Don't Get Burned by Smiling CEO Candidates

This article is adapted from "A Baseline of Executive Backgrounds," which appeared in the Winter 2002 issue of Directors & Boards magazine. The magazine's Web site is: www.directorsandboards.com. - ed. 

Applicants for top executive positions may have impressive résumés and reputations but extensive background investigations may uncover hidden, illegal activities that can hinder or destroy the organization.

When the Sunbeam Corporation board hired Al Dunlap as its CEO in 1996, it expected him to restructure the financially ailing company to profitability. Instead, it fired him 23 months later amid plummeting stock prices and allegations of fraud.

If the Sunbeam board had done a better job of checking into Dunlap's background it would have found that in the 1970s he was accused of similar fraud charges as president of Nitec Paper. Dunlap conveniently omitted all references to Nitec in the résumé he submitted to Sunbeam. But Sunbeam, which is currently in bankruptcy proceedings, could have easily found reports of his previous professional conduct on public electronic media archives.

According to the Securities and Exchange Commission (SEC), shareholder lawsuits related to the restatement of earnings grew 750 percent from 1992 to 1998. Directors' and officers' (D&O) insurance claims stemming from these complaints have surged in recent years, with some settlements exceeding $1 billion. A public company's greatest protection against these types of catastrophic losses is the integrity of its senior executives. Obviously, excessive misconduct poses a significant risk to any organization.

Organizations often overlook pre-employment screening programs as mitigating risk management tools. Screenings can assess a prospective employee's character, integrity, and historical conduct.

In-depth background investigations of executives often are costly if they go beyond readily available public records. Background investigations for CEOs or other top candidates can range from $5,000 to $20,000 depending on the number of leads. But given the compensation level of today's executives and the potential harm they can have on organizations, the benefits far outweigh the costs.

Boards of directors should approach the top candidate hiring process as they would any acquisition, joint venture, or other significant transaction involving company assets. Arguably, the risks in hiring a senior-level executive are greater than those of any transaction because there aren't any recoverable assets. Often, the companies won't conduct a background check because the candidate is well known in the business community. The resulting liabilities can be catastrophic. Therefore, nominating committees and boards should look under all stones when conducting executive background investigations.

Mitigating Exposure 

As a professional investigator, I've conducted dozens of executive background checks for corporate clients. Unfortunately, the vast majority of the work comes when a board has suspected an executive's misconduct after he or she has been hired. The general counsel, an outside law firm, the board, or some other senior management entity wants to investigate an executive suspected of financial statement fraud, inventory manipulation, embezzlement, bank fraud, or other malfeasance.

Because an employer ultimately is responsible for the conduct of its employees, it makes far more sense to conduct investigative checks prior to extending an employment offer to an executive candidate.

Preventive Measures 

According to the American Management Association, 31 percent of résumés contain material misstatements about a candidate's background. A recent study of inaccurate rÈsumÈs by the executive search firm Christian & Timbers ranked the most common misrepresentations:

• 71 percent misrepresent the number of years in a position.
• 64 percent exaggerate accomplishments.
• 60 percent exaggerate the size of the organization managed.
• 52 percent misrepresent educational degrees.
• 42 percent exaggerate compensation.
• 41 percent omit jobs entirely.

In my experience, these figures are actually conservative. Companies should at least conduct baseline checks on all potential employees, which includes reviewing and verifying:

• degrees, employment references, and dates of employment;
• consumer credit reports;
• drivers' histories;
• federal, state, county, and local criminal records for each geographic area in which the person has resided;
• bankruptcy filings; and
• liens and judgment filings.

In addition to the above list, companies checking on senior executives with fiduciary responsibilities should also conduct:

• media searches;
• professional license verifications and checks of disciplinary records (American Institute of Certified Public Accountants, state CPA societies, American Bar Association and state bar associations, National Association of Securities Dealers, etc.);
• telephone interviews of personal and professional references;
• investigations of financial disclosure forms;
• reviews of federal tax returns;
• checks of secretary of state records for outside business interests;
• reviews of SEC filings; and
• civil and criminal litigation searches for all entities disclosed or identified as a result of investigation.

Limitations 

For purposes of employment searches, there are limits as to how far back one can go in querying consumer credit histories and criminal records. However, according to the 1996 amendment to the Federal Fair Credit Reporting Act (FCRA), these "privacy laws," which vary from seven to 10 years depending on state law, are waived if the individual's salary is $75,000 or more.

While most pre-employment screening programs emphasize the checking of criminal records, white-collar crimes are frequently documented in other public record repositories such as civil dockets, lien and judgment filings, bankruptcy court, and media or other public record repositories in which there are no limitations as to how far back an investigator can examine a person's background.

Because we live in a litigious society, employers must weigh what the candidate was alleged to have done against the ultimate resolution in these cases. Simply being involved in litigation doesn't necessarily mean a person did anything illegal or unethical but hiring a person who has repeatedly defended against fraud allegations might be a risk. Employers should also be aware that some industries (i.e., real estate and construction) are more litigious than others and it's not unusual for executives in these fields to have been named in some lawsuits.

'Gumshoe' Work 

After fraud examiners have generated leads through public and nonpublic records, the "gumshoe" work begins: interviews of candidates' former legal adversaries, former coworkers, venture partners, former spouses, and other sources of potentially negative information. Executives don't become white-collar criminals overnight; they develop over time. They do things over the course of their professional career that are indicative of their future behavior. These interviews will provide a much better view of the character of executives beyond the public record. Prospective candidates should be evaluated on all information gathered in the course of the investigation.

Striking a Balance 

When conducting background checks on executive candidates, nominating committees and boards of directors must carefully consider a number of issues. Most companies lack in-house expertise so they must use outside firms. They must then decide whether to use pre-employment screening vendors or full-service investigative firms.

Typically, pre-employment screening companies perform cursory examinations of candidates' credentials and public records. It's low margin and high volume but it can be helpful for many employees and some executives.

An investigative firm often will have access to the full range of information that an employer will need to properly evaluate a top executive candidate with fiduciary responsibility. The retained firm should sign a confidentiality agreement and report directly to the board or a designate. During the investigation, the firm should immediately report any negative information to the board.

When considering an executive candidate, boards of directors should use the same standard of care as they would in approaching an acquisition, joint venture, or other significant expenditure of corporate assets. Would your board approve an acquisition based only on the acquisition target's reputation? Too often, such candidates - especially those who are known to the board - aren't held to the same level of due diligence scrutiny.

In the end, the ultimate responsibility for fully vetting a candidate's background is with the employer. The company and its shareholders will pay the price for hiring an ethically or criminally flawed executive.

Scott Moritz, CFE, is senior managing director of IPSA International Inc. in New York, N.Y.