Corporate General Counsel and Financial Reporting Quality

Abstract

We examine the role of general counsel (GC) in firms’ financial reporting quality. GCs have a broad oversight role within the firm, including keeping the firm in compliance with laws and regulations and dealing with potential violations with respect to financial reporting. Several high profile SEC investigations have resulted in lawsuits or indictments against GCs for perpetrating financial fraud, and caused many to ask: where were the gatekeepers? As such, we examine the conditions under which the GC may stray from his/her primary role as a gatekeeper. Mainly, we empirically investigate claims that compensation can impair the independence or compromise the professional judgment of a GC. We measure the level of compensation using the GCs presence or absence in the top five officers of the firm by compensation. Results are consistent with GCs straying from their role as a gatekeeper, to some extent, when highly compensated in a manner similar to the CEO and CFO. In particular, firms with highly compensated GCs have lower financial reporting quality and more aggressive accounting practices, including management of the litigation reserve. However, the results also show that highly compensated GCs play an important gatekeeping role in keeping the firm in compliance with GAAP. Thus, highly compensated GCs appear to tolerate moderately aggressive behavior, but constrain it such that it would not result in violation of securities laws and jeopardize their standing within the firm.