Corporate Fraud

Journal of Corporate Finance 45 (2017) 401–427
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Journal of Corporate Finance

j o u r n a l h o m e p a g e : w w w. e l s e v i e r . c o m / l o c a t e /
jcorpfin
Corporate fraud and external social connectedness of

independent directors☆
Yu Flora Kuang ⁎, Gladys Lee
The University of Melbourne, Australia
a r t i c l e i n f o a b s t r a c t
Article history:
We examine the effects of independent directors' external social connectedness on
Received 20 January 2017
corporate fraud commission and detection. The results show that well-connected
Received in revised form 10 May 2017
independent directors do not affect the likelihood of fraud commission but significantly
Accepted 24 May 2017
Available online 29 May 2017 reduce the likelihood of fraud detection given occurrence of a fraud. In particular, with a
one-standard-deviation increase in independent directors' connectedness, the likelihood of
fraud detection reduces by
JEL code:
22.5%. We also find that the consequences of fraud commission faced by firms with well-
M410
connected independent directors are less severe as fraud remains undetected for a longer
Keywords:
period of time and fewer people are charged with fraud when independent directors are well
Corporate
connected. We further show that independent directors' connections to fraud firms
governance Fraud
commission Fraud
significantly increase a firm's propensity to fraud commission and the likelihood of fraud
detection detection is also higher. Overall, our results suggest that directors' personal networks have a
Social connectedness “dark side”. Regulators should be aware of unintended consequences associated with
directors' external social connections when considering how to prevent and detect
corporate fraud.
© 2017 Elsevier B.V. All rights reserved.
1. Introduction
Corporate fraud has devastating consequences: corporate empires collapse, market confidence erodes, the image of the
accounting profession is tarnished, and management and directors are fired, prosecuted, and incarcerated (Association of
Certified Fraud Examiners, 2014; Free and Murphy, 2015; PwC, 2014). Studies have advocated that having strong corporate
governance and promoting independent director supervision will effectively deter occurrence of the next corporate fraud
(Agrawal and Chadha, 2005; Beasley et al., 2000). However, an improved understanding of how independent directors
function to deter and detect fraud is essential (Davis and Pesch, 2013; Trompeter et al., 2012). The literature suggests that
corporate fraud often interplays with social connections (Free and Murphy, 2015). In this study we focus on external social
connectedness (i.e. networks outside the focal firm) of independent directors. In particular, we examine the influence of
independent directors' social connectedness on fraud commission and fraud detection, as well as on the consequences of
fraud.
☆ The authors would like to thank Jeffry Netter (the Editor) and an anonymous reviewer. The authors gratefully acknowledge the helpful comments of
Margaret Abernethy, Mary Barth, Steven Balsam, Neil Fargher, Anne Lillis, Stephan Hollander, Xinning Xiao, Reggy Hooghiemstra, Bo Qin, Chen Chen, Chung Yu
Hung, and Wen He. The authors also thank all the seminar and conference participants at the University of Melbourne and 2016 AFAANZ Annual Conference on
the Gold Coast for helpful comments. Yu Flora Kuang acknowledges the financial support from the 2016 Faculty Research Grant of the University of Melbourne.
⁎ Corresponding author.
E-mail addresses: flora.kuang@unimelb.edu.au (Y.F. Kuang), gladys.lee@unimelb.edu.au (G. Lee).
http://dx.doi.org/10.1016/j.jcorpfin.2017.05.014
0929-1199/© 2017 Elsevier B.V. All rights reserved.
146 Y.F. Kuang, G. Lee / Journal of Corporate Finance 45 (2017) 401–
146 427
Independent directors play a prominent role in implementing corporate fiduciary duty (Avci et al., 2017; Coles et al.,
2014). The literature argues that independent directors' external connectedness is indicative of their social influence and
capability (Beasley, 1996; Ferris et al., 2003). But it remains unclear whether independent directors' external connectedness
implies better monitoring. Independent directors may utilize their external social connections to improve accessibility to
information and bargaining power over management (He and Huang, 2011; Mizruchi, 1996; Mol, 2001). On the other hand,
social networking requires time, effort, and attention, which can potentially be detrimental to director monitoring efficacy. For
example, external connections impose greater demands on multitasking, thereby distracting directors and diminishing their
capacity to function effectively (Ahn et al., 2010). As well-connected directors may be over-committed externally, they devote
less time and effort to monitoring—and even overlook the signs of managerial opportunism, which provide CEOs opportunities
to engage in self-interested activities (Cashman et al., 2012; Ferris et al., 2003; Fich and Shivdasani, 2006; Shivdasani and
Yermack, 1999). Thus the overall effect of directors' external connectedness toward fraud commission is yet unclear.
With respect to fraud detection, despite their important role in providing oversight and uncovering corporate misdeeds,
independent directors have incentives to conceal corporate wrongdoings. This is because independent directors have to bear
huge losses in human capital and future wealth when fraud is detected (Fich and Shivdasani, 2007; Karpoff et al., 2008). Even
when independent directors are not actively involved in wrongdoings they still suffer from the adverse consequences of fraud
revelation because the exposure of fraud will tarnish their reputation as an effective monitor and ruin their reputation in the
director labor markets (Cowen and Marcel, 2011). Reputation has significant economic value in the socially connected
corporate world (Fombrun, 1996; Grey and Balmer, 1998; Shane and Cable, 2002). Compared to less connected directors,
directors who are externally better connected have greater career concerns and a larger proportion of their wealth depends
on their reputation, which is perceived by the markets (Kang, 2008; Weigelt and Camerer, 1988). The potentially significant
reputational loss concerns well- connected directors, which explains their incentives to utilize social connections and reduce
the likelihood of fraud detection. Prior work indeed shows that social connections are often employed as a means of
influencing the SEC enforcement actions and the legal justice system (Correia, 2014; Dorminey et al., 2012; Sutherland,
1944). We thus expect that, conditional upon fraud commission, well-connected independent directors will take advantage of
their social influence to minimize the likelihood of fraud detection. We further expect that there will be less severe
consequences following fraud detection in firms with well- connected directors.
We adopt a bivariate probit modelling approach and separately model fraud commission and detection (Wang et al., 2010;
Wang, 2013). Using a sample consisting of 17,688 observations from fiscal years 1999 to 2013, our results are consistent
with our expectations. We show that independent directors' external social connectedness has no significant association with
a firm's propensity of committing fraud, but well-connected independent directors are associated with a lower likelihood of
fraud detection given the occurrence of fraud. We perform further analyses to examine the effects of director connectedness on
consequences of fraud commission. We find that in firms with well-connected independent directors, fraud remains
undetected for a longer period of time and fewer people are eventually charged with fraud, suggesting that independent
directors' external connectedness is instrumental in minimizing the costs of fraud commission. In terms of economic
significance, a one-standard deviation increase in independent directors' connectedness decreases the likelihood of fraud
detection by 22.5%.
Next, we examine the effects of interlocking directorships in fraud firms on the fraud commission and detection processes.
We find that directorships to firms that are currently involved in fraud will significantly increase a firm's propensity to commit
fraud, which is in line with prior work showing that firm practices, including those potentially detrimental to firm value,
become “contagious” via interlocking directorates (Collins et al., 2009; Ertimur et al., 2012; Shropshire, 2010). Further, the
detection rate of fraud is higher in firms sharing interlocking directors with fraud firms, suggesting that regulators are likely
aware of possible fraud contagion and accordingly increase their scrutiny toward firms that share directorships with a
fraudulent firm. More importantly, after controlling for interlocking directorships to fraudulent firms, we still find that firms
with socially influential independent directors are associated with a lower likelihood of fraud detection.
One general concern in corporate governance studies relates to the potential endogeneity problem (Faleye et al., 2014;
Wintoki et al., 2012). In our study, the concern arises due to the existence of confounding factors other than director
connectedness that may explain fraud commission and detection. We perform a series of analyses to mitigate the
endogeneity concern, including employing a two-stage least squares (2SLS) estimation method and a propensity-score-
matching approach, exploring potential channels through which directors' social influence plays a prominent role in the
fraudulent processes, conducting analysis in a sample where selection issue is less of a concern, investigating how well-
connected directors would be affected once fraud is detected, and examining the robustness of the findings toward an array
of alternative explanations. Our conclusions are drawn on the basis of consistent findings.
This study makes several important contributions to the literature. First, it contributes to corporate fraud research by
examining the effects of independent directors' social connectedness in facilitating the development of fraud. In a related
study, Khanna et al. (2015) investigate how internal relationships between CEOs and directors within a firm relate to corporate
fraud. However, the effects of external social networks on corporate control system and fraud development are under-explored
in the literature. Networking outside the focal firm plays a vital role in all social and economic transactions; internal and
external social networks are subject to distinct economic costs and benefits (Kilduff and Tsai, 2003; Tian et al., 2011). We
extend Khanna et al. (2015) by considering independent directors' external connectedness while controlling for CEO-director
internal connections. Our work thus provides a more complete picture of the development of corporate fraud.
We also extend the literature on corporate governance. To the best of our knowledge, we are the first to examine the effects
of independent directors' social connectedness on corporate fraud. Our evidence demonstrates a potential cost a firm has to
consider
Y.F. Kuang, G. Lee / Journal of Corporate Finance 45 (2017) 401– 147
427 147
when appointing directors who are externally well connected. We show that rather than publicly revealing the wrongdoings
these directors possess a greater incentive to deter the detection of fraud. Furthermore, fraud perpetrated in firms with well-
connected directors are subject to less severe consequence, indicating that independent directors' self-interests adversely
affect the best interest of shareholders and even society (Adams and Ferreira, 2007; Brochet and Srinivasan, 2014; Duchin et
al., 2010).
Our study contributes to a stream of burgeoning literature that explores how personal social networks influence corporate
behavior and firm decisions (see Cohen et al., 2008; Engelberg et al., 2012, 2013; Uzzi, 1997; among others). Our findings
suggest that it is the connections to influential firms, such as those in a major market index, which matters the most in
explaining a firm's fraudulent behavior. In contrast, social connections to small firms do not exhibit any significant power in
explaining the occurrence of corporate fraud. In additional analysis, we show that both work-related and friendship ties of
independent directors have significant effects on fraud detection and thus provide further evidence that business is embedded
in various types of social networks. Our study thus represents a timely response to a recent call to examine the substantial
influence of social ties of independent directors (Tian et al., 2011).
We further provide evidence on the “burden of fame” that well-connected directors have to bear (Wade et al., 2006). When
a director becomes more externally and socially connected they are subject to greater potential reputational costs and career
damage once fraud is publicly exposed. Our results indeed show that such directors are faced with a dimming likelihood of
receiving board seats in another firm after fraud detection in the focal firm, supporting our argument that the reputational
costs are especially substantial for well-connected board directors.
Our study further adds to the interlocking directorate literature (Collins et al., 2009; Ertimur et al., 2012; Shropshire,
2010). We show that interlocking directorships facilitate the diffusion of corporate fraudulent practices. Our findings provide
practical implications to regulators. Recent years have witnessed regulators and institutional shareholders advocating a fully
independent board of directors as the “cure-all” for corporate failures (Avci et al., 2017; Solomon, 2013). We show that
externally well- connected independent directors want to avoid reputational losses and will deter the uncovering of corporate
fraud at its occurrence, thereby suggesting that merely increasing the representativeness of independent directors on board, in
particular those that are externally well connected, does not necessarily provide an optimal solution to curbing corporate
scandals.
The rest of the paper is organized as follows. Section 2 reviews related literature and develops our hypotheses. Section 3
presents our models, describes the construction of our sample, and provides variable definitions. In Section 4 we discuss our
main findings. Section 5 reports how we handle potential endogeneity issues and discuss the robustness of our results to
various checks. Section 6 concludes the paper.
2. Related literature and hypothesis

