Board Composition and Corporate Fraud

Hatice Uzun, Samuel H. Szewczyk, and Raj Varma

The study reported here examined how various characteristics of the board
of directors and other governance features affected the occurrence of U.S.
corporate fraud in the 1978–2001 period. The findings suggest that board
composition and the structure of a board’s oversight committees are
significantly correlated with the incidence of corporate fraud. In the sample,
as the number of independent outside directors increased on a board and in
the board’s audit and compensation committees, the likelihood of corporate
wrongdoing decreased.

T
he recent high-profile accounting scandals
at Enron Corporation, WorldCom, and
numerous other companies have led to
much attention on reforms that can reduce
accounting and other types of corporate fraud. A
particularly important regulatory response was the
passage of the Sarbanes–Oxley Act of 2002, widely
regarded as the most extensive U.S. federal law
related to corporate governance since the imple-
mentation of the federal securities laws in 1933 and
1934. Another important response was the require-
ment that companies whose stock is traded on the
NYSE or listed on Nasdaq meet various corporate
governance provisions. The Sarbanes–Oxley Act
and the NYSE and Nasdaq proposals impose sev-
eral governance provisions on publicly traded com-
panies in the United States, and a significant
stipulation is improved oversight by the company’s
independent directors.
We examined how various characteristics of
the board of directors and a company’s other gov-
ernance features affect the occurrence of corporate
fraud at the company. A significant amount of
research has accumulated in recent years on the
oversight role of corporate boards with regard to
their fiduciary duty to act in the best interest of a
corporation’s shareholders. Despite extensive cov-
erage in the popular press, however, board over-
sight in companies that commit corporate fraud has
received limited attention among academics.
Moreover, most of the attention has been focused
on boards of directors at companies that commit
financial statement fraud (specifically, on the role
Hatice Uzun is assistant professor of finance at Long
Island University, Brooklyn, New York. Samuel H.
Szewczyk is an associate professor at Drexel University,
Philadelphia. Raj Varma is professor of finance at the
University of Delaware, Newark.
of the audit committee of the board). In contrast,
our study focused on whether the composition of
the board and of its oversight committees—audit,
compensation, and nominating—are significantly
related to corporate fraud.
Sample
To conduct our investigation, we constructed a
database for a sample of companies that were
accused of committing fraud during the period 1978
through 2001. We also constructed an industry- and
size-matched control sample of companies that
were not accused of committing fraud. For both
samples, we collected data on the board of directors
and other governance attributes.
Sample Selection. Press announcements of
corporate fraud were collected from the “Crime—
White Collar Crime” or “Fraud” listings in the
general news section of the Wall Street Journal Index
for 1978 through 2001. Articles in the Wall Street
Journal were used to determine when the fraud was
first publicly announced. We selected occurrences
of fraud that met the definitions of the four types
of fraud established by Karpoff and Lott (1993).
They classified frauds as fraud of stakeholders,
fraud of the government, financial reporting fraud,
and regulatory violations.
Fraud of stakeholders occurs when the company
cheats (in our study, we also included accusations
of cheating) on implicit or explicit contracts with
suppliers, employees, franchisees, or customers
other than the government. The following are exam-
ples: Spectrum Information Technologies, a wireless
data technology company, was indicted of defraud-
ing about 50 companies of more than $6 million
between 1988 and January 1994 (WSJ 24 March
1995).1 Sears, Roebuck & Company was indicted for
overcharging automobile repair customers. Sears

