Increasing firm value through detection and prevention of white collar crime Karen Schnatterly Assistant Profes

1. Moral Imagination Conference 1 Increasing firm value through detection and prevention of white collar crime Karen Schnatterly Assistant Professor University of Minnesota kschnatterly@csom.umn.edu

2. Moral Imagination Conference 2 The problem of white collar crime Costs US companies from $200 - $400 billion Vs. street crime losses of $3-4 billion and total economic loss to victims of personal and property crimes of $15.6 billion Costs 1% and 6% of sales

3. Moral Imagination Conference 3 The problem of white collar crime Enron, Waste Management, ADM, Cendant, Sunbeam, Leslie Fay�. Not just the employees and �shareholders� Index funds

4. Moral Imagination Conference 4 Research in this area Thin on the ground Mostly at the level of Boards of directors, CEOs, structure of ownership But the problem is inside the organization For example: 20-30% of us plan to steal, 20-30% of us would resist the temptation, and 40-60% of us may give in to the temptation occasionally

5. Moral Imagination Conference 5 Overview of my research Question: Do firms that have had white collar crime look �different� from firms that have not? Quick answer: Yes

6. Moral Imagination Conference 6 Theory and hypotheses Agency and organizational theory Hypotheses: Operational governance H1: Stronger accounting system=> less crime H2: Clearer policies and procedures=> less crime H3: Stronger & more comprehensive code of conduct=> less crime H4: More formal communication opportunities=> less crime H5: More informal communication opportunities => less crime H6: Better employee screening=> less crime H7: More performance-based pay for more employees=> less crime

7. Moral Imagination Conference 7 The crime firms Searched Wall Street Journal for announcements between 1988-1998 Committed by an insider In a US firm inside the US Clear crime Industries excluded: Defense Healthcare Finance Utilities Data available 77 announcements, 57 firms From 10�s of thousands of announcements to 200 to 160 to 77 Purposeful economic crime inside a firmFrom 10�s of thousands of announcements to 200 to 160 to 77 Purposeful economic crime inside a firm

8. Moral Imagination Conference 8 The �non-crime� firms Found �matches� for the 57 firms (77 announcements) Similar size, similar degree of diversification, similar industry/ies Gathered data from SEC documents for all the companies Annual report, 10K, proxy statement Year mattered�I took the data from the year prior to the announcement of the crime, so that the crime was ongoing �non-crime��non-crime�

9. Moral Imagination Conference 9 What data? Controls Structure of ownership Largest owner, CEO stock, Board stock Board Insiders, compensation, compensation type, # of meetings Audit Committee # meetings, outsiders, strength CEO # of roles, salary, options etc/salary Other Firm size, past performance (3 yrs ROA, 3 yrs change in market value)

10. Moral Imagination Conference 10 What data? Operating governance Organizational rules of the game Accounting system Policies and procedures Communication Formal Informal Code of Conduct Employee Screening Contingent pay for more employees

11. Moral Imagination Conference 11 Measures For most, straightforward # meetings, # outsiders, # shares, etc For the scales Coded 0 or 1 to 7 Gathered from the SEC documents Computer assisted text analysis identified search terms, pulled terms in their paragraph (context) I scored them based on scales developed either by myself or with experts Interrater reliability 81% or better.Interrater reliability 81% or better.

12. Moral Imagination Conference 12 Operating governance variables & measures

13. Moral Imagination Conference 13 Results Logit, ordered logit With clustering, Bd salary type only # crimes model 2 No size sig in 0-1, model 1 Audit committee strength not sig anywhere Chng Mval not sig anywhere Logit, ordered logit With clustering, Bd salary type only # crimes model 2 No size sig in 0-1, model 1 Audit committee strength not sig anywhere Chng Mval not sig anywhere

14. Moral Imagination Conference 14 Key Marginal Effects, or % impact

15. Moral Imagination Conference 15 Subsequent results Enron�s score on three key variables? MN company story MN company story

16. Moral Imagination Conference 16 White collar crime facts Discouragements to crime: Contingent pay-options-stock for Board More outsiders on the Audit Committee, more meetings Clear policies and procedures in the company Stronger Code of Conduct Cross-company communication opportunities and individuals whose job description this is Contingent pay for all employees�profit sharing�options Encouragements to crime: Larger firms Audit Committee strength Employee screening

17. Moral Imagination Conference 17 Conclusion In terms of the current debate: Board level policies (Board outsiders, etc) do not get at the root of the problem OR the solution SEC documents reflect the tip of the iceberg of the organization, signal managerial time and attention, so why could I catch this, and analysts could not? All firms should be concerned Shareholder lawsuits on the rise SEC enforcement on the rise Sentencing Guidelines can be your friends