development
2.1. Related literature
2.1.1. Social connectedness and

fraud
Corporate fraud is a popular area that attracts multidisciplinary attention. Studies have examined a wide range of topics,
including: the motivations and means of fraudulent behavior (Cressey, 1953; Dorminey et al., 2012; Free and Murphy,
2015), the effects of individual traits (such as a variety of biological and psychological pathologies) on fraud (Andon et al.,
2015; Morales et al., 2014); corporate collusions and solo offending (Free and Murphy, 2015; Hochstetler et al., 2002; Van
Mastrigt and Farrington, 2011); the role of auditors and their techniques in deterring and detecting fraud (Bell and
Carcello, 2000; Carpenter, 2007; Cleary and Thibodeau, 2005; Skousen et al., 2009); regulation, enforcement regimes, and the
corporate internal control environment (Beasley, 1996; Beasley et al., 2000; Davis and Pesch, 2013).
The influence of social connectedness on corporate fraud is an emerging and important topic. Recent studies have
examined the effect of internal connections on corporate fraud. Free and Murphy (2015) document that organizational bonds
developed among employees within a firm can lead to parties in the firm colluding to perpetrate fraud. Another study by
Khanna et al. (2015) investigates how reciprocity that develops via appointment-based connections affects CEOs' opportunity
to commit corporate fraud. Khanna et al. find that directors and executives who are connected with the CEO of their own
firm are more likely to be subservient to the CEO, thereby increasing the propensity of fraud commission and decreasing the
likelihood of fraud detection. In these studies, the authors demonstrate that affective bonds developed through internal social
connections increase the opportunities for fraud to occur. We extend this literature and focus on external social connections.
Our interest in the effect of external social connections on corporate fraud is motivated by the literature that suggests
that internal and external social connections have different implications on firm practices. The premise in the literature
states that social connections facilitate information sharing and trust building (Baker, 2000; Cohen et al., 2008; Penrose,
1959; Putnam,
2000). Internal social connections between CEO and directors within a firm will foster the development of in-group
favoritism and potentially jeopardize the arm-length independence of quality supervision, thereby generating detrimental
effects on firm value (Bruynseels and Cardinaels, 2014; Fracassi and Tate, 2012; Hwang and Kim, 2009). In the context of
corporate fraud, internal social connections affect affective bonds developed within a firm that may reduce stringency of
monitoring or increase the potential to collude (Free and Murphy, 2015; Khanna et al., 2015).
In contrast, social networks outside focal firms are generally deemed to constitute a valuable organizational resource and
convey important strategic value to the firm (Butler and Gurun, 2012; Engelberg et al., 2013; Geletkanycz et al., 2001; Mizruchi,
1996). But the implications of external connections on corporate fraud are unclear. From a positive aspect, external social
148
connections 427
improve information sharing. The reduced information asymmetry may impose a self-disciplining mechanism and
thus reduce the likelihood
427 149
of deceit, deviance, and misconduct (Baker and Faulkner, 2004; Kilduff and Tsai, 2003). From a negative aspect, socially
influential people are often granted reputation, legacy, and credibility (Bitektine, 2011; Bromley, 2000). Self-interested individuals
may misuse the public credibility and admiration to conceal their wrongdoings, or even influence the molding of the justice
system in a self- serving way (Dorminey et al., 2012; Sutherland, 1940; Yu and Yu, 2011). The net effects of external
connectedness on corporate fraud remain inconclusive.
Our study is most closely related to Khanna et al. (2015) in that we examine the effects of social connections on both
fraud commission and fraud detection.1 We differ from Khanna et al. (2015) in that we focus on the external social
connectedness of independent directors. That is, while Khanna et al. (2015) examine connections between directors and CEO
within the firm, we examine the connections between independent directors' and parties outside the firm after controlling for
CEO-director internal connections. In so doing, we attempt to examine the development of fraud in a more complete model
and explain how the motivation and opportunities embedded in independent directors' external social connectedness relate
to the process of fraud development.
2.2. Hypothesis development
2.2.1. Fraud commission

The “fraud triangle” is often applied to model the development of fraud and states there are three conditions present
when- ever a fraud occurs: (1) an incentive or pressure that motivates fraud commission; (2) an opportunity to commit
fraud; and (3) the ability of fraudsters to rationalize and justify their fraudulent behavior (Cressey, 1953; Free and Murphy,
2015). Independent directors represent a countervailing force for managerial opportunism (Avci et al., 2017; Gordon, 2007;
Nguyen and Nielsen,
2010). Strong and high-quality supervision exercised by capable independent directors helps deter managerial opportunistic
behavior (Coles et al., 2014). Prior studies suggest that well-connected directors are in a better position to supervise because
they have superior information accessibility and a greater willingness to maintain independence (Beasley, 1996; Ferris et al.,
2003; Nicholson et al., 2004), implying a decreased opportunity for fraud to occur. Consequently, a lower likelihood of fraud
commission is expected when independent directors are better connected.
However, there is also a potential downside associated with independent directors' connectedness. Social connections have
to be “periodically renewed and reconfirmed or else they lose efficacy” (Adler and Kwon, 2002). Accordingly, independent
directors who are widely connected externally need to spend time participating in social activities in order to maintain the
“freshness” and “effectiveness” of their networks. That is, maintaining the efficacy of social networks results in reduced
directors' attention allo- cated to monitoring in the focal firm. Furthermore, well-connected directors have the potential to
over-commit to other boards and committee meetings. Studies suggest that well-connected directors are busy directors and
that director busyness is associated with poorer corporate governance, lower firm performance, and sub-optimal CEO
compensation design (Core et al., 1999; Fich and Shivdasani, 2006; Shivdasani and Yermack, 1999). Thus well-connected
directors may provide weaker quality of managerial oversight (Ahn et al., 2010). The reduced monitoring quality of busy-
connected directors suggests that directors who are well connected externally may overlook the signs of managerial
opportunism and provide the opportunity for corporate fraud to develop.
Taking account of both the positive and the negative association between directors' external connectedness and fraud
commission, we expect the hypothesis to be null and our hypothesis formally states that:
H1. Ceteris paribus, external connectedness of independent directors is not significantly associated with a firm's propensity
of fraud commission.
2.2.2. Fraud detection

As a form of intangible capital, reputation confers clear-cut advantages to corporate individuals in possession of the capital
(Fombrun, 1996). The economic value associated with reputation is especially amplified in a socially connected corporate world
(Cohen et al., 2008; Engelberg et al., 2013; Faleye et al., 2014; Shane and Cable, 2002). Independent directors may have an in-
centive to prevent fraud from being detected once it has occurred, as public exposure of fraud will damage their reputation as
an effective monitor and the directors have to bear huge losses and reputational costs (Cowen and Marcel, 2011; Fich and
Shivdasani, 2007; Karpoff et al., 2008). Such losses include losing their directorships in the focal firm as well as in other firms,
suffering reputational penalties, and facing a dimming likelihood of receiving directorships in the future (Fich and
Shivdasani, 2007; Karpoff et al., 2008). Even if independent directors are innocent of wrongdoings, they will still suffer from
the adverse consequences when fraud is revealed because the salience and ambiguity of corporate failures lead to the wide-
spread concerns in the markets of the (in)capability of the directors' supervision (Cowen and Marcel, 2011). The costs are espe-
cially high for well-connected directors because compared to less-connected independent directors, independent directors who
1
Our study is also related to two working papers. Intintoli et al. (2016) and Omer et al. (2016) both investigate the association between directors' external
connectedness and financial reporting quality where measures such as accounting accruals and restatements are used to infer the quality of reporting. While
both studies examine financial quality, we focus on fraudulent corporate misconducts and malpractices, a clearer signal of corporate malfeasance.
150 427
are widely connected externally have greater reputation, future wages, and credibility at stake (Kang, 2008; Weigelt and
Camerer, 1988).
Hence, given the occurrence of fraud, well-connected independent directors have greater incentives to reduce the likelihood
of fraud detection. Prior literature argues that social connections provide an effective channel to influence the legal justice
system (Dorminey et al., 2012; Sutherland, 1944). We thus expect that well-connected independent directors will utilize their
social influence to reduce the likelihood of fraud detection. Formally stated, our hypothesis is:
H2. Ceteris paribus, connectedness of independent directors is negatively associated with a firm's likelihood of fraud
detection given occurrence of the fraud.
2.2.3. Consequences of fraud

