When Hiring CEOs, Focus on Character

On November 19, 2018, Carlos Ghosn, the chairman of Nissan, was arrested after stepping off his corporate jet in Tokyo. Japanese authorities criminally charged him for a host of financial misdeeds at Nissan, including misappropriating $5 million and concealing about $80 million of his compensation over eight years. For Ghosn, who had saved Nissan from bankruptcy after arriving in 1999, it was a stunning comedown. He had joined the company as an outsider with Brazilian, French, and Lebanese citizenship, but he had become one of Japan’s most recognized business leaders—nicknamed “Mr. Fix It” by an adoring public, celebrated in manga comic books, and awarded a medal by Emperor Akihito. After his arrest, Ghosn argued that the allegations were “meritless and unsubstantiated,” ginned up by rivals within Nissan. Nonetheless, rather than stand trial, Ghosn hired a former commando to hide him in a music-equipment box and fly him by private jet to Lebanon, where he remains a fugitive. Ghosn’s saga was shocking. How could anyone have seen it coming? In fact, there were clues. In 2014 and 2016, Ghosn threw lavish birthday parties at the Palace of Versailles for himself and his wife, perhaps with company funds. He and his family have owned a 120-foot yacht and upscale homes in Tokyo, Paris, Rio de Janeiro, Amsterdam, Beirut, and New York. He has invested in wineries and contemporary art. And even though he was awarded a compensation package four times as large as that of his counterpart at Toyota, Ghosn spent much of his tenure at Nissan complaining that he was underpaid. Those behaviors—over-the-top spending, a focus on personal earnings, and an apparent disregard for rules such as company expense policies—should be warning signals for boards. In a series of studies over the past decade, colleagues and I have sought to identify off-the-job behaviors that foretell an executive’s propensity for ethical lapses. Through this work we have pinpointed two traits—materialism and an inclination toward rule breaking—that correlate with suspicious trading activity, financial-reporting errors, and excessive risk taking. We’ve also devised novel ways to identify executives who exhibit those behaviors. Examining CEOs’ personal lives is an unorthodox method for preventing fraud. When boards, regulators, and investors consider ways to limit unethical behavior, the emphasis tends to be on systemic fixes, such as laws and regulations, large and well-funded compliance departments, heightened oversight, and reporting mechanisms such as whistleblower hotlines. That standard approach conforms with economic theory, which treats individuals as rational beings who will all respond similarly to incentives and rules. My research suggests taking a different tack: assuming that leaders’ personalities play a significant role in how they behave, and that their private actions can affect organizational behavior. If this is true, then especially when hiring CEOs, boards should consider a person’s character, with an emphasis on whether a candidate displays signs of materialism or a history of flouting rules. Ignoring those signs and installing a leader whose life away from the office raises red flags can put a company at unnecessary risk. In the following pages, I first explain the evolution of my research and its specific findings. I then discuss the practical implications for regulators and for corporate boards involved in screening and selecting top executives. Scrutinizing Personal Behavior The roots of this research stretch back 20 years. I was in graduate school during the corporate scandals of the early 2000s, including those that tarnished Enron, WorldCom, and Tyco. Soon afterward, the United States responded by passing the Sarbanes-Oxley Act, which increased oversight of corporations by regulators and boards. Yet just a few years later, a new series of scandals emerged—at Wells Fargo, Countrywide, and other firms. Companies were investing resources in internal controls, and regulators were relying on new laws to strengthen oversight, but neither seemed to eliminate wrongdoing. I began to wonder: Instead of focusing on systems and controls, should we be looking more closely at the people leading these companies? As those events were unfolding, scholars were beginning to pay more attention to the way individual managers can affect the performance of a firm. This perspective gained momentum after the 2003 publication of a landmark paper, by Marianne Bertrand and Antoinette Schoar, arguing that executives have personal styles that affect key decisions and company performance, and those styles persists even when people jump between companies. Other researchers began examining CEO risk-taking and narcissistic behavior and their effects on decision-making and firm performance. Against that backdrop, I joined with two colleagues, Robert Davidson and Abbie Smith, to explore the lifestyles of CEOs who led companies caught up in scandals. It occurred to us that conspicuous consumption could be correlated with misconduct. For instance, Tyco’s CEO, Dennis Kozlowski, spent $6,000 on a shower curtain and $15,000 on an umbrella stand for a New York apartment; he was later convicted of 22 criminal charges and served six and a half years in prison. My colleagues and I also began thinking about people’s propensity to follow or break rules. In a 2007 study, economists Ray Fisman and Edward Miguel found that the United Nations officials who received the most parking tickets in New York City tended to come from countries with the highest rates of corruption. We wondered whether scandal-prone executives were likewise apt to commit low-level offenses such as ignoring minor traffic laws. So my colleagues and I set out to investigate both rule breaking and materialistic spending among CEOs. Rule breaking. Criminology researchers have found that people who flout even minor rules are subtly communicating that they don’t believe restrictions apply to them. With assistance from private investigators, my colleagues and I did a legal-records search on more than 1,000 U.S. executives in various industries. We found that 18% of CEOs had been cited for infractions ranging from minor traffic offenses to driving under the influence, disturbing the peace, drug crimes, reckless behavior, domestic violence, and sexual assault. We first examined whether the rule breaking of those C-suite leaders was related to various corporate outcomes. We started with the most intuitive questions: Is fraudulent reporting more likely at a company if its CEO has a criminal record? Is the CEO (or CFO) more likely to be personally implicated in the fraud if he or she has a criminal record? Not surprisingly, the answer to both questions was yes. Comparing two groups of firms—those where fraud had occurred and those that were fraud-free but otherwise similar to companies in the first group—we found that if the CEO had a criminal infraction, the firm was more than twice as likely to be involved in fraud, and the CEO was seven times more likely to be personally named as a perpetrator. Furthermore, even the incidence of minor infractions (such as traffic violations) by the CEO was significantly higher at the firms that had experienced fraud than at those that hadn’t. In firms led by executives whose personal spending was excessive, we found both more fraud and more unintentional reporting errors. Intriguing as those results were, we knew that fraud is a rare occurrence. Would we observe the same pattern for a more widespread form of corporate misconduct? We decided to examine whether executives with criminal infractions were also more likely to make lucrative insider trades—the kind that are not necessarily illegal but whose outsized results and excellent timing suggest that the trader might have benefited unfairly. We found that executives with prior criminal infractions (including both serious charges and minor traffic violations) earned significantly higher profits from purchases and sales of their company stock than did executives without any infractions, and the profitability of those trades increased significantly with the severity of the infraction. We next investigated whether strong corporate-governance mechanisms—such as blackout policies that prohibit trading within certain periods, openness to scrutiny by large institutional investors, and board independence—were able to deter such trading activities. We found that those mechanisms did lower the profits of executives with traffic tickets, but they had little effect on executives who committed serious crimes. Seemingly, then, governance structures and formal control systems are unlikely to rein in the worst actors. That’s discouraging news for boards and regulators that wish to curb opportunistic insider trading and limit other undesirable behavior. Materialism. We were equally interested in studying materialistic CEOs. Materialism, as we define it, isn’t necessarily signified by having many possessions or even high-end ones; rather, it involves the zealous pursuit of wealth and luxury regardless of the cost to others. Identifying materialism in CEOs is a challenge because most chief executives have substantial assets. However, one way to screen for it is to see if someone’s possessions are excessive compared with those of peers and neighbors. After careful analysis, we chose three acquisitive behaviors—ones that we could obtain data for—as markers for materialism: owning a private home valued at twice as much as the median in the area; owning a car worth more than $75,000 (which at the time of our study represented an extremely high-end vehicle); and owning a boat more than 25 feet in length. In our sample of CEOs, 58% had one or more of those markers and qualified as materialistic; we classified the remaining 42% as frugal. We first looked for—and found—a link between fraud and materialistic CEOs. What we saw happening was a gradual weakening of the control environment in firms led by executives whose personal spending was excessive. Specifically, we observed more use of equity-based incentives (which can encourage managers to mislead capital markets by inflating reported performance), more appointments