MANAGEMENT TURNOVER AND GOVERNANCE …
governanceMANAGEMENT TURNOVER AND GOVERNANCE CHANGES FOLLOWING THE REVELATION OF FRAUD*
Anup Agrawal
Culverhouse College of Commerce and Business Administration
University of Alabama
Tuscaloosa, AL 35487-0224
(205) 348-7842
anup_agrawal@ncsu.edu
Jeffrey F. Jaffe
The Wharton School
University of Pennsylvania
Philadelphia, PA 19104
(215) 898-5615
jaffe@wharton.upenn.edu
Jonathan M. Karpoff
School of Business
University of Washington
Seattle, WA 98195
(206) 685-4954
karpoff@u.washington.edu
First draft: December 1, 1997
Revised: March 2, 1998
Final revision: September 14, 1998 Forthcoming in The Journal of Law and Economics
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MANAGEMENT TURNOVER AND GOVERNANCE CHANGES
FOLLOWING THE REVELATION OF FRAUD
ABSTRACT
Fraud scandals plausibly create incentives to change managers, in an attempt to improve the firm's performance, recover lost reputational capital, or limit the firm's exposure to liabilities that arise from the fraud. It also is possible that the revelation of fraud creates incentives to change the composition of the firm's board, to improve the external monitoring of managers or to rent new directors' valuable reputational or political capital. Despite such claims, we find little systematic evidence that firms suspected or charged with fraud have unusually high turnover among senior managers or directors. In
univariate comparisons, there is some evidence that firms committing fraud have higher managerial and director turnover. But in multivariate tests that control for other firm attributes, such evidence dis
appears. These findings indicate that the revelation of fraud does not, in general, increase the net benefits to changing managers or the firm's leadership structure.
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MANAGEMENT TURNOVER AND GOVERNANCE CHANGES
FOLLOWING THE REVELATION OF FRAUD
I. INTRODUCTION
What consequences do top managers face when their firms are discovered to be engaged in fraud? In some cases, the allegation of
fraud costs top managers their jobs. Columbia/HCA Healthcare Corp. Chairman and Chief Executive Officer (CEO) Richard Scott, for example, was fired in 1997 following federal investigations of the firm's billing practices in its home health care and hospital laboratory businesses. In 1994, Robert Winters announced his retirement as Chairman and CEO of Prudential Insurance Company of America soon after the company came
under scrutiny for fraudulent sales practices at its insurance and brokerage units. In another example, William Moore resigned as chairman, CEO, and president of Recognition Equipment Inc. in 1988 after the firm was charged with fraud, theft, and conspiracy in its efforts to obtain equipment contracts from the U.S. Postal Service. In each of these cases, the revelation or allegation of fraud appears to have motivated a change in top management.
Frauds do not always prompt managerial changes, however. D.J. Krumm, chairman and CEO of Maytag Company, retained his position despite a 1990 settlement of charges that the firm secretly reconditioned defective microwave ovens, changed their serial numbers, and sold them as new. In another example, Hertz Corporation pled guilty in 1988 to charges that
it overcharged customers for repairs to autos damaged in collisions. Although the company paid over $20 million in fines and restitution, Frank Olson kept his job as chairman and CEO. Soon after the settlement,
Olson received public accolades for his advocacy of business ethics and legislation to limit deceptive practices in the car
1rental business.
As these examples illustrate, the top managers of firms committing fraud can experience vastly different consequences. In this paper we examine empirically the effects of the revelation of corporate fraud on subsequent changes in top management and the board of directors. In doing so, we seek to distinguish between competing theoretical arguments about the consequences to top managers and board members when a firm is discovered to have committed fraud.
On the one hand, there are several reasons fraud might increase managerial turnover. One is that fraud is costly to the firm. Jonathan Karpoff and John Lott find that the initial publicity of actual or  2alleged fraud results in a statistically significant loss in the firm’s market value. As Michael Weisbach
and Jerold Warner, Ross Watts, and Karen Wruck report, poor stock price performance increases the
3probability of management change. Fraud also might prompt unusually high turnover if it results from or
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leads to financial distress. Vojislav Maksimovic and Sheridan Titman argue that firms near financial di
stress are more likely than other firms to commit fraud, and Stuart Gilson and Michael Vetsuypens find
4that firms experiencing financial distress tend to have high management turnover.
On the other hand, the public revelation of fraud might have only a negligible effect on managerial turnover. One reason is that the cost of establishing internal controls to eliminate any possibility of fraud typically is very high, implying that even well-run firms optimally risk a positive probability of fraud. Another reason is that, as Michael Jensen argues, the typical corporation's internal controls frequently  5are insufficient to prompt value-increasing changes in management. Thus, even frauds that result from
poor management might not trigger a change in corporate leadership.
Overall, our empirical results imply that the revelation of fraud, although potentially costly to the firm, has little influence on managerial turnover or on the firm's governance structure. Univariate tests indicate that firms committing fraud are somewhat more likely than a set of control firms to replace their Chairmen, CEOs, Presidents, and inside directors. But in multivariate tests that control for other firm characteristics, the influence of fraud on managerial and director turnover is negligible.
Our investigation is related to several papers that examine the characteristics of firms that commit fraud. Michael Beasley finds that the presence of outside members on the board of directors significantly reduces the probability of an accounting fraud. Patricia Dechow, Richard Sloan, and Amy Sweeney conclude that firms committing financial

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