commission
We expect an effect of independent directors' connectedness on the potential costs of fraud commission. Independent
directors can take advantage of their external connections and social influence to obstruct the process of fraud detection
(Sutherland, 1944; Wolfe and Hermanson, 2004). They are able to do so because economic decisions are embedded in social
relations, and the social influence of a corporate individual creates an atmosphere of admiration and intimidation (Dorminey
et al., 2012; Sutherland,
2
1940). Well-connected individuals often have great influence “in molding the criminal law and its administration to their
own
interests” (Sutherland, 1940); for example, by utilizing their social connections directors' possess considerable power to
lobby in favor of themselves (Cooper et al., 2010; Correia, 2014), consequently, fraud will remain undetected for a longer
period of time. Lesser penalties and legal costs are also often applied to boards and directors who can influence or even
participate in the process of molding the criminal justice system (Dorminey et al., 2012; Sutherland, 1944). Thus, we expect
that well-connected directors are more likely to avoid or mitigate the consequence of fraud (e.g. to avoid early detection and
severe penalties). Our hypothesis formally states that:
H3. Ceteris paribus, connectedness of independent directors is negatively associated with the consequences of fraud
commission.
2.2.4. Contagion effects of board

connections
Directors are socially connected when they serve on one board (Allen, 1974; Mintz and Schwartz, 1985; Palmer, 1983;
Palmer and Barber, 2001). Interlocking directorates represent an important means of diffusing corporate practices (Cai et
al., 2014; Mizruchi, 1992; Shropshire, 2010). Evidence shows that shared practices via interlocking directorships can
sometimes be detrimental (Collins et al., 2009; Ertimur et al., 2012; Zajac and Westphal, 1996); for example, earnings
management and accounting restatements spread among firms through interlocking directorates (Chiu et al., 2013; Gleason et
al., 2008), as well as board compensation practices in stock option backdating (Bizjak et al., 2009) and the design of
compensation contracts (Hallock, 1997).
In the context of fraud, we expect that fraudulent behavior will spread between firms via interlocking directorates. The
reason is that firms whose directors sit on the board of a fraudulent firm may have opportunities to gain insight to the “tricks”
of fraudulent practices. In this way, the otherwise secret “information” becomes common knowledge shared among firms in
the network of a fraudulent firm, and fraud may become “contagious”. Thus formally stated, we expect that:
H4. Ceteris paribus, interlocking directorates affect corporate

fraud.
3. Data, sample, and empirical

methodology
3.1. Data and sample selection
We compile our data from several sources. BoardEx provides data on individual directors' social connections and corporate
governance. We obtained the BoardEx Core Reports in January 2014 and our investigation window covers the fiscal years
from
1999 to 2013. Our initial sample consists of 46,413 firm-years of U.S.-listed firms from BoardEx with complete information on
social connections and corporate governance characteristics. We then merge the dataset with financial information from
Compustat. The sample size reduces to 39,694 observations. We next obtain and merge capital market information from CRSP.
This procedure reduces the sample size to 35,354. We then merge our dataset with I/B/E/S data and 21,833 firm-years remain.
We also obtain audit-related information from Audit Analytics and our final sample consists of 17,688 firm-years.
Our fraud sample is from the SEC's Accounting and Auditing Enforcement Releases (AAERs) and Stanford Law School's
Secu- rities Class Action Clearinghouse (SSCAC), consistent with prior research that investigates corporate fraud (e.g. Khanna
et al.,
2015; Wang, 2013; Wang et al., 2010).3 AAERs are issued by the SEC during or at the conclusion of an investigation detailing
en-
an auditor, or an officer for alleged accounting or auditing misconduct (Dechow et 151
forcement action against a company, 427 al.,
2011). We identify 397 cases of fraud from the SEC's AAER database in which the SEC charged a U.S. public company for
accounting
2
For example, Larcker et al. (2013) demonstrate that firms central to corporate social networks earn superior stock returns and receive significantly higher
appre- ciation from the markets.
3
Karpoff et al. (2016) discuss the potential bias of using SSCAC's data to infer corporate fraud. With acknowledgement of the potential issue, we follow the
general
practice in prior literature and collect information of fraud cases from AAER and SSCAC websites.
152 427
misconduct. We supplement the SEC cases with the SSCAC on shareholders' private civil lawsuits. The SSCAC provides
information on “virtually all alleged frauds with more than a de minimis effect on the stock price that could generate private
litigation” (Khanna et al., 2015). We exclude cases that involved exchange-traded funds, and foreign-listed or privately traded
firms, as well as cases that were still ongoing or were dismissed by the court. We next merge the fraud sample with the
sample we previously compiled from various databases. Our final sample consists of 206 AAER cases and 201 civil lawsuits, in
which 354 were detected during our investigation window (i.e. from 1999 to 2013), and 53 were committed during our
investigation window but detected after 2013.4 The number of fraud cases in our sample is comparable to prior studies using
similar databases (Khanna et al., 2015; Wang et al., 2010).
3.2. Empirical model for fraud commission and

detection
3.2.1. Bivariate probit model

Corporate fraud is partially observable (Wang, 2013; Wang et al., 2010). Standard econometric methods, such as a
standard probit model, cannot adequately address the partial observability and tend to generate biased results (Poirier, 1980).
We employ a bivariate probit model to handle the partial observability (Feinstein, 1990; Wang, 2013; Wang et al., 2010). In
particular, for each firm, i, we model the two processes (fraud commission and detection) as follows:
427 153
Fraud commissionit ¼ XC;it α þ ε it ð1aÞ
Fraud detectioni ¼ XD;it β þ μ ð1bÞ

it
∗ ∗
where Fraud commission it and Fraud detectionit stand for firm i's incentive to commit fraud and the potential to be
caught,
respectively. Following prior literature (Khanna et al., 2015; Wang, 2013; Wang et al., 2010), we create two indicator
∗
variables: Fraud commissionit equals one if Fraud commissionit N 0, and zero otherwise; Fraud detectionit equals one if
∗
Fraud detection it N 0, and zero otherwise. XC , in Model (1a) represents a row vector containing variables that explain
the determinants of committing fraud, and XD , it in Model (1b) includes the determinant variables of fraud detection.
The terms εit and μit are error terms following a bivariate normal distribution.
Due to the partial observability of fraud, the outcome we observe is a combination of the fraud commission and detec-
tion:
Observeit ¼ Fraud commissionit Fraud detectionit ð2Þ
where Observeit in Model (2) is one if firm i has committed fraud and been detected in year t, and zero if firm i has not
committed fraud or has committed fraud and not been detected. Let Φ denote the bivariate standard normal cumulative
distribution function.
The empirical model for Observeit is:
PðObserveit ¼ 1Þ ¼ PðFraud commissionit Fraud detectionit ¼ 1Þ ¼ PðFraud commissionit ¼ 1ÞPðFraud detectionit ¼

1Þ
ð3aÞ
¼ Φ X C;it α; X D;it β; σ
PðObserveit ¼ 0Þ ¼ PðFraud commissionit Fraud detectionit ¼ 0Þ ¼ PðFraud commissionit ¼ 0ÞPðFraud detectionit ¼

0Þ
þ PðFraud commissionit ¼ 1ÞPðFraud detectionit ¼ 0Þ
ð3bÞ
¼ 1 −Φ X C;it α; X D;it β; σ
We estimate the model using the maximum-likelihood method, and the log-likelihood function for the model is:
Lðα; β; σ Þ ¼ ∑ log½PðObserveit ¼ 1Þ þ ∑ log½PðObserveit ¼ 0Þ ð4Þ

