Companies Accused of Fraud Have Fewer Independent Directors, Study in Financial Analysts Journal Finds.

CHARLOTTESVILLE, Va. -- As the proportion of independent, outside directors on a board and its oversight committees increases, the likelihood of corporate fraud decreases, according to a study of U.S. companies published in the June issue of Financial Analysts Journal, a research publication for investment practitioners worldwide published by CFA Institute.

But the study also found that, in general, companies that had a compensation committee of the board were actually more likely to commit or be accused of fraud - although, the fewer business or personal ties compensation committee members had with the company and its executives, the less likelihood there was of corporate fraud.

The study's authors - three professors from Long Island University, Drexel University in Philadelphia and University of Delaware - examined a sample of 133 companies accused of fraud between 1978 and 2001, and matched them with a sample of 133 companies of similar size and in the same industries that had not been accused of fraud. The researchers then looked for statistically significant differences in board member independence, board size, frequency of board meetings and other variables between the two groups of companies.

The researchers found that, compared to the non-fraud companies, companies accused of committing fraud:

--had a lower percentage of outside (non-executive) directors

--had a lower percentage of independent directors (directors with no business or personal ties to the company).

--were less likely to have an audit committee of the board

--were more likely to have a compensation committee of the board

--had a lower level of independence on its audit, compensation and nominating committees (measured by the percentage of directors on these committees with no business or personal ties to the company).

Noting that new rules by the New York Stock Exchange and NASDAQ require companies to have a majority of independent directors on their boards, the authors conclude, "Our results support this requirement and its underlying motivation. We found that a higher proportion of independent outside directors is associated with less likelihood of corporate wrongdoing."

And noting that the Sarbanes-Oxley Act instructs public corporations to create independent audit committees, the authors write, "Our findings support this requirement and the recent tightening of the definition of 'independent' by NYSE and NASDAQ."

The surprising finding that companies accused of fraud were more likely to have a compensation committee of the board is troubling, the authors write.

"The implication is that compensation committees have been ineffective in evaluating and properly rewarding the performance of top executives. They may also have designed compensation packages with dysfunctional incentives."

However, the composition of the compensation committee was a significant mitigating factor. The more that directors on the compensation committee were independent of any other business or personal ties with the company, the less likelihood there was of corporate fraud.

The researchers did not, however, find statistically significant differences between the fraud and no-fraud groups when they tested for:

--board size

--frequency of board meetings

--frequency of audit, compensation and nominating committee meetings

--whether a board had a nominating committee

--financial performance of the company

--the length of time that the CEO had served on the board

--whether the president or CEO also served as chairman of the board.

"These results suggest that the influence of the CEO on the board does not detract from its effectiveness in monitoring for fraud," the authors write.

The study was conducted and authored by:

--Hatice Uzun, assistant professor of finance at Long Island University, Brooklyn, New York;

--Samuel H. Szewczyk, an associate professor at Drexel University, Philadelphia;

--Raj Varma, professor of finance at the University of Delaware, Newark.

The authors are responsible for the facts and opinions presented in their paper. Their views are not necessarily the views of the Financial Analysts Journal or of CFA Institute.

The Financial Analysts Journal is a bimonthly research journal that publishes academically rigorous papers that have direct relevance to practitioners. It began publishing in 1945 and today is read by more than 70,000 securities analysts, portfolio managers and other investment practitioners in more than 100 countries.

Financial Analysts Journal is published by CFA Institute, the non-profit professional association that administers the 42-year-old Chartered Financial Analyst(R) curriculum and examination program worldwide and sets voluntary, ethics-based professional and performance-reporting standards for the investment industry

CFA Institute was known as the Association for Investment Management and Research (AIMR) from 1990 until May 2004. Headquartered in Charlottesville, Va., USA, it also has offices in London and Hong Kong. More information may be found at www.cfainstitute.org or by calling 1-800-247-8132 or 1-434-951-5499.