The Audit Analytics Accounting Quality + Risk Matrix (AQRM) makes it easy to identify accounting, audit, and governance red flags for public companies. This blog series breaks down the risks associated with specific firm-level events included in the AQRM.
Red flag events concerning company insiders are important for understanding future risks. The overall quality and success of a company are related to its insiders and leadership. Shareholders and investors should pay particular attention to CEO and CFO turnover and insider pledged shares, as these events can pose a significant risk to the company.
CEO and CFO Turnover
Investors and stakeholders should always take note of changes in executives. CEOs and CFOs are directly responsible for a company’s tone-at-the-top and financial reporting. As a result, any change to the top leadership structure will inherently cause other operational changes.
Companies must publicly disclose changes in employment for certain named directors and officers in an 8-K Item 5.02 within five business days of the change. These disclosures make the information readily accessible. However, it can be difficult to use digital filings alone to piece together multiple disclosures to gain a bigger picture. Changes are often disclosed in different filings and the specifics of the changes may be located across multiple filings. As a result, it can be very challenging to manually track CEO and CFO turnover. Additionally, tracking changes through artificial intelligence (AI) or automatic data extraction may not capture the nuance involved. However, monitoring executive turnover is an important aspect of understanding associated risks.
In general, researchers have found that executive turnover has a negative correlation to firm performance. CEO turnover, in particular, is associated with abnormal returns around the time of the announcement, having a direct impact on firm operations and shareholder wealth.
Both CEO and CFO changes are a red flag for accounting quality concerns and financial reporting issues. Researchers have positively associated CEO turnovers with earnings management practice. They have also positively linked CFO turnover with firms that have weak internal controls.
In addition, there is a relationship between executive turnover and audit fees. However, the nature of the impact depends on the circumstances of the departure. The forced ousting of a CEO can result in increased audit fees due to the perceived increased risk associated with an involuntary dismissal. Alternatively, CFO turnover after a material restatement can mitigate the increase in audit fees that typically follows a restatement.
Sudden, unplanned executive turnover, even if not a dismissal, is a red flag. An executive turnover can signal underlying firm issues with corporate governance and/or accounting quality issues.
For an example of what executive turnover could indicate, consider Under Armour. Between 2015 and 2019, Under Armour appointed three different CFOs; in 2019, the founder and CEO suddenly stepped down. There were numerous allegations of tone-at-the-top issues. However, two weeks after the CEO stepped down, more severe news broke out. The company was under federal investigation due to revenue management practices and disclosure violations dating back to 2015. Under Armour eventually settled these charges with the SEC in 2021.
While this is an extreme case, the executive turnover at Under Armour, particularly the sudden resignation of the founder without a succession plan in place, was a significant red flag. This red flag exposed unresolved issues and it indicated an increase in risk across a lengthy timespan.
Pledged Securities
Another red flag for corporate governance concerns is when company insiders take actions such as pledging company shares as collateral. The practice of pledging company shares can influence management decisions and negatively impact share price.
The SEC requires disclosure about securities pledged by certain beneficial owners and directors to indicate – “by footnote or otherwise” – the number of ownership shares that have been pledged. Companies often inconsistently disclose this information in either a 10-K or in their proxy, and they often bury the information in a footnote to a complicated table full of numbers. As a result, the information is difficult to both find and decipher. However, due to the heightened risks the practice poses to the company, one cannot overlook the existence of a company insider’s pledge shares.
In general, insider pledging corresponds with a significant increase in business risk, despite unchanged firm fundamentals. The ISS has denounced the practice as a wholly irresponsible use of company equity.
Pledged shares exposed to a margin call could force the insider to sell their shares or forfeit a substantial holding. This selling or forfeit could lead to a significant change in ownership and possibly even violate insider trading policies. These consequences incentivize corporate decisions that benefit the insider with pledged shares and not necessarily the firm as a whole.
Shares pledged as collateral that are exposed to a margin call can drastically depress the stock price if the stock is subsequently sold into the market.
For example, the stock price of Inovio Pharmaceuticals [INO] dropped significantly after a broker called a margin loan in 2019 and commenced selling shares pledged by the CEO to satisfy the loan obligation. Inovio’s declining stock price initially triggered the margin call, and then selling the shares had a further negative impact.
As seen with Inovio, an insider pledging shares can be a way to benefit from the capital of owning company shares without needing to sell them, but there are significant risks associated with this practice.
A final risk associated with share pledging includes insiders pledging shares as a part of a monetization or hedging strategy to protect themselves from negative economic exposure, indicating a latent risk for investors.
Interested in our content? Be sure to subscribe to receive our email notifications.