Institutional investors who have experienced corporate fraud develop tools to sniff out future wrongdoing and become much more active in corporate governance.
In a recent study from Harvard Business School, assistant professor and author Trung Nguyen found that institutional investors who have owned a security that has later been the victim of corporate fraud and financial misconduct — what Nguyen calls “treated” investors — are more likely than peers who have not had the experience to avoid the securities of suspicious companies in the future. In fact, investors who have lost money from bad corporate actors become much more active in governance at the companies they own in the future. Well governed companies are more transparent and accountable to shareholders.
In the years following the fraud incident, these investors are also better able to pick stocks with lower predicted likelihoods of fraud, more likely to vote against management preferences, and less inclined to vote for “problematic” directors. Additionally, on average, public companies whose shareholder base has a high proportion of institutional investors who have gone through a fraud ordeal are less likely to get sanctioned by the Securities and Exchange Commission for accounting issues.
“If an investor has that experience, they were burned,” Nguyen told Institutional Investor. “I wanted to see whether there was learning from that experience.”
Nguyen focuses heavily on mutual fund portfolio managers who have experienced corporate fraud, citing previous research which found that these types of investors are less likely to “load up on risky securities.”
In the research paper, Nguyen wrote, “Furthermore, mutual funds that experienced corporate fraud intensify their corporate governance activities and vote significantly more against management at other firms in their portfolios, compared to the voting behavior at the same firms by otherwise similar funds but that did not experience any fraud, especially on issues related to director election, audit, and financial statement. I find that fraud-experienced investors are significantly less likely to vote for problematic directors.” Nguyen defines problematic directors as candidates who hold more than three outside director positions or have strong social ties to the CEO of the firm.
Nguyen examines the holdings of institutional investors before and after they experience fraud, comparing their voting behavior and corporate governance efforts to those of other investors.
To measure a management's propensity to engage in accounting manipulation, Nguyen employs what she calls a “Beneish score.” The score uses certain financial measures to determine whether a company's management has manipulated its earnings. In the study, experienced investors’ holdings produce a lower average Beneish score than firms of investors who have not experienced fraud. A lower score means firms have a lower likelihood of accounting manipulation; a higher score means firms are more likely to fudge the numbers.
“This is consistent with investors learning from their encounter with fraud and, consequently, being able to pick stocks that have a lower predicted likelihood of corporate fraud based on the Beneish model,” the report said.
Investors Become Quasi-Activists After Fraud
Nguyen also looked at the “spillover” effect of corporate governance — the idea that a burned investor’s experience will affect how they behave toward remaining portfolio firms. In order to measure post-fraud change in institutional investors’ corporate governance activities, Nguyen looked at the percentage of institutional investor votes that aligned with management preferences at the firms that have both experienced and inexperienced investors. When compared to firms where fraud has never occurred, investors who have recently experienced fraud are more likely to vote against the grain.
“I find that these differential changes happen only after the ‘treated’ institutional investors have just experienced a corporate fraud incident,” the report said. “There are corporate governance spillovers brought about by investors learning from and experience with corporate fraud: in the years after the ‘treated’ investors' fraud experience, they are less likely to vote in alignment with management.”
This shift occurred most frequently in decisions about director elections, audits, and financial statement issues. In director elections, experienced investors, when it comes to fraud, are less likely than inexperienced investors to vote for “problematic” candidates, the report said. This trend is most prominent during the year after the fraud occurred.
“People usually argue that those who have connections to CEOs are less likely to have a fair or effective monitoring role toward management,” Nguyen said. “I also look at directors who are busy, meaning they hold a lot of outside directorship in outside companies. We expect that those would not be as effective if their jobs were busy.”
But Brett Friedman, managing partner of Winhall Risk Analytics, pushed back against the idea of institutional investors learning long-term lessons from fraud. He said it’s not a question of changed behavior, but of how long that changed behavior will last.
“The question really isn't whether investors change their behavior after experiencing fraud,” Friedman said. “Of course they do — everyone adapts somewhat after experiencing an extreme event. People drive more safely after seeing someone drive off a cliff — that's not surprising. My question is not whether they change their behavior but for how long.”
The study’s analysis looks at the three years before and after the fraud event.
“My experience is that investors do indeed learn from bad events but tend to revert after a few instances,” Friedman said.