Observeit ¼1 Observeit ¼0
We include year and industry (defined by the first two digits of SIC codes) fixed effects in the model. Further, the
standard errors are clustered by firms in the estimation to control for heteroskedasticity (White, 1980).
4
The literature argues that there is a high likelihood that private lawsuits may be frivolous while enforcement actions undertaken by the SEC are less likely
to be frivolous; even in cases where the settlement amount is small (such cases may be of high legal importance). We handle the possibility of the inclusion of
frivolous civil lawsuits in a number of ways. First, our sample does not include ongoing cases or cases in which the judge dismissed the action or ruled in favor of
the defendant. Sec- ond, we re-estimate our model without class action lawsuits and obtain similar results. Third, we re-estimate our model by excluding civil
lawsuits settled for less than US$3 million as an indicator to separate frivolous from substantiated cases; our results are qualitatively similar. When merging the
fraud sample with BoardEx, we notice a drop in the number of observations. This is because BoardEx does not cover de-listed firms, American Depository
Receipts, or firms traded over-the-counter.
3.2.2. Variable definitions
3.2.2.1. Fraud commission. We define our measure for fraud commit as the year when a fraud is committed. We manually
collect information on the year(s) in which fraud was committed. For the AAER fraud cases, we retrieve the information
as alleged in the “SEC Complaint,” which are available from the SEC's AAER database. For the civil action cases, we obtain
the period of alleged fraud from SSCAC's website for each case (under the headings “Class Period Start” and “Class Period
End”). We use an indicator variable for fraud commission (fraud), which equals one if the firm observation shows an alleged
fraud, and zero otherwise.
3.2.2.2. Fraud detection. Consistent with Khanna et al. (2015), the date of fraud detection was the earliest of the following
dates: (1) the date the firm announced an informal request by regulators for information relating to the subsequent enforce-
ment action; (2) the date the firm received a notice of a formal order of investigation from regulators; (3) the date of the
first regulatory proceeding or class action lawsuit filed in the related enforcement action; (4) the date of the first public
announcement of an activity that reveals to investors a possible enforcement action in the future; (5) the date of the an-
nouncement of the firm receiving a Wells Notice to an enforcement action or the date the firm announces they have reached
a settlement in an intended enforcement action5; or (6) the date on which the first related private civil class action lawsuit
was filed for the same activity described in the enforcement action by regulators. We conduct searches on LexisNexis and
Google for press announcements made by the target firm about whether they are under an informal investigation, a formal
investigation, or whether they have been a recipient of a Wells Notice. We obtain the dates when a civil claim was filed and
settled from legal documents available on the SEC or SSCAC websites. From the dates collected we use the earliest date as
the date of fraud detection.
Table 1 presents the sample distribution: Panel A provides the sample distribution by year and Panel B demonstrates the
sample distribution by industry. We observe significant industry patterns in corporate fraud litigation. In particular, chemicals
and allied products, electronic and other electrical equipment and components, and the business services industries are more
frequently involved in fraud litigation. The observations justify our controlling for year and industry fixed effects in the
bivariate probit model. Table 2 presents the descriptive statistics of the variables used in our analyses. On average, over 5% of
our sample firm- year observations are involved in corporate fraud.
3.2.2.3. Social connections. We focus on social connections that are established via third-party work (Borgatti, 2012; Engelberg et
al., 2012). We follow the literature and remove redundant ties (Abernethy et al., 2017; Aldrich, 1999; Larcker et al., 2013;
Zajac,
6
1988). The social network literature suggests that social connectedness represents a major form of “long-lived assets” with
expectations of a future flow of economic benefits (Adler and Kwon, 2002; Uzzi, 1997). Therefore, our estimation of social con-
nections incorporates concurrent as well as historical relationships to reflect the sustainability of social connectedness. To cap-
ture the full breadth of social connectedness, we measure directors' social connectedness by its degree centrality, betweenness
centrality, closeness centrality, and eigenvector centrality (Freeman, 1979). The four measures capture related dimensions of
social connectedness: the degree of centrality gives the number of direct contacts for a point in the social world and reflects
the information contained in all possible paths in a network, while the measures of betweenness and closeness capture infor-
mation sharing in the shortest or geodesic paths, and eigenvector centrality measure gives an estimation of the overall social
influence.
Appendix A describes the construction of our social connection measures. Panel A summarizes the Pearson and Spearman
correlations between the individual centrality measures. As documented in the literature (Larcker et al., 2013), the four
centralities exhibit high pairwise correlations (P-value b 0.01). Given the high correlations among individual variables of social
connectedness, we employ a principal component analysis (PCA) approach and combine the four measures into a composite
construct (connect) whose value increases with the level of independent directors' connectedness. Panel B in Appendix A
reports a PCA of the four individual centrality measures, which shows that the first principal component captures nearly 77%
of the variations in DEGREE, BETWEENNESS, CLOSENESS, and EIGENVECTOR. Furthermore, that is also the only component
with an eigenvalue greater than one. Panel C provides the descriptive statistics of the individual connection variables. The mean
value of DEGREE is 45.53, indicating that independent directors on a board roughly connect to 46 firms externally and it is about
six external connections per director (an average board in our sample has eight independent directors). We perform Shapiro-
Wilk normality tests and find that the distributions of four centrality measures are highly right-skewed (P-value b 0.01),
suggesting that there are few observations with extremely high levels of connectedness, as previously documented in the
literature (Kilduff and Tsai, 2003; Robins, 2015).
5
A Wells Notice is sent from the SEC to a company or an individual after the regulators have determined that there is sufficient wrongdoing to warrant the
filing of a civil claim.
6
As a demonstration, Directors A and B in Firm X both connect to Director C in Firm Y. When estimating Firm X's connectedness, we count the X–Y connection
only
once. We estimate social connections based on prior employment experience of independent directors (including board memberships, senior management
employment, and local department employment). In additional analysis, we focus on degree centrality and categorize social connections into work-related,
social activity, and educational ties. Our results show that social connections established through employment and social activities play a significant role in
explaining corporate fraud while educational ties do not significantly affect fraud processes. In the main analysis, we follow the literature and employ a set of
measures based on work-related connections (Larcker et al., 2013; Lusher et al., 2013; Robins, 2015). The results based on degree centrality of other types of social
connections are discussed in Section 5.
Table 1
Sample distribution.
The table reports distribution of our sample. Panel A presents sample distribution by year and Panel B gives sample distribution by industry. fraud is an indicator
variable equal to one if firm observation shows an alleged fraud, and zero otherwise.
Panel A: distribution by year in number of firms
Year Total fraud
=0 =1
1999 40 25 15
2000 558 490 68
2001 687 607 80
2002 757 674 83
2003 1143 1046 97
2004 1339 1228 111
2005 1462 1365 97
2006 1543 1455 88
2007 1611 1539 72
2008 1558 1493 65
2009 1557 1504 53
2010 1721 1677 44
2011 1746 1708 38
2012 1741 1709 32
2013 225 224 1
Total 17,688 16,744 944
Panel B: distribution by industry in number of firms
Two-digit SIC industry code and industry name # % in full fraud = 0 fraud = 1
of sample
obs
13 Oil and gas extraction 933 5.3 874 59

15 Building construction—general contractors and operative builders 150 0.8 133 17
16 Heavy construction other than building construction-contractors 102 0.6 99 3
20 Food and kindred products 420 2.4 387 33
23 Apparel and other finished products made from fabrics and similar materials 205 1.2 193 12
26 Paper and allied products 203 1.1 191 12
28 Chemicals and allied products 2059 11.6 1923 136
30 Rubber and miscellaneous plastics products 188 1.1 178 10
33 Primary metal industries 279 1.6 264 15
34 Fabricated metal products, except machinery and transportation equipment 273 1.5 259 14
35 Industrial and commercial machinery and computer equipment 1384 7.8 1312 72
36 Electronic and other electrical equipment and components 1911 10.8 1785 126
37 Transportation equipment 561 3.2 531 30
38 Measuring, analyzing, and controlling instruments; photographic, medical, and optical goods; watches 1471 8.3 1395 76
and clocks
42 Motor freight transportation 168 0.9 167 1
43 United States postal service 93 0.5 86 7
48 Communications 599 3.4 575 24
49 Electric, gas, and sanitary services 1172 6.6 1130 42
50 Wholesale trade—durable goods 439 2.5 427 12
51 Wholesale trade—non-durable goods 234 1.3 222 12
54 Food stores 62 0.4 59 3
55 Automotive dealers and gasoline service stations 195 1.1 187 8
56 Apparel and accessory stores 322 1.8 312 10
59 Miscellaneous retail 406 2.3 394 12
60 Depository institutions 358 2.0 349 9
62 Security, and commodity brokers, dealers, exchanges, and services 73 0.4 70 3
63 Insurance carriers 230 1.3 214 16
72 Personal services 72 0.4 65 7
73 Business services 2268 12.8 2153 115
80 Health services 413 2.3 395 18
87 Engineering, accounting, research, management, and related services 421 2.4 402 19
99 Non-classifiable establishments 24 0.1 13 11
Total 17,688 16,744 944
To investigate the contagion effects of interlocking directorships between well-connected firms and fraudulent firms we
focus on degree centrality and categorize independent directors' overall employment-based connections into connections to
fraud firms (fraud_lock) and non-fraud firms (nonfraud_lock). In particular, we replace connect in Models (3a) and (3b) with
fraud_lock and nonfraud_lock and analyze how corporate fraud becomes contagious via interlocking directorates. In our
sample, connections to fraud firms are rare—only 5% of our observations share interlocking directorates with fraudulent firms.
Table 2
Descriptive
statistics.
This table reports descriptive statistics for variables used in the main analyses. Panel A presents the descriptive statistics for the full sample (n = 17,688).
connect captures independent director connectedness. It is a composite measure of external connections of independent directors computed based upon
principal component analysis (PCA) of four centrality measures: degree centrality, betweenness centrality, closeness centrality, and eigenvector centrality.
Appendix A provides detailed explanations of the four centrality measures. size is the natural logarithm of total assets. tobinq is measured as the market value of
common equity, plus the book value of total liabilities, divided by the book value of total assets. ebitda is earnings before interest, taxes, depreciation, and
amortization, divided by the book value of total assets. growth is the five-year average annual sales growth rate. lev is the same of short- and long-term debt,
divided by the book value of total assets. vol_return is the volatility of daily stock return during the year. ind_tobinq is the median of tobinq in an industry in a
given year, where industry is defined by the first two digits of SIC codes. stockturnover is the ratio of the total number of shares traded during the fiscal year t to
the total number of common shares outstanding. mkt_ret is the annual buy-and-hold stock returns. icr is the industry concentration ratio, defined as the sum of
the percentage market share (in sales) of the top four firms among all firms in Compustat in each industry-year, where industry is defined by the first two digits
of SIC codes. hi_lit is an indicator equal to one if firm belongs to the list of industries (with high litigation risk), and zero otherwise. SIC lists include 2833 to
2836, 3570 to 3577, 3600 to 3674, 5200 to 5961, 7370 to 7374, or 8731 to 8734. bigN is an indicator equal to one if a firm's annual report is audited by a big N
auditor, and zero otherwise. lnanalyst is the natural logarithm of one plus the number of analysts following the firm during the year. lnbsize is the natural
logarithm of number of board members. lnacsize is the natural logarithm of number of audit committee members. brd_ind is the proportion of independent
directors on the board. ac_ind is the proportion of independent directors in the auditor committee. brd_own is percentage of outstanding common shares held by
all directors on the board. brd_tenure is average tenure of directors on board. brd_coopt is proportion of directors on the board appointed during a CEO's tenure.
ceoduality is an indicator variable equal to one if a CEO also chairs the board, and zero otherwise. chg_aud is an indicator variable equal to one if there is auditor
change during the year, and zero otherwise. fraud is an indicator variable equal to one if firm observation shows an alleged fraud, and zero otherwise. fraud_lock
is the number of connections that independent directors have to fraud firms through past employment. nonfraud_lock is the number of connections that
independent directors have to non-fraud firms through past employment. Panel B presents the comparisons in variable descriptive statistics between the fraud
(n = 944) and no fraud (n = 16,744) samples. Panel C provides comparison results between boards with well-connected and less well-connected indepen-
dent directors. brd_busy is the average number of outside boards that an independent director sits on. Panel D presents the descriptive statistics for the fraud
detection sample (n = 407). fraud_dur is the period in number of years between the beginning and detection of alleged fraud. num_charged is the number of
people charged in a litigation or enforcement action. settle_amt is the natural logarithm of settlement amount paid by a firm in million USD. ***, **, * represent
significance at the 0.01, 0.05, and 0.1 levels (two-tailed), respectively.
Panel A: full sample descriptive statistics (n = 17,688)
Variables N Mean P25 Median P75 SD
connect 17,688 0.000 − 1.003 − 0.342 0.607 1.756
Firm economic characteristics

size 17,688 6.952 5.628 6.883 8.203 1.878
tobinq 17,688 1.724 0.885 1.282 2.047 1.406
ebitda 17,688 0.093 0.064 0.115 0.169 0.167
growth 17,688 0.207 0.044 0.111 0.222 0.410
lev 17,688 0.203 0.013 0.169 0.321 0.200
vol_return 17,688 0.045 0.020 0.028 0.039 0.092
ind_tobinq 17,688 1.834 1.288 1.697 2.243 0.763
stockturnover 17,688 2.313 1.065 1.812 2.967 1.823
mkt_ret 17,688 0.152 − 0.205 0.049 0.323 0.661
icr 17,688 0.001 0.000 0.000 0.000 0.008
hi_lit 17,688 0.355 0.000 0.000 1.000 0.479
Corporate governance and monitoring variables

