Getting Paid When the Books Are Cooked: CEO Initial Compensation in the Aftermath of Financial Misconduct

With the increase in uncertainty during disruptive times, the focus on firm-level wrongdoing is ever more evident. Firm-level misconduct, such as financial fraud, restatement issues, or other similar harmful activities, affects not only the firm itself but also various internal and external stakeholders. Following large scale examples such as Enron (Fazrad,2005) and, more recently, Volkswagen, there is a need to emphasise further the knowledge on corporate governance responses to resolve the matter (König, et al., 2020). This paper looks at a typical corporate governance response, replacement of the CEO, through new lenses. Replacing the CEO can result from firms engaging in scapegoating by the board of directors to find and signal a change following firm-wide misconduct (Buyl, et al., 2015). Nevertheless,in most cases, the CEO is knowingly aware of the matter (Beasley, et al., 2010), meaning that a replacement of the CEO is the appropriate decision to resolve the misconduct issues. The paper combines aspects from the literature on executive pay (Jensen & Murphy, 1990; Moriarty, 2005), particularly focusing on the initial remuneration (Graffin, et al., 2013; Graffin, et al., 2020; Chen, 2015) with financial fraud literature. The latter area has attracted interest from multiple fields such as strategic management (Koch-Bayram & Wernicke, 2018; Park, et al., 2020; Castro, et al., 2020), accounting & finance (Li, et al., 2020) and international business(Bahoo, et al., 2020; Cuervo-Cazurra, 2016; Cuervo-Cazurra, 2006). The paper shows that a new CEO entering a firm in a post-misconduct regime faces higher job demands than CEOs taking over a firm without misconduct. The added complexity and job demands lead to higher initial pay for the new CEO in a post-misconduct situation. By utilising a dataset on executive compensation and data on firms violating the US Security and Exchange Commission’s laws (SEC) (Dechow, et al., 2011), we show empirical support for our main hypothesis regarding a larger compensation package in a post-financial misconduct context. We further test for various moderating factors.