In recent decades, it seems the only reason one flavor of corporate or financial misbehavior falls out of the public discourse is because a newer one has taken its place. Following the widespread corporate frauds of the 1990s, the unscrupulous acts of bankers that contributed to the financial crisis, and the Ponzi scheme orchestrated by Bernie Madoff, to name a few, the thoughtful observer must be left anticipating the next scandalous headline. Given the steady flow of reprehensible actions by business professionals, a considerable amount of attention has been focused on understanding, and perhaps mitigating, egregious behaviors in the business world.

One area where academics have been making significant strides is in the field of Behavioral Ethics. In departure from a long-standing normative tradition of proposing how people should behave, the behavioral approach concerns itself more with understanding how – and why – people actually behave.  Behavioralists recognize that if we can understand the factors that affect whether individuals behave ethically, we can possibly nudge people toward better behavior. More ethical patterns of behavior may be obtainable simply by educating people about the specific stimuli or circumstances that are more likely to lead to questionable behavior, or possibly through manipulation of individuals’ environments such that it is easier to do the right thing (Bazerman and Gino, 2012).

One pattern supported by behavioral lab experiments is that people are less likely to cheat when ethical considerations are more salient; i.e., when they are made to stand out in an obvious way. For example, when students participated in a game that could lead to a monetary reward, they were less likely to cheat if they were first asked to write out the Ten Commandments (Mazar, Amir, and Ariely, 2008). In a different experiment conducted by Gino, Ayal, and Ariely (2009), there was less cheating when an actor pretending to be one of the participants asked aloud before the game began, “So, is it OK to cheat?” to which the experimenter responded “You can do whatever you want.”  These studies appear to demonstrate that humans choose to behave more or less ethically depending on whether they are reminded to consider the ethical dimensions of their actions — even when the reminder is indirect.

In a new working paper titled “Do Executives Behave Better when Dishonesty is More Salient?” we consider whether executives demonstrate similar patterns of behavior in the real world. To identify a quasi-experimental setting where this question can be evaluated, we focus on executives located in areas where a major political scandal is revealed publicly.  Political scandals receive a great deal of attention in the news and it is our expectation that their exposure is increasing in geographic proximity to where it occurred. These high profile ethical and/or legal missteps are therefore more salient to local executives, and we hypothesize that they will modify their behavior to a greater extent than those living further away.

Focusing on two suspect executive behaviors – insider trading and earnings management – we find considerable support for this hypothesis. We start by evaluating the profits generated by insiders’ trades, which can be viewed as a proxy for informed trading. In a difference-in-differences setting, we find that the average returns to local insiders’ stock sales declines considerably after the revelation of a local political scandal, suggesting that they are less likely to be motivated by private information. We also find lower levels of stock sales by insiders ahead of observed large stock price declines. For example, during the year following the revelation of a scandal, insiders sell approximately 30% fewer shares on average ahead of months with a greater than -5% abnormal stock return.

To identify whether insiders change their behavior when calculating earnings on behalf of their firms, we evaluate two different measures of earnings management that are common in the accounting literature. Accounting researchers argue that higher propensities to just meet or beat analysts’ earnings expectations could indicate that firms are actively managing their reported earnings to attain these thresholds. These reported earnings patterns are even more suspect if they are coupled with greater usage of discretionary judgements when computing earnings. Consistent with our hypothesis, we find that firms are 13% less likely to report quarterly earnings that just meet or beat analysts’ forecasts during the first year after a local political scandal is revealed. They also use significantly fewer discretionary accruals when computing their reported earnings during these quarters. Together, these results suggest that when dishonesty is made more salient, insiders act more ethically both when trading in their own accounts and when acting on behalf of their firms.

A possible alternative explanation for our findings is that when a local political scandal is investigated, corporate insiders change their behavior because of an increase in the probability of being caught engaging in illegal acts themselves. To help rule out this alternative, we evaluate whether insiders’ trading patterns vary with the level of local media attention given to the political scandals. We find that insiders are both less likely to sell their stock and their trades are less profitable in months with more local news articles about the scandals. This suggests that any changes in insider behavior is not in response to either real or perceived changes in the odds of being caught for wrongdoing since the level of law enforcement activities is unlikely to vary across such short time periods.

To conclude, this study provide evidence that corporate insiders react to the public revelation of the unethical behaviors of others by acting more honestly themselves. This suggests that the individuals in control of our public companies can change their behavior, and that they appear to do so in response to certain stimuli. Even the suggestion that certain self-serving actions are unethical and illegal appears to cause some executives to choose more appropriate courses of action on behalf of themselves and the firms they run. Our findings could provide guidance on how to develop legal regimes that more effectively deter unwanted behaviors in the business community.  For example, it may be reasonable to use taxpayer funds to advertise public service announcements in city centers and around corporate headquarters that remind the public about acts that are illegal or inappropriate.  This tactic (or other similar alternatives) may in fact serve as low-cost means of deterring unwanted and costly behaviors, and, in turn, reduce the cost of investigating and prosecuting such actions after they occur.

References

Bazerman, Max H., and Gino, Francesca, 2012, Behavioral Ethics: Toward a Deeper Understanding of Moral Judgment and Dishonesty, Annual Review of Law and Social Science 8: 85-104.

Gino, Francesca, Shahar Ayal, and Dan Ariely, 2009, Contagion and Differentiation in Unethical Behavior: The Effect of One Bad Apple on the Barrel, Psychological Science 20, 393–398.

Mazar, Nina, On Amir, and Dan Ariely, 2008, The Dishonesty of Honest People: A Theory of Self-Concept Maintenance, Journal of Marketing Research XLV,  633-644.

The preceding post comes to us from David C. Cicero, Assistant Professor of Finance at the University of Alabama – Culverhouse College of Commerce & Business Administration and Mi Shen, doctoral candidate in finance at the University of Alabama.  The post is based on their paper, which is entitled “Do Executives Behave Better When Dishonesty is More Salient?” and available here.