Thinking of hiring the next rainmaker? You better investigate their past first

In October 2020, the Tampa Bay Buccaneers signed seven-time Pro Bowl wide receiver Antonio Brown – a top NFL talent who has faced allegations of reckless driving, felony burglary with battery, sexual assault and violating the NFL’s Personal Conduct Policy. The Bucs released Brown on Jan. 6, 2022, four days after an on-field display during which he removed his pads and stormed off the field, shirtless. Many commentators expressed concern for Brown’s mental health; others argued this latest incident was foreseeable.

The Brown analog exists in the business world every day. When top managerial talent is in short supply, there is a strong temptation for HR directors or boards to hire an executive with a great interview and a strong resume. But is it wise to simply employ the most talented executive available?

Professor Adam Yore conducted a series of studies co-written with Brandon Cline (Mississippi State University), Brant Christensen (University of Oklahoma), Nathan Lundstrom (University of Kansas) and Ralph Walkling (Drexel University) on the topic of managerial quality. The resounding answer from these studies is that you should pay attention to their past first.

Integrity is a quality that is universally revered, but its ethereal nature makes it difficult to quantify. In “The Consequences of Managerial Indiscretions: Sex, Lies, and Firm Value,” Professor Yore and his co-writers identified arguably “low integrity” executives at U.S. public companies facing allegations of ethically questionable behavior, such as sexual harassment, public dishonesty, illegal substance abuse and violence. We treat these “managerial indiscretions” as signals of the value these individuals place on their personal reputations by engaging in such behavior.

This research shows executives’ off-the-clock activities have a major impact on their companies. At the revelation of a managerial indiscretion, there is an immediate 1.6% loss in shareholder value, which translates into an average loss of $110 million in stock market capitalization. When committed by the CEO, the loss in shareholder value is 4.1% or $226 million.

The research group totaled the financial consequences resulting from these indiscretions (e.g., legal settlements, executive hours lost, severance costs, etc.) and found they only average around $600,000. Almost the entirety of the shareholder wealth destruction is attributable to damaging the company’s reputation.

A CEO’s deceitful behavior hurts the company’s ability to develop new business relationships. Indiscretions are associated with significant declines in the number of new major customers and joint venture partnerships. Customer losses are particularly severe for indiscretions that damage the firm’s reputation the most. Profitability suffers shortly after.

Evidence suggests these individuals imperil the reliability of the firm’s financials. Low integrity executives aggressively manage reported earnings, and their firms are also more likely to engage in wrongdoing targeted by shareholder class action lawsuits and U.S. federal fraud investigations.

Although low integrity executives suffer professional consequences for their actions, so do their bosses. The probability of CEO turnover rises by 41% following an indiscretion and surviving CEOs see an average drop in salary and bonus of around $400,000, but shareholders also punish their boards at the annual meeting. Board members receive significantly lower votes at the next director election.

In a follow-up study, “The Market Price of Managerial Indiscretions,” we dig more deeply into the implications for shareholder wealth. This paper shows the reputational damage is not limited to a single news cycle. Following an indiscretion announcement, the company’s stock significantly underperforms their risk-adjusted benchmark return by as much as 10% for up to 12 months. The underperformance is not about simply losing a talented executive from an indiscretion-related dismissal. The market reacts negatively whether the executive was central to the organization or not. Thus, it is the reputational damage that counts.

Professor Yore and his colleagues are currently conducting research investigating how the company’s outside monitors respond to these allegations. This research suggests shenanigans in the C-suite can put the company at odds with their public auditors.

Audit standards direct public accounting firms to consider the “integrity and ethical values” of top management when assessing the broader internal control environment. Our preliminary results suggest public auditors take management’s questionable antics as a signal of a poor tone at the top and a risk to financial reporting quality.

Specifically, accounting firms spend substantially more time on their annual audits following indiscretions and, in response, charge 18% higher fees for their services that year. This effect is most evident when the alleged indiscretion relates to either sexual misadventure or personal dishonesty. Furthermore, such behavior may result in the audit firm dropping the client altogether. Audit firms are three times as likely to resign from a client after a manager is accused of a personal indiscretion.

Collectively, this stream of research demonstrates integrity is not just a buzzword, but rather something that should be taken very seriously when hiring a top executive. A manager’s character and integrity matters just as much to the bottom line as any other quality that a potential top executive may bring to the table.