May/June 2004 33
Financial Analysts Journal
overcharged almost 90 percent of the time, and it
pressured repair personnel to overcharge by setting
punitive sales quotas (WSJ 12 June 1992). Sloans
Supermarkets was charged by U.S. federal prosecu-
tors for operating a coupon scam that defrauded
manufacturers of at least $3.5 million over 10 years
(WSJ 15 March 1993).
Fraud of government occurs when the company
cheats (or is accused of cheating) on implicit or
explicit contracts with a government agency. Most
government fraud in our sample involved defense
contracts. For example, in 1982, General Research
Corporation was indicted for allegedly conspiring
to defraud the U.S. Army in the award of a com-
puter software contract (WSJ 15 March 1982). Fre-
quency Electronics was accused in 1993 of
overcharging the U.S. Defense Department on a
contract (WSJ 19 November 1993). In another
famous case, Rockwell International Corporation
was investigated in 1985 for improperly charging
the Defense Department for “overhead items such
as entertainment and public relations” on military
contracts (WSJ 29 October 1985). Other examples
are the indictment of Genisco Technology Corpo-
ration for defrauding the government in connec-
tion with contracts to build parts for strategic
weapons systems (WSJ 25 March 1988) and the
government’s allegation, in 1986, that TRW Inc.
fraudulently misstated labor and material costs on
subcontracts for making and supplying military
aircraft parts and equipment (WSJ 24 June 1986).
Frauds of financial reporting take place when
agents of the company misrepresent (or are accused
of misrepresenting) the company’s financial condi-
tion. For example, in 1990, ATI Medical misrepre-
sented its financial condition to inflate its stock
price and make it an attractive merger candidate
(WSJ 27 March 1990). Circle Express was charged
with conspiring to misstate financial information
for 1986 and 1987 first-quarter earnings (WSJ 16
April 1990). Endotronics shareholders sued the
company and its manager for allegedly issuing
“fraudulent financial and operating reports” to
inflate the price of its common stock (WSJ 5 March
1987). In another well-known case, Crazy Eddie
and its chairman were sued in 1990 for engaging in
a “massive financial fraud” to overstate the com-
pany’s earnings over a three-year period (WSJ 24
January 1990).
Regulatory violations, the last type of corporate
fraud, include frauds involving violations of regu-
lations enforced by federal agencies. In the sample,
we considered the following illegal activities to be
regulatory violations: bribery or illegal payments,
employee discrimination, environmental pollu-
tion, antitrust law violation, price fixing, and false
advertising. For example, in a well-publicized case,
34
E.F. Hutton & Company pleaded guilty in 1985 to
a large check-kiting scheme involving banks in
New York State (WSJ 3 May 1985). In 1986, PepsiCo
was indicted on charges of conspiring to fix soft-
drink prices in Virginia and obstructing a federal
grand jury investigation of the alleged antitrust
violations (WSJ 29 October 1986).
After identifying cases of fraud, we matched
each “fraud company” with a “no-fraud” counter-
part based on the fraud company’s industry and
size. We used the CRSP database to generate a list
of all companies that shared each fraud company’s
two-digit SIC code. Within the list of industry com-
panies, we selected the matched no-fraud company
as the company whose market value of equity was
closest to that of the fraud company on the last day
of the month preceding the announcement of cor-
porate fraud.
This procedure resulted in a sample of 133 pairs
of fraud and no-fraud companies matched by indus-
try and size for which we were able to obtain proxy
statements for all the companies. The sample con-
sisted of 24 pairs of frauds of stakeholders, 38 pairs
of frauds of government, 28 pairs of financial report-
ing fraud, and 43 pairs of regulatory violation.
Statistical Description of Sample. Means,
medians, and pairwise comparisons (fraud vs. no-
fraud companies) for various characteristics of the
board of directors are in Table 1. The matched pairs
of the pairwise comparisons varied from 30 to 133
depending on the availability of data. The pairwise
differences in board composition show that differ-
ences in board size and percentages of inside direc-
tors, outside directors, independent directors
(outside directors who have no affiliation with the
company other than being on the board), and
“gray” directors (outside directors who have some
nonboard affiliation with the company) are statis-
tically different from zero. On average, fraud com-
panies in this sample had larger boards, a higher
percentage of inside directors on the board, and a
higher percentage of gray directors. No-fraud
matching companies had a higher percentage of
outside directors that were independent.
The pairwise differences in audit committees
show that no-fraud companies, on average, had a
significantly higher percentage of outside direc-
tors and a higher percentage of independent out-
side directors. The fraud companies, however,
had a higher percentage of gray directors on the
audit committee.
No-fraud companies in the sample also had a
significantly higher percentage of outside direc-
tors on both the compensation committee and the
nominating committee. Fraud companies had a
©2004, AIMR®
 Board Composition and Corporate Fraud

Table 1. Statistical Description of Board and Committees: Fraud vs. No-Fraud Companies, 1978–2001
Mean Median
Category Fraud No-Fraud p-Value Fraud No-Fraud p-Value
Board composition
Board size (number) 11.27 10.54 0.06* 11.00 10 0.19
Inside directors (% of board size) 29.86 23.89 0.00*** 27.27 22.22 0.00**
Outside directors (% of board size) 69.61 76.13 0.00*** 72.73 77.78 0.00***
Independent directors (% of outside directors) 81.92 91.11 0.00*** 83.33 100.00 0.00***
Gray directors (% of outside directors) 18.17 8.76 0.00*** 16.67 0.00 0.00***
Meeting frequency (annual number) 7.14 6.90 0.49 6.5 6 0.34