bigN 17,688 0.852 1.000 1.000 1.000 0.355
lnanalyst 17,688 1.553 0.693 1.609 2.250 0.898
lnbsize 17,688 2.129 1.946 2.079 2.303 0.271
lnacsize 17,688 1.277 1.099 1.099 1.386 0.239
brd_ind 17,688 0.822 0.778 0.857 0.889 0.093
ac_ind 17,688 0.977 1.000 1.000 1.000 0.094
brd_own 17,688 0.007 0.000 0.000 0.000 0.029
brd_tenure 17,688 8.287 5.511 7.716 10.375 3.863
brd_coopt 17,688 0.405 0.125 0.364 0.667 0.317
ceoduality 17,688 0.622 0.000 1.000 1.000 0.485
chg_aud 17,688 0.055 0.000 0.000 0.000 0.228
Fraud variable
fraud 17,688 0.053 0.000 0.000 0.000 0.225
nonfraud_lock 17,688 107.514 2.000 16.000 145.000 177.093
fraud_lock 17,688 0.288 0.000 0.000 0.000 1.949
Panel B: comparison of fraud and no fraud samples
fraud = 1 (n = 944) fraud = 0 (n = 16,744) Test of mean Test of median
Mean Median SD Mean Median SD t z
connect 0.246 − 0.241 2.085 − 0.014 − 0.346 1.735 4.42*** 2.64**

size 7.884 7.877 2.097 6.900 6.844 1.851 15.77*** 13.83***
tobinq 1.881 1.373 1.553 1.715 1.277 1.397 3.53*** 3.11***
ebitda 0.104 0.117 0.141 0.093 0.115 0.169 1.99* 0.75
growth 0.267 0.144 0.447 0.204 0.109 0.408 4.60*** 7.73***
(continued on next page)

154 427
Table 2 (continued)
Panel B: comparison of fraud and no fraud samples
fraud = 1 (n = 944) fraud = 0 (n = 16,744) Test of mean Test of median
Mean Median SD Mean Median SD t z
lev 0.225 0.208 0.190 0.202 0.166 0.200 3.48*** 4.80***

vol_return 0.042 0.028 0.088 0.046 0.027 0.092 − 1.17 2.14***
ind_tobinq 2.022 1.933 0.820 1.824 1.677 0.758 7.81*** 7.23***
stockturnover 2.833 2.099 2.247 2.283 1.800 1.792 9.03*** 7.07***
mkt_ret 0.095 − 0.027 0.741 0.155 0.052 0.656 − 2.73*** − 5.35***
icr 0.001 0.000 0.005 0.001 0.000 0.009 − 0.80 − 3.86***
hi_lit 0.426 0.000 0.495 0.351 0.000 0.477 4.68*** 4.68***
Corporate governance and monitoring

bigN 0.851 1.000 0.356 0.878 1.000 0.327 − 2.30** − 2.30**
lnanalyst 2.001 2.197 0.867 1.528 1.609 0.893 15.89*** 16.11***
lnbsize 2.208 2.197 0.310 2.125 2.079 0.268 9.14*** 8.34***
lnacsize 1.305 1.386 0.269 1.275 1.099 0.237 3.82*** 3.63 ***
brd_ind 0.815 0.833 0.096 0.823 0.857 0.093 − 2.41** − 2.27**
ac_ind 0.940 1.000 0.151 0.979 1.000 0.089 − 12.40*** − 6.57***
brd_own 0.011 0.000 0.037 0.007 0.000 0.029 4.31*** 12.67***
brd_tenure 8.034 7.600 3.860 8.301 7.727 3.862 − 2.07** − 2.28***
brd_coopt 0.463 0.429 0.346 0.402 0.364 0.315 5.71*** 4.98***
ceoduality 0.744 1.000 0.437 0.615 1.000 0.487 7.92*** 7.91***
chg_aud 0.065 0.000 0.246 0.054 0.000 0.227 1.33 1.33
Panel C: comparison of high and low social connections
connect N median connect b median Test of mean
n Mean SD n Mean SD t
brd_busy 8308 4.803 0.019 8267 4.676 0.020 4.610***
Panel D: fraud detection sample descriptive statistics (n = 407)
fraud_dur 407 3.389 1.000 3.000 5.000 2.404

num_charged 407 3.037 1.000 2.000 4.000 3.059
settle_amt (in mil) 407 54.600 2.500 7.700 26.000 368.000
3.2.2.4. Other variables. When estimating the bivariate probit model we need to include a vector containing an exogenous
identifying variable that is correlated with the dependent variable in one model (Fraud detection*it), yet uncorrelated with
the residual term of the other model (εit) (Wilde, 2008). We include auditor turnover as an identifying variable (chg_aud) in
the fraud detection model but not in the fraud commission model to satisfy the exclusion restriction. Auditor changes often
prompt a comprehensive re-examination of internal control, financial reporting, and previous business processes (Menon
and Williams, 2008; Tanyi et al., 2010). For example, Hennes et al. (2008) show that there is a positive association between au-
ditor turnover and the likelihood of detecting financial misconduct committed in the previous auditor's incumbency. While the
direct effects of auditor change on the ex ante likelihood of committing fraud are less obvious because the hiring decision might
7
be made after the fraud has been committed.
We specify all other control variables in the two probit equations. These variables are widely recognized in the literature
(see for example Khanna et al., 2015; Wang et al., 2010) as capturing a firm's propensity toward committing fraud and the
likelihood of fraud detection. Appendix B provides detailed variable definitions.
3.2.2.4.1. Corporate governance and monitoring. Our first set of control variables includes proxies for both internal and
external monitoring. lnbsize gives the natural logarithm of the number of directors on the board and controls for board
efficacy at monitoring (Abernethy et al., 2015; Jensen, 1993). Board monitoring may improve with the representativeness of the
independent directors on the board (Hermalin and Weisbach, 1998; Weisbach, 1988). So we include brd_ind measured as the
percentage of independent directors on the board. Further, given the influence of audit committees on internal control and
oversight, we include the natural logarithm of audit committee size, lnacsize, and the percentage of independent directors on
the audit committee, ac_ind. We control for the proportion of board directors appointed during the CEO's tenure, brd_coopt,
following Khanna et al. (2015). We include analyst coverage, lnanalyst, as analyst coverage is considered as a form of external
monitoring (Healy and
7
As an alternative method we follow Khanna et al. (2015) and include CEO stock option compensation in the fraud commission model but not the detection
model. The results are qualitatively similar and the discussion is included in Section 5 robustness tests.
427 155
8
Palepu, 2001; Yu, 2008). We also include an indicator for a Big N auditor, bigN. Large audit firms provide higher audit quality
and thus higher quality external monitoring is expected (Francis and Wang, 2008). We include ceoduality to control for CEOs'
power. We also control for the aggregate ownership of board directors (brd_own) and average tenure of board directors
(brd_tenure) because they are both important indicators for board influence and experience (Hooghiemstra et al., 2015).
3.2.2.4.2. Firm economic characteristics. Our next set of variables relates to a firm's economic characteristics because
economic conditions affect the propensity to commit fraud as well as fraud detection (Wang et al., 2010), including Tobin's Q
(tobinq), accounting performance (ebitda), stock volatility (vol_return), stock turnover (stockturnover), firm size (size), sales
growth rate (growth), leverage (lev), industry Tobin's Q (ind_tobinq), industry concentration ratio (icr), and industry litigation
intensity (hi_lit) (Dechow et al., 2011). In addition, we control for a firm's market return during the year (mkt_ret) and a
quadratic term of industry Tobin's Q (ind_tobinq_sq) (Wang et al., 2010). All continuous variables were winsorized at the top
and bottom 1% to mitigate outlier bias.
Descriptive statistics reported in Table 2 are generally consistent with the prior literature (Coles et al., 2014; Khanna et al.,
2015; Wang et al., 2010). Panel B in Table 2 presents univariate comparisons between the fraud firms and the non-fraud
firms. In comparison to firms that were not involved in fraud, firms that committed fraud have better socially connected
independent directors; they are also larger, experience higher growth, have a higher leverage ratio, have higher shareholder
trading activity, operate in high litigation risk industries, have more analysts following, and are audited by a non-Big N
auditor, but the market return during the years when fraud is committed is significantly lower. With respect to corporate
governance, fraudulent firms tend to have a larger board, higher frequency of a chairperson CEO, greater ownership by board
members, and a higher percentage of coopted board members. Further, fraudulent firms have a larger audit committee, but
lower board independence, and a lower percentage of independent directors on the audit committee; on average fraud firms
have a shorter-tenured board than non-fraudulent firms. Importantly, our identifying variable, change of auditor (chg_aud), is
not significantly different between the fraud and non-fraud subsamples, but is significantly higher in firms where fraud was
detected in comparison to their coun- terparts (P-value b 0.01, untabulated), which validates our choice of the identifying
variable.9
We also compare director busyness between boards with high versus low director connectedness, where director busyness
is measured by the average number of outside boards an independent director sits on (brd_busy). The results are reported in
Panel C of Table 2. The variable brd_busy is significantly greater for board directors with high external connectedness
compared to those with low external connectedness (P-value b 0.01), consistent with our argument that well-connected
directors may have reduced monitoring quality because they are busy with external commitments. We further examine the
number of director turnover following the year of fraud detection and find that turnover is significantly higher for
boards with well-connected directors (mean = 1.971) in comparison to less-connected directors (mean = 1.186) (P-value b
0.01), suggesting that well-connected directors indeed incur greater costs following revelation of fraud and encounter a
higher turnover.
In addition, we examine the pairwise correlations among variables. The results (untabulated) show that fraud commission
and detection are significantly and positively correlated (rho = 0.33; P-value b 0.01), which supports our employment of a
bivariate probit modelling approach to handle the latent processes. The correlations of other variables are generally consistent
with prior literature (Bruynseels and Cardinaels, 2014; Coles et al., 2014; Wang et al., 2010).10
3.3. Empirical models for consequences of

