Corporate Governance Changes Following Reputational Damage in the Financial Industry

Abstract

In this paper, we empirically study the motives and consequences of corporate governance changes following possible causes of reputational damage in the financial industry. To do so, we present a comprehensive analysis of the causes and effects of changes in the top management position (i.e., the CEO), the board composition (i.e., non-CEO executive directors, independent directors and board size), and the board activity (i.e., the frequency of board meetings) following 26 income-decreasing financial statement restatement announcements and 294 large operational loss announcements (i.e., of at least $10 million in value) in 75 U.S. financial firms from 1995 to 2009. First, in consistence with literature, an event study analysis shows that internal fraud announcements cause the most severe reputational damage to the loss firms followed by lower and similar reputational damages of restatement and other event announcements (i.e., all internally-caused operational loss announcements except for internal fraud announcements) with no reputational effect of external fraud announcements. Second, our results show that restatement announcements are associated with a higher probability of the CEO turnover by the end of the announcement year, less incoming executive directors, more outgoing independent directors, less change in board size and an enhancement in board activity. Additionally, internal fraud announcements are more probably to cause the CEO to leave out his position only in the next fiscal year (for higher losses) and cause more incumbent executive directors to quit the board and less new independent directors to be hired to the board thus leading to a reduction in the board size. Also, higher other event loss amounts might enforce the CEO to resign and motivate the board to enhance its activity. Although they cause no reputational damage, external fraud announcements are associated with less outgoing independent directors and less incoming executive directors. Finally, we employ the ex post market-adjusted stock performance as a measure of stakeholders’ trust following corporate governance changes in loss firms. Interestingly, our results suggest that equity market participants (i.e., potential investors) trust more financial firms that decrease the presence of non-CEO executive directors following restatement and internal fraud announcements, financial firms that increase the presence of independent directors on their boards following internal fraud announcements and financial firms that enhance their board activities following restatement and other event announcements while they suspect financial firms that immediately change their CEOs following other event and external fraud announcements. All in all, our paper contributes toward a better understanding of the reasoning that governs the decisions and actions of shareholders and boards with respect to enhancing corporate governance mechanisms following reputational damage in the financial industry and how the market responds to the signals involved in such decisions and actions.