Audit committee
Outside directors (% of members) 95.81 98.51 0.08* 100.00 100.00 0.05**
Independent directors (% of outside members) 81.66 94.72 0.00*** 100.00 100.00 0.00***
Gray directors (% of outside members) 18.34 5.28 0.00*** 0.00 0.00 0.00***
Meeting frequency (annual number) 3.04 3.14 0.70 3.00 3.00 0.64

Compensation committee
Outside directors (% of members) 92.68 96.13 0.03** 100.00 100.00 0.02**
Independent directors (% of outside members) 81.65 97.47 0.00*** 100.00 100.00 0.00***
Gray directors (% of outside members) 18.56 2.53 0.00*** 0.00 0.00 0.00***
Meeting frequency (annual number) 7.14 6.90 0.49 6.5 6.0 0.34

Nominating committee
Outside directors (% of committee members) 81.65 89.85 0.03** 85.71 100 0.04**
Independent directors (% of outside committee members) 78.90 96.94 0.01*** 92.85 100 0.01***
Gray directors (% of outside members) 21.10 3.06 0.00*** 7.14 0.00 0.00***
Meeting frequency (annual number) 2.08 2.04 0.59 2 2 0.83
Notes: The variables on board composition, board size, board committees, and number of board and committee meetings were obtained
from proxy statement with filing dates just prior to the first announcement of corporate fraud. Significance of the mean of the pairwise
differences is based on a t-test; significance of the median of the pairwise differences is based on a Wilcoxon signed test.
*Significant at the 10 percent level.
**Significant at the 5 percent level.
***Significant at the 1 percent level.

significantly higher percentage of gray outside
directors on both committees. Pairwise differences
show no significant difference in the frequency of
board meetings or meetings of audit, compensa-
tion, and nominating committees.
Overall, the pairwise comparisons suggest that
systematic differences between fraud companies
and no-fraud matching companies are apparent in
certain characteristics of the boards of directors.
These univariate comparisons should be viewed
with caution, however, when making inferences
about the connection between governance attributes
and corporate fraud. The pairwise tests implicitly
assume that other potentially relevant company
characteristics are fixed, which may not be the case.
For this reason, we used a logit regression to test our
hypotheses in a multivariate framework.2
Hypotheses
The hypotheses we tested entailed discovering the
relationship between fraud and board composi-
tion, board size, board chair, committee structure,
and frequency of board or committee meetings.
Board Composition. First, the standard view
among governance experts is that board indepen-
dence is a necessary condition for effective gover-
nance. Fama (1980) and Fama and Jensen (1983)
suggested that the board’s effectiveness in monitor-
ing management is a function of the mix of insiders
and outsiders who serve on the board. Consistent
with this monitoring argument, Weisbach (1988)
reported a higher correlation between CEO turn-
over and company performance for companies in
which outsiders predominated on the board of
directors than for companies in which insiders pre-
dominated. Rosenstein and Wyatt (1990) also
found that the addition of another outside director
to the board increased firm value. Brickley, Coles,
and Terry (1994) found that the average stock mar-
ket reaction to announcements of poison pills is
positive when the board has a majority of outside