fraud
We examine the effects of director connectedness on the consequences of fraud. In particular, we examine the duration
that fraud remains undetected (i.e. the difference between the beginning year of fraud and year of fraud detection,
fraud_dur) and number of people being charged with fraud (num_charged). If independent directors utilize their
connectedness to reduce the likelihood of fraud detection, it will then take a longer period of time before fraud is detected.
In addition, we also investigate the association between director connectedness and number of people being charged with fraud
as the consequences of fraud detection can be measured by the number of people being charged with fraud: the more people
involved in the lawsuits, the more likely the firm will attract undesirable attention from the media and the public, which will
engender greater reputational damage to the directors. We perform the analyses in a sample of 407 observations where fraud
was detected based on information from AAER and SSCAC.
To investigate fraud duration we employ both OLS and the Cox (1972) proportional hazard model using fraud_dur as the
dependent variable. We include control variables in Model (3a). Further, we include the settlement amount (settle_amt)
11
because it is correlated with fraud detection. Similar to Khanna et al. (2015), our variable of interest (connect) and control
variables are computed as the average over each fraud period. To investigate the effect of director social connectedness on
the number of people being charged with fraud we run a Tobit regression, as the dependent variable (the number of people)
is non-negative in the
8
In our main analyses, we consider Arthur Anderson LLP one of the big audit firms before its collapse. When excluding it from the definition of Big N auditors,
we obtain consistent results.
9
An identifying variable should have a significant correlation to one dependent variable in the bivariate model while no significant and direct correlation is
expected
between the identifying variable and the other dependent variable in the model (Greene, 2008; Wooldridge,
2013).
10
All variance inflation factor (VIF) scores are below 3.64, except for ind_tobinq and ind_tobinq_sq as they are correlated by construction. When we remove
ind_tobinq_sq, all VIFs are below the recommended threshold of 10 (Hair et al., 2010). The highest VIF is size at 3.46, and the mean VIF is 1.40, suggesting that
severe multicollinearity is not likely to be an issue.
11
156 In fraud duration analysis we include 53 cases
427 that were detected after our investigation window, but the fraud was committed in our investigation window.
When
excluding them from the sample we obtain consistent
results.
427 157
regression (Tobin, 1958). In the Tobit regression we include the settlement amount paid by the firm (settle_amt) to proxy for
12
the severity of fraud ; the inclusion of other controls follows prior literature (Khanna et al., 2015).
Panel D in Table 2 provides descriptive statistics of fraud detection-related variables. The average duration of fraud is 3.389
years. On average, more than three corporate individuals are charged in the fraudulent firm, which is in line with the
literature that corporate fraud often involves more than one actor (Tillman, 2009). Further, the settlement amount varies
considerably in our sample, with a mean of US$54.60 million and a median of US$7.7 million.
4. Main results and discussion
4.1. Corporate fraud and independent director connectedness
Table 3 reports the results of the bivariate probit regressions on the association between independent directors'
connections and corporate fraud. The model provides satisfactory power in explaining the probability of committing and
detecting fraud (P-value b 0.01). The results corresponding to the fraud commission equation and fraud detection equation
are summarized in Columns (1) and (2), respectively.
In Column (1), the fraud commission equation, the coefficient on connect is not significant, which is consistent with H1
that connectedness of independent directors do not have a significant association to fraud commission. Although independent
directors who have more external social connections are able to access a wider range of information and resources, their
monitoring efficacy is unclear. While improved information accessibility may enhance directors' monitoring ability (Intintoli
et al., 2016; Omer et al., 2016), externally well-connected directors may have too many external commitments, such that it
distracts directors' focus and undermines their quality of oversight in the current firm (Ahn et al., 2010; Cashman et al.,
2012). The insignificant association between director connectedness and fraud commission suggests that the two plausible
effects coexist.
Our results on fraud detection are presented in Column (2) of Table 3. The coefficient on connect is significantly negative
(P-value b 0.05), indicating a lower likelihood of fraud detection when independent directors are well-connected externally.
The results are consistent with H2 that in firms with well-connected independent directors, the detection rate is
significantly lower given the occurrence of fraud.
Turning to the control variables, our results are consistent with the prior literature (Khanna et al., 2015; Wang et al.,
2010). Firms that are larger in size and with greater shareholder trading activity are more likely to perpetrate fraud and run
a higher risk of fraud detection. Further, firms have a greater tendency to engage in fraud when the proportion of coopted
directors on the board is greater, while the fraud detection rate is significantly lower in those firms. Firms in industries where
firms on average are more likely to be involved in litigation cases have a greater tendency toward fraud commission. Firms
audited by a Big N audit firm have a lower propensity toward fraud commission and a lower likelihood of fraud detection. Higher
sales growth and greater stock return volatility are related to a higher incidence of fraud. For firms with low share performance
or accounting performance there is a lower likelihood of fraud detection; while board independence is associated with a
lower likelihood of fraud commission. Finally, the identifying variable chg_aud is significantly positive in the detection model,
suggesting, as expected, new auditors are likely to re-examine the work of their predecessor, thereby increasing the likelihood
of detecting fraud.
In summary, our findings demonstrate that while the association between independent directors' connectedness and fraud
commission is not significant, fraud detection is significantly lower when independent directors are well connected.
4.2. Consequences of fraud
Panel A in Table 4 presents the results of the duration of undetected fraud. The OLS estimations are summarized in
Column (1). The significant and positive coefficient on connect in Column (1) (P-value b 0.01) suggests that greater
independent directors' connectedness is associated with longer fraud duration. The results stay consistent when we use a Cox
regression. In Column (2), the hazard ratio of connect is 0.872 (P-value b 0.01), suggesting that a one-standard-deviation
13
increase in independent directors' connectedness reduces the likelihood of fraud detection or exposure by 22.5%. The control
variables also demonstrate significant power in explaining the duration in which the fraud remains undetected. In particular,
more severe cases of fraud, proxied by the settlement amount, tend to be detected earlier. Further, fraud duration has a U-
shaped relationship with industry-level Tobin's Q suggesting that firms in industries with a high Tobin's Q initially have a
longer period of undetected fraud, but after a certain threshold further increases in industry Tobin's Q relate to a shortened
fraud duration.14
12
Fraud in firms with well-connected directors may be less severe because of the nature of misconduct. Therefore, our findings might be explained by the
differences in the nature of the severity of fraud between firms with well-connected versus less-connected directors. We address this concern in a number of
ways. First, control for fraud severity (settle_amt) when investigating the effects of director connectedness on fraud consequences. Our results show that after
controlling for fraud severity, well-connected board directors face a lower cost after fraud detection. We also investigate the correlation between director
connectedness (connect) and proxies for fraud severity (fraud_dur and settle_amt). The correlation between connect and settle_amt is not statistically significant,
but is significantly positive between connect and fraud_dur. Together, these results indicate that it is less likely that fraud committed by firms with well-
connected directors will be less severe, if not the opposite.
13
Panel A in Table 2 shows that the standard deviation of connect is 1.756. So with a one standard-deviation increase in connect, the odds of detection will
decrease by
[(1–0.872) ∗ 1.756 ∗ 100%] =
22.5%.
14
158 427 a very high Tobin's Q may indicate that those industries have greater importance in the economy and thus
The decreased fraud duration in industries with
are exposed to greater public scrutiny. Firms in those industries will therefore find it more difficult to sustain fraud undetected for a longer period of time.
427 159
Table 3
Corporate fraud and board
connectedness.
This table reports the results of a bivariate probit model that examines the association between connectedness of independent directors (connect) on the commission
(fraud) and detection of fraud (detect | fraud). connect captures independent director connectedness. It is a composite measure of external connections of
independent directors computed based upon principal component analysis (PCA) of four centrality measures: degree centrality, betweenness centrality, closeness
centrality, and eigenvector centrality. Appendix A provides detailed explanations of the four centrality measures. size is the natural logarithm of total assets. tobinq
is measured as the market value of common equity, plus the book value of total liabilities divided by the book value of total assets. ebitda is earnings before
interest, taxes, depreciation, and amortization divided by the book value of total assets. growth is the five-year average annual sales growth rate. lev is the same of
short- and long-term debt, divided by the book value of total assets. vol_return is the volatility of daily stock return during the year. ind_tobinq is the median of
tobinq in an industry in a given year, where industry is defined by the first two digits of SIC codes. ind_tobinq_sq is a quadratic term of ind_tobinq. stockturnover is
the ratio of the total number of shares traded during the fiscal year t to the total number of common shares outstanding. mkt_ret is the annual buy-and-hold stock
returns. icr is the industry concentration ratio, defined as the sum of the percentage market share (in sales) of the top four firms among all firms in Compustat in
each industry-year, where industry is defined by the first two digits of SIC codes. hi_lit is an indicator equal to one if the firm belongs to the list of industries (with
high litigation risk), and zero otherwise. SIC lists include 2833 to 2836, 3570 to 3577, 3600 to 3674, 5200 to 5961, 7370 to
7374, or 8731 to 8734. bigN is an indicator equal to one if a firm's annual report is audited by a big N auditor, and zero otherwise. lnanalyst is the natural logarithm
of one plus the number of analysts following the firm during the year. lnbsize is the natural logarithm of number of board members. lnacsize is the natural logarithm
of number of audit committee members. brd_ind is the proportion of independent directors on the board. ac_ind is the proportion of independent directors in the
auditor committee. brd_own is percentage of outstanding common shares held by all directors on the board. brd_tenure is average tenure of directors on board.
brd_coopt is proportion of directors on the board appointed during a CEO's tenure. ceoduality is an indicator variable equal to one if a CEO also chairs the board, and
zero otherwise. chg_aud is an indicator variable equal to one if there is auditor change during the year, and zero otherwise. The dependent variable in Column (1) is
fraud, which is an indicator variable equal to one if firm observation shows an alleged fraud, and zero otherwise. The dependent variable in Column (2) is detect |
fraud, measured as an indicator variable equal to one if alleged fraud is detected, and zero otherwise. Consistent with Khanna et al. (2015), the fraud detection date
is the earliest of the following dates: (1) the date the firm announces an informal request by regulators for information relating to the subsequent enforcement
action; (2) the date the firm receives a notice of a formal order of investigation from regulators; or (3) the date of first regulatory proceeding or civil class action
lawsuit filed in the related enforcement action. Standards errors are robust, clustered by firm. ***,
**, * represent significance at the 0.01, 0.05, and 0.1 levels (two-tailed),
respectively.
Fraud detect | fraud
Coeff. z Coeff. z
(1) (2)
connect 0.011 1.03 − 0.031** − 2.57

