Explore Rice

1/15/2006 12:02:00 AM

Trust in corporate America starts with the CEO

New SEC regulations may have generally restored public confidence in corporate America, beginning with a requirement that CEOs and CFOs personally swear by their companies' financial statements. While viewed as a crucial first step, not all executives' oaths improved their companies' stock prices. The difference, indicates a new Rice study, is the level of shareholders' faith in their CEO's trustworthiness.

--------------

Following the fraudulent reporting of Enron and WorldCom, the Securities and Exchange Commission required CEOs and CFOs of large publicly traded companies to personally swear by their firms' financial statements. A Jones School researcher believes this SEC requirement, which now applies to all companies, has generally helped rebuild public confidence in corporate America, but not necessarily in every company.   That, she claims, depends on shareholders' faith in their CEO's trustworthiness as reflected in the company's stock prices.

"On average, the stock values of companies did improve following the filings of those firms' executive oaths by the SEC's first deadline on August 14, 2002, says Yan Zhang, an assistant professor of management at Rice's Jesse H. Jones Graduate School of Management.

"This suggests that the commission's requirement generally may have helped to rebuild the public's confidence in companies' financial disclosures.

The extent to which executive oaths had positive, negative or no impact on companies' stock prices, however, has depended on the credibility of their CEOs, according to Zhang. Part of that trust is based on their top executives' investment or level of shareholding in the company and on the number of external directorships their CEOs hold.

"If the CEO is a shareholder, the cost of certifying false financial statements will be borne, at least partially, by the CEO, Zhang says.

"Previous studies show that as the percentage of shares owned increases, it becomes more difficult for the owner to leave the firm by selling off its shares.

Executives' managerial reputation -- often reflected in the quality and number of board memberships they hold -- also is a factor regarding CEOs' credibility with their shareholders. As Zhang points out, the more external directorships CEOs have, the more is at stake in terms of their reputation and prestige should they certify false statements.

Zhang recently completed one of the few empirical studies to examine the impact of the new SEC standards on the public's trust in corporate America.   In its attempt to rebuild public confidence following recent accounting scandals, the SEC required the CEOs and CFOs of large publicly traded companies to personally certify their firms' financial statements. The deadline for the first of these executive oaths was August 14, 2002. After passage of the Sarbanes-Oxley Act, all company CEOs were required to do the same.

To closely link the CEOs' executive oaths to a company's valuation, Zhang studied only those firms that had not experienced any major event such as declarations of dividends, unexpected losses or earnings, or law suits that might also explain changes in their stock prices before or after the August 2002 deadline.   She then calculated each company's abnormal return, those returns earned by a firm after the markets have adjusted for the "normal return process.

The average dollar value in price changes per firm following executive oaths was significant. Within two days of the executive oath being filed, it was $37.23 million per firm. Over a three-day window, the average price change was $46.40 million and within four days of the filing, it amounted to $67.60 million per firm.

In addition to CEOs' shareholdings in their own firms and directorships in other companies, Zhang examined the CEOs' tenure with their companies and whether they had been in office at a time when the company filed financial restatements. She found that generally the number of years CEOs are in office does not have a significant impact on their credibility with shareholders, but the credibility of incumbent CEOs is hurt when they are associated with their companies' prior financial restatements.

While a few studies have examined how an organization's legitimacy is restored after a crisis, Zhang's research shows that executive oaths when filed by credible CEOs represent an important component of the new SEC standards.

"I believe these findings offer further evidence on how both the new standards as well as companies' strategic leaders matter when it comes to restoring their firms' value, Zhang concludes.

A native of China, Zhang has conducted research and written extensively about CEO successions and the organizational consequences, global strategic alliances, and multinational companies' strategies and operations in emerging markets.

She earned undergraduate and graduate degrees in economics from Nanjing University in Nanjing, China, and a second master's degree in international business from City University of Hong Kong.   She received her Ph.D. in strategic management from the Marshall School of Business at the University of Southern California.

For more information on this research, contact Zhang at yanzh@rice.edu or Debra Thomas in the Jones School at dthomas@rice.edu .