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Companies based in cities with less ethical cultures commit more financial misconduct

Chris Parsons Headshot

Chris Parsons

The likelihood that a firm will cook the books is heavily influenced by the ethical norms of the city in which it is headquartered.

That’s the conclusion of a recent Journal of Finance study by Chris Parsons, the Joshua Green Family Endowed Professor of Finance and Business Economics at the University of Washington Foster School of Business.

Parsons and his co-authors ranked the incidence of financial misconduct cases involving public companies located in and around the 20 largest metro areas of the United States, noting a wide variation. For instance, corporate misdeeds are three times more likely to occur at firms headquartered in Dallas, St. Louis and Miami than at firms in Indianapolis, Seattle and Minneapolis.

These rates correlate closely with the general ethical culture of each city, which the researchers captured in an index that takes into account the behaviors of local business leaders, financial advisors, physicians, politicians—even spouses.

“A city’s ethical culture strongly predicts what public firms headquartered there will do,” Parsons says. “It tells us that we are a product of our environment.”

Establishing patterns

The study—co-written by Johan Sulaeman of the National University of Singapore and Sheridan Titman of the University of Texas at Austin—is simple in concept. “It’s a scatter plot, essentially,” Parsons says.

The first task was to populate the Y axis: corporate financial misconduct by city.

The researchers drew from a hand-collected database of nearly 13,000 cases of financial misconduct that were enforced by the Securities and Exchange Commission (SEC) and the Department of Justice (DOJ) between 1970 and 2010. This list is from a paper co-authored by Jonathan Karpoff, a professor of finance and the Washington Mutual Endowed Chair in Innovation at the Foster School.

The range of infractions is vast, including misrepresenting earnings, concealing relevant news, trading on proprietary information and spreading false rumors to depress the stock price of a takeover target.

When Parsons, et al, parsed these cases by the nation’s largest metro areas, they found dramatically different rates of corporate misconduct.

The midsection was occupied by firms headquartered in Boston, Orlando, Phoenix, Philadelphia and Detroit. Firms in Indianapolis, Seattle, Minneapolis and Cleveland had the lowest rates of financial misconduct. And firms in New York, Houston, Dallas, St. Louis and Miami had the highest rates of misconduct—roughly three times the rate of those in the cleanest cities.

But what explains these geographical variations?

Sleaze matters

The researchers examined the effects of ethical norms across a number of behaviors involving various white-collar peers.

“Social attitudes toward right and wrong may differ across cities,” Parsons says. “A given behavior may be frowned upon in Minneapolis, questionable in Phoenix and acceptable in Houston.”

To establish each city’s ethical benchmark, they calculated per capita rates of political corruption, fraud by financial advisors, backdating of executive stock options, unscrupulous financial relationships between doctors and drug companies, and spousal infidelity.

These measures intentionally included both illegal and merely unethical activities as a means of controlling for the effect of stricter law enforcement in some cities.

“Legal but unethical activities are probably more useful in our setting,” Parsons says. “Are they breaking any laws? No. They’re breaking a social contract.”

This data on these activities was carefully assembled. Political corruption rates derived from a DOJ report to congress. ProPublica’s “Dollars for Docs” website provided listings of pay-to-play relationships between physicians and the drug companies that court them to prescribe their medications. Option backdating data came courtesy of the Wall Street Journal and Dow Jones News Service. Financial advisor fraud was revealed in historical Form U4 filings that brokers, advisors and issuers of securities are required to submit to become registered. And spousal infidelity rates came from the widely publicized hack of the website Ashley Madison, exposing biographic information on 40 million users seeking extramarital affairs.

Stitching together these data sets, the authors created what’s termed in the paper the “Average City Rankings of White-Collar Misbehavior.”

Unofficially, Parsons calls it the “sleaze index.”

This index forms the X axis of that simple scatter chart. And the correlation between ethical culture on the X and financial behavior on the Y is unmistakable: incidences of corporate financial misconduct track closely to the ethical norms of the cities they call home.

Not causal, but predictive

Parsons stops short of declaring a causal connection. But there’s no denying the effect of a city’s ethical standards on the behavior of its corporate leadership.

He and his colleagues determined that ethical culture has more influence on financial misconduct than many other potential factors, including industry clustering, enforcement intensity, economic outlook or demographic factors such as average education, age and even propensity to practice religion across a city.

Cities exert a kind of ethical peer pressure based on what’s acceptable in many different kinds of behavior.

“The fundamental insight of our paper is that we’re all from somewhere,” Parsons says. “When you are in a city, you’re marinating in the average happiness, the average angst, the average outrage and the average ethical norms. This is not easy to measure. But we have shown that when a city is clean, it’s generally clean in every dimension. And when it’s dirty, it’s dirty in every dimension. We’re a lot more connected that you might think.”

The Geography of Financial Misconduct” was published in the October 2018 Journal of Finance.