size 0.192*** 6.26 0.199*** 7.29
tobinq 0.008 0.37 − 0.022 − 0.94
ebitda − 0.264 − 1.42 − 0.548*** − 2.99
growth 0.092* 1.71 0.032 0.64
lev − 0.008 − 0.05 − 0.278* − 1.77
vol_return 0.647* 1.86 0.143 0.45
ind_tobinq 0.255 1.16 0.053 0.21
ind_tobinq_sq − 0.058 − 1.45 − 0.009 − 0.18
stockturnover 0.068*** 4.26 0.102*** 7.84
mkt_ret − 0.037 − 1.22 − 0.124** − 2.51
icr − 8.823* − 1.67 1.200 0.87
hi_lit 0.342*** 2.76 0.133 1.45

bigN − 0.303*** − 3.55 − 0.196** − 2.41
lnanalyst 0.027 0.64 − 0.014 − 0.32
lnbsize 0.017 0.11 0.056 0.42
lnacsize − 0.018 − 0.14 − 0.178 − 1.35
brd_ind − 0.584* − 1.77 0.032 0.10
ac_ind − 0.411* − 1.88 − 0.163 − 0.63
brd_own − 0.813 − 0.92 − 0.586 − 0.80
brd_tenure − 0.005 − 0.59 − 0.008 − 1.10
brd_coopt 0.250*** 3.47 − 0.202*** − 2.69
ceoduality 0.061 0.95 − 0.045 − 0.84
chg_aud 0.202** 2.58
constant − 0.631 − 1.18 − 1.727*** − 2.82
Year dummies Yes
Industry dummies Yes
Log pseudolikelihood − 4441.219 (P-value b 0.01)
N 17,688
Panel B in Table 4 presents our findings on the relation between director external connectedness and the number of
people being charged when fraud is detected. The significantly negative coefficient on connect (P-value b 0.01) suggests that
fewer people are charged with fraud when independent directors are well connected.15 To sum up, our results are consistent
with H3 that directors' external connectedness delays fraud detection and the directors are faced with less severe
consequences when the
15
We also investigate whether connectedness relates to settlement duration and settlement amount. Directors may have incentive to impede an
investigation into suspected firm misconduct and minimize settlement payment, thereby increasing settlement time and decreasing settlement amount. However,
these actions engender costs, and lengthy settlement times potentially attract intense public discussion and undesirable media coverage, and the intention to reach a
lower settlement amount drags out the settlement longer. Therefore, board directors may have an incentive to solicit a quicker settlement in order to minimize the
160
potential reputational penalties, even at the cost
427
of higher settlement fees. Our results show that connect does not exhibit any statistical significance in explaining
the settlement period or settlement amount.
427 161
Table 4
Consequences of fraud.
This table reports the results of analyses that examine the association between connectedness of independent directors (connect) on the consequences of fraud.
Panel A presents the results of the effect of director connections on the duration of undetected fraud for the fraud detection sample (n = 407) where the
dependent variable is fraud_dur. Column (1) reports OLS regression results while Column (2) reports results of Cox regressions. All independent and control
variables in Panel A (with the exception of settle_amt) are the average value over the period of fraud. connect captures independent director connectedness. It is a
composite measure of external connections of independent directors computed based upon principal component analysis (PCA) of four centrality measures:
degree centrality, betweenness centrality, closeness centrality, and eigenvector centrality. Appendix A provides detailed explanations of the four centrality
measures. size is the natural logarithm of total assets. tobinq is measured as the market value of common equity, plus the book value of total liabilities, divided by
the book value of total assets. ebitda is earnings before interest, taxes, depreciation, and amortization, divided by the book value of total assets. growth is the
five-year average annual sales growth rate. lev is the same of short- and long-term debt, divided by the book value of total assets. vol_return is the volatility of
daily stock return during the year. ind_tobinq is the median of tobinq in an industry in a given year, where industry is defined by the first two digits of SIC codes.
ind_tobinq_sq is a quadratic term of ind_tobinq. stockturnover is the ratio of the total number of shares traded during the fiscal year t to the total number of
common shares outstanding. mkt_ret is the annual buy-and-hold stock returns. icr is the industry concentration ratio, defined as the sum of the percentage
market share (in sales) of the top four firms among all firms in Compustat in each industry-year, where industry is defined by the first two digits of SIC codes.
hi_lit is an indicator equal to one if the firm belongs to the list of industries (with high litigation risk), and zero otherwise. SIC lists include 2833 to 2836, 3570 to
3577, 3600 to 3674, 5200 to 5961, 7370 to 7374, or 8731 to 8734. bigN is an indicator equal to one if a firm's annual report is audited by a big N auditor, and zero
otherwise. lnanalyst is the natural logarithm of one plus the number of analysts following the firm during the year. lnbsize is the natural logarithm of number of
board members. lnacsize is the natural logarithm of number of audit committee members. brd_ind is the proportion of independent directors on the board.
ac_ind is the proportion of independent directors in the auditor committee. brd_own is percentage of outstanding common shares held by all directors on the
board. brd_tenure is average tenure of directors on board. brd_coopt is proportion of directors on the board appointed during a CEO's tenure. ceoduality is an
indicator variable equal to one if a CEO also chairs the board, and zero otherwise. fraud_dur gives the period in number of years between the beginning and
detection of alleged fraud. num_charged is the number of people charged in a litigation or enforcement action. settle_amt is the natural logarithm of settlement
amount paid by a firm in million USD. Panel B reports the results of a Tobit regression that examines the effect of director connections on the number of
individuals charged for the fraud and the dependent variable is num_charged. All independent and control variables in Panel B (with the exception of
num_charged and settle_amt) are the average value over the period of fraud. Standards errors are robust, clustered by firm. ***, **, * represent significance at the
0.01, 0.05, and 0.1 levels (two-tailed), respectively.
Panel A: duration of undetected fraud
OLS _t
Coeff. t Hazard ratio z

(1) (2)
connect 0.309*** 2.65 0.872*** − 3.43

size 0.171 1.57 0.933 − 1.53
tobinq − 0.049 − 0.61 1.020 0.58
ebitda − 0.081 − 0.11 0.901 − 0.29
growth 0.088 0.31 0.958 − 0.34
lev − 0.408 − 0.53 0.932 − 0.25
vol_return − 0.027 − 0.02 1.235 0.49
ind_tobinq 3.142** 2.53 0.185*** − 2.70
ind_tobinq_sq − 0.651** − 2.55 1.434*** 2.90
stockturnover − 0.090 − 1.35 1.030 0.97
mkt_ret 0.173 0.88 0.875 − 1.14
icr − 20.723 − 0.25 0.032 − 0.10
hi_lit − 0.133 − 0.27 0.941 − 0.37

bigN 0.455 1.14 0.752* − 1.71
lnanalyst − 0.152 − 0.62 1.115 1.19
lnbsize 0.638 1.05 0.794 − 1.05
lnacsize 0.040 0.07 0.961 − 0.16
brd_ind − 1.960 − 1.41 1.887 1.23
ac_ind 0.660 0.72 0.911 − 0.25
brd_own 0.545 0.16 0.252 − 0.96
brd_tenure 0.053* 1.80 0.983 − 1.49
brd_coopt 0.411 0.91 0.870 − 0.86
ceoduality 0.200 0.65 0.875 − 1.12
settle_amt − 0.058** − 2.12 1.024*** 2.83
constant − 0.666 − 0.27
Industry dummies Yes Yes
2
Adjusted R 0.258
Log pseudolikelihood − 2065.971
N 407 407
Panel B: individuals charged
Coeff. t
(1)
connect − 0.475*** − 3.70

size − 0.044 − 0.37
tobinq 0.234 1.53
162 427
Table 4 (continued)
Panel B: individuals charged
Coeff. t
(1)
ebitda 0.859 0.60