May/June 2004 35
Financial Analysts Journal
directors and negative when it does not. Both these
findings are consistent with the premise that out-
side directors represent shareholder interests.
When corporate fraud is uncovered or alleged,
the company faces substantial reputational costs
(Karpoff and Lott), which could affect the reputa-
tions of the company’s outside directors in the mar-
kets for their work or services. Bhagat, Brickley,
and Coles (1987) and Fama and Jensen argued that
reputational concerns and fear of lawsuits can
motivate outside directors to represent the interests
of shareholders. Beasley (1996) examined whether
a larger proportion of outside members on the
board of directors and certain characteristics of
outside directors affect the likelihood of financial
statement fraud. Using a logit regression analysis
of 75 fraud and 75 no-fraud companies, he found
that the inclusion of outside members on the board
of directors increases the board’s effectiveness at
monitoring management for the prevention of
financial statement fraud.
We expected that if having a higher percentage
of outside directors on the board of directors
increases its effectiveness as a monitor of manage-
ment, the following hypothesis would be true:
Hypothesis 1. The percentage of outside direc-
tors on the board of directors is lower for fraud
companies than for a matched sample of no-
fraud companies.3
Second, some so-called outside directors may
have business (actual or potential) or family ties to
management and are thus less likely to monitor
management (Kosnick 1987). Therefore, as in pre-
vious studies (Hermalin and Weisbach 1988; Shiv-
dasani 1993; Vicknair, Hickman, and Carnes 1993;
Fama; Fama and Jensen), we classified outside
directors as independent or gray. Examples of gray
outside directors are lawyers, investment bankers,
consultants, executives of advertising agencies,
former employees, and family members. Given
their business or family ties to the company, gray
directors are less likely to monitor managers than
truly independent directors. Consequently, we
expected a higher percentage of independent direc-
tors to be associated with greater effectiveness of
the board as a monitor of management. We tested
the following hypothesis.
Hypothesis 2. The percentage of independent
directors on the board of directors is lower for
fraud companies than for a matched sample of
no-fraud companies.
B o a r d S i z e . Lipton and Lorsch (1992) and
Jensen (1993) observed that when corporate boards
expand beyond seven or eight people, they are less
likely to function effectively as a curb on manage-
36
ment and are easier for the CEO to control. Holth-
ausen and Larcker (1993a, 1993b) suggested that
board size can influence executive compensation
and company performance. They reported a posi-
tive relationship between board size and the value
of CEO compensation, but they failed to find con-
sistent evidence of an association between board
size and company performance. Yermack (1996),
however, presented evidence that small boards of
directors are more effective than large boards.
Using Tobin’s q as an approximation of market
valuation, he found an inverse relationship between
board size and firm value in a sample of 452 large
U.S. industrial corporations between 1984 and 1991.
Therefore, we tested the following hypothesis:
Hypothesis 3. The size of the board of directors
is larger for fraud companies than for a
matched sample of no-fraud companies.
Board Chair. Mintzberg (1983) noted that the
company CEO is inevitably the single most power-
ful individual in the whole system of power in and
around the organization. The board has a significant
role in the process of hiring, firing, evaluating, and
compensating the CEO, but in many companies, the
CEO also serves as chair of the board. The chair can
exercise significant control over the board through
his or her power to set the board’s agenda. Jensen
argued that the CEO cannot perform the chair’s
monitoring function apart from his or her personal
interest. Therefore, separating the chair from the
CEO/president position may be important if the
board is to be an effective monitoring device. In this
connection, we tested the following hypothesis:
Hypothesis 4. Boards of directors of fraud com-
panies are more likely to have a CEO/president
who serves as chair than are boards of directors
of a matched sample of no-fraud companies.
Committee Structure. Board committees are
assuming an increasingly important role in the
monitoring and governance of corporations. Audit
committees are responsible for overseeing the
financial reporting process and ensuring the objec-
tivity of the external audit. Compensation commit-
tees evaluate the performance of senior managers
and determine the nature and amount of all com-
pensation for senior officers of the company. The
compensation committee can alleviate agency
problems by constructing and implementing incen-
tive and bonus schemes that are designed to align
the goals of senior managers and shareholders.
Nominating committees review information
assembled for the purpose of selecting candidates
for nomination to membership on the board. They
are central to the effective functioning of the board
©2004, AIMR®

