IU prof's study suggests putting shareholders on the line

August 31, 2013

Despite tougher federal laws aimed at curbing executive malfeasance, a study by an Indiana University professor advocates making shareholders more responsible for watching management—or facing financial penalties themselves.

IU Kelley School of Business assistant professor Curtis Wesley II and co-author Hermann Ndofor of Texas A&M University likely won’t be invited to parties by investor clubs now that their provocative work has been published in Business Ethics Quarterly.

Wesley Wesley

They suggest firms aren’t adequately penalized as declines in their stock price do not adequately compensate for the gains associated with providing erroneous earnings.

“Additionally, it appears that the market cannot discern between firms that are later sanctioned by the SEC and those that may have simply reported inaccurate earnings in error.”

Wesley said that when it comes to fraudulent financial statements, everyone focuses on punishing executives and the company. But what about those who also benefit from inflated earnings reports, such as shareholders?

Wesley argues that shareholders—at least those who own large stakes—have the ear of management and are able to provide greater scrutiny of top executives.

He argues that other shareholders still bear the responsibility of management oversight even though they are less capable. “And when shareholders profit from malfeasance that occurs when they held shares, is it not reasonable that restitution is made?”

To the extent those shareholders fail to provide sufficient oversight to force a change in management behavior, they could be subject to a claw-back of dividends they received between the time a company first reported earnings and when it restated them.

Wesley said advances in computerized transactional services could make such a claw-back practical.

“My overarching theme is, there needs to be some increased level of enforcement of existing laws and regulations, including much stiffer penalties for firms themselves,” he told IBJ.

Regulators have established a remedy for executives who benefit because of an error, and for board members who failed to provide proper oversight to allow the error to occur. But “perhaps if investors are more adequately motivated to incentivize executives to manage well and report accurately, and directors to monitor more aggressively and effectively, incidents of fraud would decrease.”

Going after shareholders would have its problems, said George Farra, a principal of Woodley Farra Manion Portfolio Management in Indianapolis.

How, for instance, would someone discern that shareholders knew management was overstating earnings? What if a shareholder discovered through his own analysis that something was amiss and sold ahead of the news hitting the market?

“Would they be penalized for doing private research and not informing the public of what they found?” wonders Farra.

He noted that Congress and regulators have taken numerous steps in recent years to crack down on insider trading or other corporate wrongdoing. Sarbanes-Oxley, for instance, requires executives to attest to the accuracy of financial reporting under penalties that could include jail time.

Farra also contends that stock prices are punished, sometimes substantially, when a company misstates earnings. “The market is a very swift disciplining mechanism.”

Putting more of a squeeze on investors to oversee and catch rascally management also could become yet another inhibitor for companies to go public, Farra added.

Wesley and Ndofor say their main premise is that sanctions are not severe enough on the firm.

One option would be to allow shareholders to sack a company’s entire board for ethical lapses of the management team it’s supposed to be monitoring.

Such an action would impose a severe “reputational penalty” to directors, particularly those who serve on the boards of several companies.•


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