Why Profit and Prominence Can Make Good Firms Go Bad
Numerous high-profile, profitable firms have engaged in illegal activities to improve their performance. In recent history, we can easily recall the experiences of Enron, Arthur Anderson and Barings Bank.
Why would these firms engage in such bad — and risky — behaviour? Being caught can compromise profits and access to key resources and cause reputational damage for both the firm and its management.
Researchers Yuri Mishina (Michigan State University), Bernadine Dykes (University of Delaware), Emily Block (University of Notre Dame) and Timothy Pollock (The Pennsylvania State University) argue it’s because managers, once profitable, don’t like to lose.
The researchers examined data from a set of 194 S&P 500 manufacturers from 1990-1999. “Illegal activity” included convictions or settlements for environmental violations, anti-competitive actions, false claims and fraud in any given year.
The authors found firms that do well (i.e. outperform market expectations or other firms in their industries) are more likely to be involved in illegal activities than those that don’t. Also, prominent firms that are successful are even more likely to engage in illegal activity. This seems counterintuitive — we might expect firms that perpetually “lose out” would be most likely to engage in illegal activities.
What explains these startling observations? As behavioural economics and psychology show, individuals don’t always make rational decisions. In this same vein, the authors focus on three likely explanations.
Nobel laureate Daniel Kahneman and his colleague Amos Tversky found people take more risks when they are about to lose money they already possess than if they have the opportunity to gain money. Based on this logic, Mishina and colleagues argue that firms that face escalating investor expectations may choose to engage in illegal activities — and risk being caught — rather than face certain punishment from the financial market for falling short.
Based on the idea that prior business wins appear to be winnings from the "house" (in gambling terms), managers may behave recklessly with this unexpected or easy cash.
Previous success makes managers think they’re infallible. In turn, they engage in increasingly risky activities.
All things equal, the chance of a firm engaging in illegal activity was 15.4 percent. Firms that out-performed industry peers were more likely to engage in illegal actions, as were those that out-performed market expectations.
Prominent firms were far more likely to undertake illegal action than other firms (18.4 percent compared with 10.2 percent). Surprisingly, lower-profile firms were not more likely to engage in illegal activity — even when they out-performed market expectations.
This research can help investors and regulators hone in on firms that should be screened carefully because of the higher risk of undertaking illegal activities.
The lesson for firms and industries: Consider the pressure placed on managers and executives to consistently top prior achievements. Try compensating executives primarily on longer-term performance rather than quarterly earnings.