over time. Indeed, new director and board commit-
tee nominations are among a board’s most impor-
tant long-term functions.
Klein (1998), analyzing the committee struc-
ture of boards and the role of directors on the
committees, found that committee structures with
specialized roles enhance the board’s productivity
and efficiency. Beasley examined whether the pres-
ence of an audit committee is associated with a
reduced likelihood of fraudulent behavior. His
results suggest that audit committees do not signif-
icantly reduce the likelihood of financial statement
fraud. Beasley, Carcello, Hermanson, and Lapides
(2000), however, studied financial statement frauds
during the late 1980s through the 1990s in three
volatile industries (technologies, health care, and
financial services) and were able to highlight cor-
porate governance differences between fraud com-
panies and no-fraud companies on an industry-by-
industry basis. They found that fraud companies in
the technology and health care industries have
fewer audit committee meetings and that fraud
companies in all three industries have less internal
audit support.
Laws, regulations, and recent developments
recognize the important roles that internal monitor-
ing committees—audit, compensation, and nomi-
nating committees—play in corporate governance
and oversight. They also recognize that effective
monitoring requires that committees be indepen-
dent of management. The Sarbanes–Oxley Act of
2002 requires public companies to create an inde-
pendent audit committee from its board of direc-
tors. The NYSE, since 1978, has required registrants
to have an audit committee made up wholly of
independent outside directors. Recently, the NYSE
has proposed that listed companies have compen-
sation and nominating committees also and that
each be composed solely of independent directors.
The American Law Institute and the Business
Round Table also advocate that audit, compensa-
tion, and nominating committees comprise solely
directors who are independent from management.
To uncover the relationship between the exist-
ence and independence of board committees and
the likelihood of corporate fraud, we tested the
following hypotheses:
Hypothesis 5. Boards of directors of fraud com-
panies are less likely to have an audit commit-
tee than boards of directors of a matched
sample of no-fraud companies.
Hypothesis 6. Boards of directors of fraud com-
panies are less likely to have a compensation
committee than boards of directors of a
matched sample of no-fraud companies.
May/June 2004
Board Composition and Corporate Fraud
Hypothesis 7. Boards of directors of fraud com-
panies are less likely to have a nominating
committee than boards of directors of a
matched sample of no-fraud companies.
Hypothesis 8. Monitoring committees have a
lower percentage of independent directors for
fraud companies than for a matched sample of
no-fraud companies.
F r e q u e n c y o f B o a r d a n d C o m mi t t e e
M e e t i n g s . On the one hand, Lipton and Lorsch
and Byrne (1996) argued that boards that meet
frequently are more likely to perform their duties
diligently and in accord with shareholders’ inter-
ests. On the other hand, Jensen pointed out that
board meetings are not necessarily useful because,
given their limited time, they cannot be used for
meaningful exchange of ideas among directors or
with managers. Vafeas (1999) examined the associ-
ation between board activity (measured by the fre-
quency of meetings) and corporate performance.
He found that one way in which boards react to
poor performance is by increasing the frequency of
board meetings. He also found that frequent board
meetings are followed, in turn, by enhanced oper-
ating performance. Overall, his results suggest that
board activity as measured by meeting frequency
is an important dimension of board operations.
When Beasley et al. examined the relationship
between frequency of audit committee meetings
and likelihood of financial statement fraud, they
found that fraud companies have fewer audit com-
mittee meetings.
We examined these issues by testing the fol-
lowing hypotheses:
Hypothesis 9. Fraud companies have fewer
board meetings than a matched sample of no-
fraud companies.
Hypothesis 10. Fraud companies have fewer
audit, compensation, and nominating commit-
tee meetings than a matched sample of no-
fraud companies.
Regression Variables
Definitions of variables and the models we used in
the logit regressions to test the hypotheses are sum-
marized in Exhibit 1. The dependent variable
(FRAUD) in each regression was a dummy variable
that indicated whether or not fraud was present in
the company. The dummy variable took a value of
1 when a company was alleged to have committed
fraud and a value of 0 otherwise. Data on board and
committee composition, board size, and frequency
of board and audit, compensation, and nominating
committee meetings came from proxy statements
with filing dates just prior to the first announcement
of fraud.
37
Financial Analysts Journal

Exhibit 1. Logit Regression Models

Variables
Independent variables of interest
%OUTSIDE = percentage of the board members who were not currently officers of the company.
%IND = percentage of outside directors who were considered to be independent.
BSIZE = total number of directors.
BOSS = a dummy variable with a value of 1 if the chair of the board held the managerial position of CEO or president
(value of 0 otherwise).
AUD = a dummy variable with a value of 1 if the company had an audit committee (value of 0 otherwise).
COM = a dummy variable with a value of 1 if the company had a compensation committee (value of 0 otherwise).
NOM = a dummy variable with a value of 1 if the company had a nominating committee (value of 0 otherwise).
%AOUT = percentage of outside directors on the audit committee.
%COUT = percentage of outside directors on the compensation committee.
%NOUT = percentage of outside directors on the nominating committee.
%AGRAY = percentage of outside directors on the audit committee who were considered to be gray.
%CGRAY = percentage of outside directors on the compensation committee who were considered to be gray.
%NGRAY = percentage of outside directors on the nominating committee who were considered to be gray.
BFREQ = number of meetings held by board of directors annually.
AUDFREQ = number of meetings held by audit committee annually.
COMFREQ = number of meetings held by compensation committee annually.
NOMFREQ = number of meetings held by nominating committee annually.

Control variables
CEOTEN = number of years the CEO had served as a director.
PPER = a dummy variable with a value of 1 if the company reported at least three annual net losses in the six-year period
preceding the first year of corporate fraud (value of 0 otherwise).
INST = percentage of the company’s outstanding shares owned by institutional investors.