of materialistic CFOs, less intensive monitoring by the board, and a greater probability of a weakness in internal controls. All those conditions created an environment where fraudulent reporting was more likely—and we found both more fraud (on the part of executives other than the CEO) and more unintentional reporting errors. Next we focused our attention on banks, whose business model facilitates the measurement of risk-taking behaviors. For a sample of about 300 banks, we found that those with materialistic CEOs had relatively lax systems for risk management and thus faced more threat of significant negative performance than banks led by frugal CEOs. Furthermore, we found that materialistic CEOs also contributed to a deterioration in corporate culture that led employees to more aggressively exploit insider-trading opportunities during the 2007–2009 financial crisis. However, firms run by materialistic CEOs were also associated with higher returns than firms with frugal CEOs were. In another study we examined how the materialism of top executives affected firms’ corporate social responsibility (CSR) performance. We found that firms with materialistic leaders received lower scores from CSR ratings agencies than did firms with frugal leaders (as a result of meager charitable giving, for example, or the spread of harmful pollutants in the community). Our finding aligns with other scholarship showing that materialistic people display a lack of concern for the well-being of others and the environment. Responding to the Research When I talk with executives, directors, and investors about this work, they generally react with surprise. Initially some people wonder how academic researchers can get information about CEOs’ criminal history and personal property. (As I tell them, private investigators in the United States can legally access many relevant public records.) For board members and others involved in succession decisions, our findings often prompt reflection about how much due diligence they typically do. Although they might order background checks on external candidates (which sometimes include a search of legal records), they rarely take that step for internal candidates seeking a promotion to a C-suite role. As one person I spoke with put it, “We don’t even look at these issues. We don’t care what they’re doing off the job, and we probably should.” Other people who learn about our research say it jibes with what they’ve heard or read about some prominent CEOs. For example, Steve Jobs was known for flouting rules he considered a nuisance: He refused to put a license plate on his car, and at Apple headquarters he routinely parked in spots reserved for drivers with handicaps. Although Jobs was never charged with corporate wrongdoing, Apple was implicated in a scandal involving the backdating of his stock options. Another example involves Theranos founder Elizabeth Holmes, who was recently convicted of defrauding the investors in her failed blood-testing company. During her trial (when she was reportedly living on a $135 million estate), prosecutors suggested that maintaining a lavish lifestyle was a motive for her criminal behavior. Regulators have reacted to our research with interest. In 2016 I spent a year working at the U.S. Securities and Exchange Commission, which hired me in part because of these studies. The SEC believes that the size of investors’ losses is often related to how long misconduct goes undetected, so it has a vested interest in spotting fraud as early as possible. To that end, the SEC hopes to become better at predicting where fraud might happen instead of waiting for it to be exposed. Some of this effort involves using financial modeling to identify firms whose financial reports bear similarities to prior cases of fraud. Adding leadership behavior or off-the-job red flags as another tool for prediction is a promising idea, but regulators are proceeding cautiously because of concerns about privacy and other ethical issues. Meanwhile, the research continues. In 2021 two colleagues and I published a paper on the effects of incentives for corporate whistleblowers. We found that contrary to claims by critics, the bounties that some governments (including the United States) pay to whistleblowers do help uncover fraud, with no apparent rise in meritless claims. In another line of inquiry, I’m continuing to seek new ways to better distinguish materialistic CEOs from those who are frugal. It’s worth asking, Should we consider the way a CEO’s personal philanthropy offsets luxury purchases, and can that benevolent behavior act as a counterweight to materialism? As my work evolves, I hope to offer clearer answers to such questions. For now, let me state firmly that boards needn’t reject CEO candidates simply because of a speeding ticket or an excessively valuable home. However, directors should view these as warning signs, especially if a legal infraction has happened recently or repeatedly. The data suggests that the risk is too great to ignore.

When Hiring CEOs, Focus on Character

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