis may be applicable outside Canada, particularly in the U.S. where very few public companies are as controlled as were these Canadian firms. The characteristics of those Canadian firms may have given the hubristic CEOs more opportunity to indulge their egotistical goals, in ways that might not be available to many CEOs in the U.S., even to highly egotistical American CEOs.

 

Of course, there are countless examples of egotistical CEOs of U.S companies that led their companies in fraudulent misconduct –it is just that the presence of a hubristic CEO may or may not be as indicative of fraudulent misconduct in the U.S. as in Canada. Perhaps it is a topic for further study.

 

There is the problem about what to do with the authors’ conclusions, even if we accept them as valid and applicable both in Canada and outside as well. It is not as if analysts, auditors or D&O insurance underwriters can administer personality tests to measure the size of CEOs egos. And favorable press, even highly favorable press, is not always an indicator of problems looming – to the contrary, the media reports might be lavishing praise not because they are duped by fraud, but because the company’s performance actually is praiseworthy. Moreover, many CEOs have enormous egos. Arguably, only someone with a massive ego would even attempt to do their jobs.

 

In the end, the authors are suggesting only that signs of hubris should be watched for, and where found in the presence of more typical red flags, uses as a trigger for further investigation – an observation that is undeniably sound.

 

One final observation is that at some level, the authors’ research conclusions are consistent with the research I discussed in a prior blog post (here) that suggested an inverse correlation between the size of CEO’s houses and their company’s performance. Both studies suggest that if a company becomes an instrument in a CEO’s self-aggrandizement, shareholders better watch out.

 

Very special thanks to Professor Michel Magnan for providing me with a copy of the research paper. Hat tip to the Securities Docket (here), for linking to an August 26, 2009 Toronto Globe and Mail article (here) discussing the research paper.

 

And Speaking of Hubris: One of the more astonishing parts of the global financial crisis is the outsized role that banks based in Iceland played, particularly in the early stages of the crisis. The question of how several banks from a very small county in the North Atlantic created such havoc is one of the great puzzles of the crisis.

 

Picking up on the Canadian authors’ research, I would suggest that one of the ways Icelandic banks came to assume such an outsized, and ultimately dangerous role, was hubris. If you have any doubt, watch the following (pre-collapse) video from Kaupthing Bank, which, before it was seized by Iceland’s banking regulators, had transformed itself into Iceland’s largest bank. You don’t think there were some massive egos involving in this operation? (Fatal last words: "We can if we think we can… We think we can continue to grow the same way we always have.") 

 

Hat tip to Clusterstock (here) for the link to the video.

 

http://www.youtube.com/v/31U54cgf_OQ&color1=0xb1b1b1&color2=0xcfcfcf&hl=en&feature=player_embedded&fs=1