Models
Model 1
FRAUDi = α + β1%OUTSIDEi + β2%INDi + β3CEOTENi + β4PPERi + β5INSTi + εi

Model 2
FRAUDi = α + β1%OUTSIDEi + β2%INDi + β3BSIZEi + β4BOSSi + β5BFREQi + β6CEOTENi + β7PPERi + β8INSTi + εi

Model 3
FRAUDi = α + β1%OUTSIDEi + β2%INDi + β3AUDi + β4COMi + β5NOMi + β6CEOTENi + β7PPERi + β8INSTi + εi

Model 4
FRAUDi = α + β1%OUTSIDEi + β2%INDi + β3%AOUTi + β4%AGRAYi + β5AUDFREQi + β6CEOTENi + β7PPERi + β8INSTi + εi

Model 5
FRAUDi = α + β1%OUTSIDEi + β2%INDi + β3%COUTi + β4%CGRAYi + β5COMFREQi + β6CEOTENi + β7PPERi + β8INSTi + εi

Model 6
FRAUDi = α + β1%OUTSIDEi + β2%INDi + β3%NOUTi + β4%NGRAYi + β5NOMFREQi + β6CEOTENi + β7PPERi + β8INSTi + εi

Independent Variables of Interest. The vari-
able %OUTSIDE includes all independent and gray
directors. Inside directors were the board members
who were current officers of the company. The
variable %IND indicates the percentage of the total
number of outside directors who were indepen-
dent. In the regression results, negative and signif-
icant coefficients on the variables %OUTSIDE and
%IND would support, respectively, H1 (the per-
centage of outside directors is lower for fraud com-
panies) and H2 (the percentage of independent
directors is lower for fraud companies).
A positive and significant coefficient for board
size (BSIZE) would support H3 (size of the board
is larger for fraud companies).
The variable BOSS (indicating whether the
chair of the board is also the CEO or president)
would support H4 (same CEO and president is
more likely in fraud companies) if the coefficient is
positive and significant.
To examine whether the presence and indepen-
dence of committees are associated with a reduced
likelihood of fraudulent behavior, we examined the
relationship between three committees and

38 ©2004, AIMR®

likelihood of fraud. The AUD, COM, and NOM
variables indicate the presence or absence of each
such committee. A negative and significant coeffi-
cient on those variables would support, respec-
tively, H5 (audit committees are less likely in fraud
companies), H6 (compensation committees are less
likely in fraud companies), and H7 (nominating
committees are less likely in fraud companies).
A negative and significant coefficient on the
variables %AOUT, %COUT, and %NOUT would
support H8 (monitoring committees in fraud com-
panies have a lower percentage of independent
directors). A positive and significant coefficient on
the variables %AGRAY, %CGRAY, and %NGRAY
would support H8.
As for the frequency of meetings, a negative
and significant coefficient on the variables BFREQ
(number of meetings held by the board annually)
and AUDFREQ, COMFREQ, and NOMFREQ
(number of meetings by the committees) would
support H9 (fraud companies have fewer board
meetings) and/or H10 (fraud companies have
fewer committee meetings).
Control Variables. Hermalin and Wiesbach
noted that an established CEO has relatively more
power than a new CEO. Therefore, we included
CEO tenure (CEOTEN) in the logit regressions to
control for differences in the length of the CEO’s
service on the board. Tenure was computed as
uninterrupted years on the board of directors
(Shivdasani). If CEO tenure increases the CEO’s
power on the board and reduces the board’s effec-
tiveness in monitoring for fraud, a positive coeffi-
cient should be found.
Bell, Szykowny, and Willingham (1991) noted
that poor financial performance increases the likeli-
hood of financial fraud. Therefore, we included the
variable PPER (poor performance) to control for
differences in financial performances between
fraud and no-fraud companies. We measured poor
financial performance in a manner similar to that of
DeAngelo and DeAngelo (1990), DeAngelo, DeAn-
gelo, and Skinner (1994), and Beasley. A positive
coefficient for the variable PPER would be expected.
Finally, institutional investors may play a sig-
nificant role as external monitors of corporate activ-
ity (Agrawal and Mandelker 1990). As large
investors with significant economic stakes, institu-
tional investors have more incentive to monitor
managers than do small investors (Shleifer and
Vishny 1986). McConnell and Servaes (1990)
reported a positive relationship between Tobin’s q
ratio (an approximation of the company’s growth
opportunities) and degree of institutional owner-
ship. Han and Suk (1998) also examined the effect
May/June 2004
Board Composition and Corporate Fraud
of institutional ownership on company perfor-
mance. They found that stock returns are positively
related to institutional ownership. Thus, we
included the variable INST to control for the exter-
nal monitoring by institutional investors. A nega-
tive coefficient would be expected for INST.
Empirical Results
The results of the logit regressions for the full sam-
ple of fraud and no-fraud companies are in Table 2.
The pairwise comparisons in Table 1 show system-
atic differences between fraud and no-fraud compa-
nies in composition and size of their boards. The
logit regressions found a strong association between
board composition and the likelihood of fraud.
Consistent with the hypotheses that the per-
centages of outside and independent directors are
lower for fraud companies than no-fraud compa-
nies (H1 and H2, respectively), Table 2 shows that
the coefficients for %OUTSIDE and %IND are
both negative and statistically significant. These
results indicate that the boards of companies that
have not committed fraud have a higher percent-
age of outside and independent directors than do
the boards of fraud companies. This finding is
consistent with Fama and with Fama and Jensen,
who argued that higher percentages of outside
and independent directors increase the effective-
ness of board oversight.
The coefficients for BSIZE and BFREQ are pos-
itive but not statistically significant. Therefore, we
cannot accept H3 or H9 that the size of the board or
the frequency of its meetings affects the effective-
ness of the board’s monitoring for fraud.
Although the coefficient for BOSS is positive,
as predicted, it is not statistically significant. We
cannot, therefore, accept H4 that companies that
commit fraud are more likely to have CEOs serving
as board chairs. Moreover, the tenure of the CEO
on the board (CEOTEN) is not a significant factor
in explaining the likelihood of corporate fraud.
Taken together, these results suggest that the influ-
ence of the CEO on the board does not detract from
its effectiveness in monitoring for fraud.
Table 2 also presents results for the structure of
the board’s committees. The coefficients for the
presence of the audit committee and the compensa-
tion committee are statistically significant but have
opposite signs. The coefficient for the presence of a
nominating committee is not significant and, there-
fore, does not support hypothesis H7 (fraud compa-
nies are less likely to have a nominating committee).
This result is not totally unexpected because the
monitoring function of a nominating committee is
not as direct or immediate as that of the audit and
compensation committees.
39
Financial Analysts Journal

