Thought of the Week – Can ESG practices reduce corporate fraud?
I often promote the view that ESG practices are not so much about enhancing returns but rather about reducing risks. One area where I have so far not seen too much research of the benefits (or lack thereof) of ESG practices is corporate fraud. Do firms with better ESG practices have fewer cases of fraud? Junho Park and his colleagues attacked that problem from a rather surprising angle…
Intuitively, if someone had asked me to look into the link between ESG practices and corporate fraud, I would have looked into all the documented cases of corporate fraud (ranging from embezzlement of funds via tax fraud to collusion with competitors) and compared the ESG practices of companies that committed fraud with those of companies that didn’t.
Instead, the researchers started with the literature on facial masculinity. The shape of our faces is to a nontrivial degree influenced by the level of testosterone and other hormones. Men with higher testosterone levels have more “square” faces while people with lower testosterone levels have more rounded “feminine” faces. Thus, one can infer from a face’s width-to-height ratio not only how masculine someone looks, but also if this person has on average a higher or lower testosterone level in their bloodstream.
But testosterone doesn’t only influence the shape of body parts. We all know that people with high testosterone tend to be more aggressive and take more risks. That is the true evolutionary purpose of testosterone. It prepares a person for fight or strenuous activity. Unfortunately, higher testosterone levels not only indicate a higher propensity to undertake risky endeavours, but also a higher propensity to overstep the line and commit fraud or break all kinds of rules. From speeding in a car to corporate fraud, everything can to some degree be linked to testosterone levels. This study, for example, found that companies run by CEOs with more masculine faces were more likely to engage in financial misreporting.
In their study of 9,049 CEOs of publicly listed companies in South Korea, Junho Park and his colleagues found that the average likelihood of a CEO being engaged in corporate fraud is some 3.7% with collusion being the most commonly reported and prosecuted form of fraud. Corporate fraud is rare, but it exists. And it can incur significant costs for shareholders. Amazingly, the likelihood of committing fraud is highly correlated with facial masculinity. A one standard deviation increase in the facial width-to-height ratio (the traditional measure for facial masculinity) implies a three times increase in the likelihood of a CEO engaging in corporate fraud to 11.2%.
Testosterone-driven CEOs are far more likely to cheat and a testosterone-driven corporate culture is far more likely to lead to transgressions in business.
But how can ESG practices reduce the risk of corporate fraud? It’s not as if one can “cancel” more masculine-looking CEOs and refuse to hire them. The simple answer is to let CEOs issue corporate sustainability reports with voluntary commitments by the CEO to take certain actions. Companies that had more masculine-looking CEOs but published a voluntary sustainability report that “committed” the CEO to certain actions saw no increase in corporate fraud.
Another way to reduce corporate fraud is to align the compensation of the CEO with the interests of the shareholders by paying a larger share of the CEO’s compensation package in shares or options. This also led to a decline in corporate fraud by more masculine-looking CEOs, but – unlike a voluntary sustainability commitment – it reduced the incidences of corporate fraud only by half.
In the end, the lesson to me is that corporate culture matters. More masculine-looking CEOs on average have higher testosterone levels and are more inclined to take on risks. But this risk-taking behaviour can be channelled for either good or bad purposes. Publishing a voluntary sustainability report is a form of commitment for the CEO that makes him aware of his obligations to shareholders and provides a mental boundary that he is unlikely to cross.
But, which companies run by high-testosterone CEOs will commit to publishing a voluntary sustainability report? It’s certainly not a company where the CEO is more or less a small dictator with few checks and balances. Instead, such a voluntary action is likely to happen at companies where the overall culture is already committed to “doing the right thing”. A CEO with high testosterone levels joins such an organisation and is channelled by the culture of the firm to use his risk-taking in a productive and beneficial way.
Thought of the Week features investment-related and economics-related musings that don’t necessarily have anything to do with current markets. They are designed to take a step back and think about the world a little bit differently. Feel free to share these thoughts with your colleagues whenever you find them interesting. If you have colleagues who would like to receive this publication please ask them to send an email to [email protected]. This publication is free for everyone.
