Which is the biggest red flag for a potential accounting fraud: Bad corporate governance, an overinflated share price or too many stock options?
None of the above, according to a new study by researchers from three Canadian universities.
They argue that the biggest risk factor for fraud is a CEO with a truly oversized ego.
An academic review of 15 Canadian corporate fraud cases between 1995 and 2005 suggests the list of common warning signs of potential fraud is missing the most important item - the extent to which the company's chief executive officer is lauded in the media or by analysts.
Michel Magnan, a business professor at Concordia University in Montreal and one of the authors of the report, argues that generous doses of external praise can lead an egotistical executive to start to believe his or her own press, creating hubris or an exaggerated sense of self-confidence that leads CEOs to believe they can do whatever they want and get away with it.
"In most of these cases, these companies and the executives involved were quite present in the media or closely followed by analysts - they were market darlings, so to speak," Prof. Magnan said in a recent interview.
"That was interesting, because you'd think fraudsters would like to hide or do things covertly, but that's not what we found," he added.
The study, co-authored by Denis Cormier of the Université du Québec à Montréal and Pascale Lapointe-Antunes of Brock University in St. Catharines, Ont., examined cases of alleged fraud or other wrongdoing at companies such as Bre-X Minerals Ltd., Cinar Corp., Hollinger Inc., Livent Inc., Philip Services Corp., Mount Real Corp. and YBM Magnex International Inc., among others.
It concluded that many of the companies and their top executives had ample positive media and analyst coverage before problems came to light, which the authors argue could serve as evidence the CEOs might have developed excessive hubris.
"In our view, such coverage translated into a higher sense of self-confidence or invulnerability among the executives," the study says.
Prof. Magnan said the research could be useful for regulators or auditors, who are taught to rely on a "fraud triangle" of factors that could help boost fraud detection at companies.
Those factors include the presence of ample incentives to commit fraud - such as large share ownership or stock option grants - as well as situations where a company's share price appears overvalued, putting pressure on executives to meet inflated expectations. Weak corporate governance practices are also considered a red flag.
The study concludes that while many of these red flags were present in the cases examined, such conditions are also present at a large proportion of companies in general and do not sufficiently narrow down a reasonable pool of dangerous situations.
"Red flags essentially morph into red herrings that may lead to numerous and unfruitful wild investigation chases," the report says.
The research even suggests that the appearance of good corporate governance could actually help executives get away with fraud by creating a cloak of respectability around CEOs. In seven of the 15 cases studied, the companies had boards with "star" directors who brought credibility to the board, the study notes.
Prof. Magnan acknowledged that it may be difficult for outsiders to identify executives who are dangerously egotistical, given that CEOs do not take public personality tests, and virtually every top executive has a healthy dose of self-confidence.
"But there is a tipping point where they fall into a state which is not ego any more, but it's like an illness," he said.
He said observers can look for clues in the external coverage of a CEO as well as his or her public comments and corporate decisions. The study suggests that external clues of hubris could be inconsistencies between an executive's statements and "observable facts or realities," outlandish claims, or a lack of concern for operational details.
Despite the study's conclusions, Prof. Magnan does not believe it is a bad sign when an executive receives positive media coverage or awards for his or her accomplishments. Nor, he says, was the study trying to prove there is truth to a common wry observation that an "executive of the year" award is a jinx that will be followed shortly afterward by news of financial problems at the company.
"But if you keep getting awards and awards and you start making decisions based on your own inflated self-image without rational arguments, it's a sign you're off track in some sense," he said.
'Red flags' of corporate fraud
A review of 15 corporate frauds in Canada between 1995 and 2005 found similar "red flags" were present in many of the cases. The study concludes the most important red flag is hubris, or irrational self-confidence by a top executive. These factors were present in many or all of the companies studied:
1. CEO an important or controlling shareholder.
2. Complex corporate or ownership structures.
3. Extremely active with mergers, acquisitions and divestitures.
4. Unique or uncommon business models or areas of operation.
5. Shares valued on unrealistic earnings expectations.
6. Executives had large incentives from shares or options, or the company was issuing shares to raise money.
7. Executives displayed evidence of extravagant lifestyles.
8. Evidence - only available after the fact - that executives rationalized improper behaviour with comments such as, "Everyone was doing it."
9. Executives had prior history of violating regulations or engaging in controversial business actions.
10. Majority of independent directors on the board (almost half of cases) had prominent "star" directors.
11. Audited by one of the "big four" audit firms during the time of the fraud.
12. Engaged prominent investment banking firms before or during the fraud.
13. Received ample positive analyst or media coverage, "which can have enhanced executives' self-confidence or arrogance and comforted them in their ability to engage in fraudulent activities without being caught."