Table 2. Logit Regression Results for Full Sample, Data for 1978–2001
(p-values in parentheses)
Variable Expected Sign Model 1 Model 2 Model 3 Model 4 Model 5 Model 6
Independent Variables
Board
%OUTSIDE – –0.037 –0.041 –0.043 –0.037 –0.041 –0.039
(0.00*** ) (0.00***) (0.00***) (0.00***) (0.00***) (0.0***)
%IND – –0.038 –0.040 –0.041 –0.013 –0.014 –0.024
(0.00***) (0.00***) (0.00***) (0.19) (0.14) (0.00***)
BSIZE + 0.033
(0.39)
BOSS + 0.499
(0.25)
BFREQ – 0.014
(0.74)
Committees
AUD – –1.503
(0.08*)
COM – 1.269
(0.04**)
NOM – 0.371
(0.23)
%AOUT – –0.011
(0.13)
%AGRAY + 0.047
(0.00***)
AUDFREQ – 0.043
(0.63)
%COUT – –0.000
(0.89)
%CGRAY + 0.057
(0.00***)
COMFREQ – 0.076
(0.28)
%NOUT – –0.005
(0.30)
%NGRAY + 0.098
(0.00***)
NOMFREQ – 0.106
(0.47)
Control Variables
CEOTEN + 0.004 0.004 0.009 0.003 0.010 0.005
(0.75) (0.75) (0.55) (0.80) (0.49) (0.71)
PPER + 0.266 0.351 0.439 0.403 0.178 0.144
(0.65) (0.56) (0.48) (0.50) (0.78) (0.82)
INST – 0.007 0.011 0.004 0.006 0.007 0.005
(0.27) (0.10) (0.47) (0.32) (0.31) (0.39)

Constant 5.729 5.150 6.454 4.091 3.205 4.447

(0.00***) (0.00***) (0.00***) (0.00***) (0.01***) (0.00***)
Note: The likelihood ratio statistic was computed to test the hypothesis that all the coefficients are simultaneously equal to 0.
*Significant at the 10 percent level.
**Significant at the 5 percent level.
***Significant at the 1 percent level.

40 ©2004, AIMR®

The coefficient for AUD is negative, as pre-
dicted by H5, so we found that the presence of an
audit committee is associated with a lower likeli-
hood of corporate fraud. The coefficient for the
percentage of outside directors on the committee
(%AOUT) is negative and not significant at the 10
percent level (although marginally significant at the
13 percent level). The coefficient for the percentage
of outside directors that are gray directors on the
audit committee, however, is significant and posi-
tive. These results indicate that a higher degree of
independence in the audit committee contributes to
lowering the likelihood of fraud (supporting H8).
Contrary to the prediction of H6, the coefficient
for COM is significantly positive. This result is
troubling because it suggests that the activities of
compensation committees are systematically dys-
functional and increase the likelihood of corporate
fraud. Comments in the press have pointed out
possible problems that could adversely affect or
even compromise the effectiveness of compensa-
tion committees. Roger W. Raber, chief executive of
the National Association of Corporate Directors,
commented that compensation committees are
“definitely more clubby” than they should be (NYT
18 December 2002, p. A1). He also noted, “They just
don’t have the rigor that we see with other commit-
tees, especially audit committees” (p. A1). The
director of a compensation consulting firm
observed, “Historically, it has been extremely rare
that a board would ever countermand, even ques-
tion, what the compensation committee decided to
do” (p. C8). And according to lawyers and share-
holder activists, shareholders find it very difficult
to challenge the board at shareholders’ meetings
and in court about the compensation package given
to the chief executive (p. C8). Executive compensa-
tion packages awarding lucrative stock options
have allegedly contributed to many current corpo-
rate ills, including fraud. In his 2002 testimony to
the U.S. Senate Banking Committee, Federal
Reserve Chairman Alan Greenspan asserted that
poorly structured options were a major contributor
to a climate of “infectious greed” in the 1990s and
created incentives that “overcame the good judg-
ment of too many corporate managers” (WSJ 17
December 2002, p. B3).
As shown in Table 2, however, the composition
of the compensation committee is a significant fac-
tor in the likelihood of corporate fraud. Although
the coefficient for percentage of outside directors
on this committee (%COUT) is insignificant, the
coefficient for percentage of outside directors on
the committee that are gray (%CGRAY) is positive
and significant (as predicted by H8). These results
indicate that the percentage of outside directors
May/June 2004
Board Composition and Corporate Fraud
may not be significant but the degree to which
those outside directors have business or personal
ties to the company or chief executive affects the
likelihood of fraud.
Other factors may also affect the indepen-
dence of the compensation committee. The direc-
tors on the committee frequently work with the
company’s personnel executives and with outside
consultants in developing compensation pack-
ages. These consultants may have other business
ties with the company and are often hired on the
recommendation of the chief executive. Moreover,
the compensation committee is not required to
disclose the experts with whom it consults in
designing the compensation package of the chief
executive (NYT 24 January 2002).
As reported in Table 2, the models that exam-
ined committee structure produced coefficients for
the frequency of committee meetings that are not
statistically significant. Consequently, the hypoth-
esis that fraud companies have fewer committee
meetings (H10) is not supported.
Finally, the results in Table 2 indicate that poor
financial performance (PPER) does not signifi-
cantly affect the likelihood of fraud. Interestingly,
the results also indicate that institutional investors
(INST) are not effective external monitors for cor-
porate fraud and are, therefore, no substitute for
effective internal monitoring.
Conclusions
The scandals at numerous high-profile companies
have led to public perception of a crisis in corpo-
rate governance, to subsequent passage of the
Sarbanes–Oxley Act, and to establishment by the
NYSE and Nasdaq of strengthened governance
requirements, including enhanced oversight by
independent company directors.
We examined how various characteristics of
the board of directors and board committees affect
the occurrence of corporate fraud. The results indi-
cate that board composition and the structure of its
oversight committees are significantly related to
the incidence of corporate fraud.
The new NYSE and Nasdaq rules require com-
panies to have a majority of independent directors
on their boards so as to “increase the quality of the
board and lessen the possibility of damaging con-
flicts of interest” (“Final Corporate Governance
Listing Standards” 2003, p 4). 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.
41
Financial Analysts Journal
The Sarbanes–Oxley Act instructs public cor-
porations to create an independent audit committee
from its board of directors. Since 1978, the NYSE has
required listed companies to have audit committees
also composed of independent directors. The NYSE
and Nasdaq now require companies to have a com-
pensation committee and a nominating committee
composed solely of independent directors. Our
findings support this requirement and the recent
tightening of the definition of “independent” by the
NYSE and Nasdaq. We found that the presence of
audit committees and compensation committees
and the independence of these committees are sig-
nificantly related to the occurrence of fraud. In par-
ticular, although independent outside directors
predominated on the audit and compensation com-
mittees, the presence of outside directors who were
not independent because they had business or per-
sonal ties to the company significantly increased the
likelihood of fraud in the sample.
Notes
1. References to articles in the Wall Street Journal (WSJ) and
New York Times (NYT) will be given in this form in the text.
2. Logit regression is used for testing choice-based samples,
which are constructed by sampling on a chosen variable
rather than sampling from the population at random. Our
one-to-one matching sample resulted in a choice-based
sample composed of equal numbers of matched fraud and
no-fraud companies. The sample differed from a randomly
selected sample because the occurrence of fraud is most
likely less than 50 percent in a population of companies. The
dependent variable in the logit regressions was dichoto-
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