growth 0.544 1.42
lev − 1.252 − 0.95
mkt_ret − 0.294 − 0.75
settle_amt 0.182*** 4.79
constant − 2.879** − 2.21
2
Pseudo R 0.059
N 407
fraud is detected. Our findings are also in line with prior studies suggesting that social connections provide firms with
opportunities to obscure and even legitimize their misconduct (Cooper et al., 2010; Correia, 2014; Wu et al., 2016).
4.3. Plausible contagion effects of fraud
To investigate whether fraud becomes “contagious” between firms via interlocking directorates, as predicted in H4, we
replicate Models (3a) and (3b) by replacing connect with fraud_lock and nonfraud_lock. The regression results are presented in
Table 5. The coefficient on fraud_lock is significantly positive in both fraud commission, Column (1), and detection, Column (2)
(P-value b 0.01), thereby suggesting that consistent with H4, fraudulent practices are indeed diffused within fraudulent firms'
networks, as firms linked to fraudulent firms via independent directors' directorships possess a higher propensity toward fraud.
Further, the possible contagion effect of fraud is likely to have been anticipated by regulators because the likelihood of fraud
detection is higher when a firm connects to a fraudulent firm. In other words, more stringent regulatory scrutiny is imposed on
firms involved in a fraudulent firm's network.
The variable nonfraud_lock captures a firm's connections to non-fraud firms via independent directors' directorships. The
variable is not significant in Column (1) while significantly negative in Column (2) (P-value b 0.01), suggesting that director
connectedness to non-fraud firms does not exhibit a significant association to fraud commission but relates to significantly lower
a fraud detection rate. Our prior findings on the effects of independent directors' connectedness stay consistent and are not
driven by interlocking directorships to fraud firms.
5. Endogeneity and other robustness checks
5.1. Two-stage least squares (2SLS)
Endogeneity arises in our study as neither director connectedness nor fraud is random, which may lead to biased and incon-
sistent parameter estimates and result in unreliable inferences (Greene, 2008; Roberts and Whited, 2012; Wintoki et al., 2012).
In this section, we conduct several tests to address the potential endogeneity problem and test for the robustness of our
findings.
To mitigate the concern of selection bias due to unobservable factors, we adopt an instrumental variable two-stage least
squares (2SLS) approach (Tucker, 2010). The basic requirement for validity of instrumental variables is that the instruments
should have no effect on the dependent variable other than through their effect on the suspected endogenous independent
variable. In our case, director connectedness (connect) is treated endogenous. Consistent with Faleye et al. (2014), we employ
the number of past industries that independent directors have worked in (pastindustries) as our instrumental variable for
their external connectedness. Independent directors' past experiences measured by the number of industries they have
worked in is highly correlated with their connectedness external to the focal firm, while the correlation between this variable
16
and fraud pos- sibilities in the focal firm is neither obvious nor direct. Following Khanna et al. (2015), we estimate the
first-stage regression separately for the fraud commission and fraud detection models. In particular, we include different sets
of control variables as specified in Models (3a) and (3b) and regress connect on pastindustries. We then use the predicted
value from each stage-one model to replace the endogenous variable connect in the second-stage regressions (i.e. the
bivariate probit model). Our results, reported on Panel A of Table 6, indicate that, as expected, directors' historic employment
records have a significantly positive relationship to their external connectedness. More importantly, our primary results on
fraud commission and detection still hold.
16
When we add pastindustries to Models (3a) and (3b), the variable does not load significantly. We consider our findings on fraud consequences to be
relatively un- affected by the endogeneity problem because there is a clear timeline when we construct the measurements, such that the consequences measures
(i.e. fraud duration and the number of people charged) are measured after independent director connectedness.
427 163
Table 5
Contagion effects of fraud via interlocking
directorates.
This table reports the results of the contagion effects of connections. Columns (1) and (2) present the results of a bivariate probit regression for corporate fraud
that examines the number of interlocking connections with fraud firms (fraud_lock) and number of interlocking connections with non-fraud firms
(nonfraud_lock). fraud_lock is the number of connections that independent directors have to fraud firms through past employment. nonfraud_lock is the number
of connections that independent directors have to non-fraud firms through past employment. size is the natural logarithm of total assets. tobinq is measured as
the market value of common equity, plus the book value of total liabilities, divided by the book value of total assets. ebitda is earnings before interest, taxes,
depreciation, and amortization, divided by the book value of total assets. growth is the five-year average annual sales growth rate. lev is the same of short- and
long-term debt, divided by the book value of total assets. vol_return is the volatility of daily stock return during the year. ind_tobinq is the median of tobinq in an
industry in a given year, where industry is defined by the first two digits of SIC codes. ind_tobinq_sq is a quadratic term of ind_tobinq. stockturnover is the ratio of
the total number of shares traded during the fiscal year t to the total number of common shares outstanding. mkt_ret is the annual buy-and-hold stock returns. icr
is the industry concentration ratio, defined as the sum of the percentage market share (in sales) of the top four firms among all firms in Compustat in each
industry-year, where industry is defined by the first two digits of SIC codes. hi_lit is an indicator equal to one if firm belongs to the list of industries (with high
litigation risk), and zero otherwise. SIC lists include 2833 to 2836, 3570 to 3577, 3600 to 3674,
5200 to 5961, 7370 to 7374, or 8731 to 8734. bigN is an indicator equal to one if a firm's annual report is audited by a big N auditor, and zero otherwise. lnanalyst
is the natural logarithm of one plus the number of analysts following the firm during the year. lnbsize is the natural logarithm of number of board members.
lnacsize is the natural logarithm of number of audit committee members. brd_ind is the proportion of independent directors on the board. ac_ind is the
proportion of independent directors in the auditor committee. brd_own is percentage of outstanding common shares held by all directors on the board.
brd_tenure is average tenure of directors on board. brd_coopt is proportion of directors on the board appointed during a CEO's tenure. ceoduality is an indicator
variable equal to one if a CEO also chairs the board, and zero otherwise. chg_aud is an indicator variable equal to one if there is auditor change during the year,
and zero otherwise. The dependent variable in Column (1) is fraud, which is an indicator variable equal to one if firm observation shows an alleged fraud, and
zero otherwise. The dependent variable in Column (2) is detect | fraud, measured as an indicator variable equal to one if alleged fraud is detected, and zero
otherwise. Consistent with Khanna et al. (2015), the fraud detection date is the earliest of the following dates: (1) the date the firm announces an informal
request by regulators for information relating to the subsequent enforcement action; (2) the date the firm receives a notice of a formal order of investigation
from regulators; or (3) the date of first regulatory proceeding or civil class action lawsuit filed in the related enforcement action. Standards errors are robust,
clustered by firm. ***, **, * refer to significance at the 0.01, 0.05, and 0.1 levels (two-tailed), respectively.
fraud detect | fraud
Coeff. z Coeff. z
(1) (2)
nonfraud_lock 0.000 1.43 − 0.001*** − 3.82

fraud_lock 0.043*** 3.73 0.054*** 5.90

size 0.170*** 5.35 0.171*** 5.90
tobinq 0.006 0.26 − 0.028 − 1.23
ebitda − 0.189 − 1.01 − 0.495*** − 2.71
growth 0.092* 1.72 0.043 0.86
lev 0.029 0.19 − 0.243 − 1.57
vol_return 0.626* 1.78 0.126 0.39
ind_tobinq 0.236 1.05 0.028 0.11
ind_tobinq_sq − 0.055 − 1.33 − 0.003 − 0.05
stockturnover 0.065*** 4.15 0.099*** 7.53
mkt_ret − 0.042 − 1.40 − 0.127*** − 2.65
icr − 9.701* − 1.77 0.896 0.58
hi_lit 0.334*** 2.68 0.137 1.47

bigN − 0.286*** − 3.36 − 0.183** − 2.25
lnanalyst 0.037 0.87 − 0.005 − 0.12
lnbsize − 0.074 − 0.46 0.035 0.26
lnacsize − 0.027 − 0.20 − 0.211 − 1.53
brd_ind − 0.525 − 1.60 − 0.078 − 0.26
ac_ind − 0.290 − 1.33 − 0.254 − 0.98
brd_own − 0.735 − 0.84 − 0.446 − 0.62
brd_tenure − 0.003 − 0.29 − 0.006 − 0.83
brd_coopt 0.268*** 3.71 − 0.200*** − 2.65
ceoduality 0.069 1.07 − 0.061 − 1.15
chg_aud 0.194** 2.44
constant − 0.689 − 1.32 − 1.123* − 1.89
Year dummies Yes
N 17,688
5.2. “Important” social connections
It is possible that some connections are more valuable than others (Engelberg et al., 2013). Directors who are socially
connected to influential firms in the markets—such as those in a major market index—should have greater reputational
capital at stake because possible reputational damage arising from the revelation of fraud in the focal firm will jeopardize the
connections and the associated benefits they have in the influential firms. We thus expect our results to be stronger for
independent directors who possess “important” social connections. We operationalize “important connections” as social
connections to S&P 500 firms. More specifically, we count the number of employment-related connections independent
directors have to S&P 500 firms
164 427
Table 6
Tests to address endogeneity
concerns.
This table reports the results of tests conducted to address endogeneity concerns. Panel A reports instrumental variable 2SLS regression results for the bivariate
probit model. The endogenous variable is connect and the instrumental variable, pastindustries, is the number of past industry sectors in which the director
worked (Faleye et al., 2014). The first-stage regression results are summarized in Columns (1) and (2); and the second-stage regression results are reported in
Columns (3) and (4). The variable connecthat is the predicted values from the first-stage regression results in Column (1) while connecthat2 is the predicted
values from the first-stage regression results in Column (2). Panel B reports results that examine “important” compared to “less important” connections.
“Important” connections (s&p500) are operationalized as the number of employment-based connections independent directors of a focal firm has to firms in
the S&P 500 index, and “less important” connections (smallcap) are operationalized as the number of employment-based connections independent directors of a
focal firm has to firms in the S&P SmallCap 600 index. Panel C reports the results of a propensity-score matched sample that examines the effect of director
connections (connect) on the commission (fraud) and detection of fraud (detect | fraud). The matching is based on directors' connectedness. Panel D reports the
results of a sample with predicted bivariate probability of fraud commission and detection above the median. Standards errors are robust, clustered by firm. ***,
**, * refer to significance at the 0.01, 0.05, and 0.1 levels (two-tailed), respectively.
Panel A: instrumental regression results
First stage Second stage
Dependent variable: connect connect Fraud detect | fraud
Coeff. t Coeff. t Coeff. z Coeff. z

(1) (2) (3) (4)
pastindustries 0.342 141.35*** 0.342 141.35***

connecthat 0.015 1.20
connecthat2 − 0.051** − 2.38
427 165
Controls Yes – all control variables in Yes – all control variables in Yes – all control variables in Yes – all control variables in
Model (3a) Model (3b) Model (3a) Model (3b)
Year dummies Yes Yes Yes
Industry dummies Yes Yes Yes
Adjusted R-squared 0.620 (P b 0.01) 0.620 (P b 0.01)
N 17,688 17,688 17,688
Panel B: importance of social connections
Coeff. z Coeff. z
(1) (2)
s&p500 0.001 0.14 − 0.017** − 2.06

smallcap 0.000 0.08 0.004 0.24
Controls Yes
Year dummies Yes
N 17,688
Panel C: bivariate probit model with propensity-score matched sample on propensity of social connectedness
Coeff. z Coeff. z
(1) (2)
connect 0.017 1.36 − 0.037** − 2.24

Controls Yes
Year dummies Yes
N 11,505
Panel D: bivariate probit model with predicted bivariate probability of fraud commission and detection above the median
Coeff. z Coeff. z
(1) (2)
connect 0.010 0.84 − 0.031** − 2.35

Controls Yes
Year dummies Yes
N 8845
(s&p500). Further, we construct a measure to capture “less important” connections by counting the number of employment-
related connections directors have to S&P SmallCap 600 firms (smallcap). We substitute connect in Models (3a) and (3b) with
s&p500 and smallcap.
Our results are reported in Panel B of Table 6. The variable smallcap does not provide any statistically significant power in
explaining fraud commission or detection as its coefficient is not significant in Column (1) or Column (2). More importantly,
the coefficient of s&p500 is not significant in the fraud commission model, but it is significantly negative in the fraud
detection model. Taken together, we find that it is the “important” connections possessed by independent directors that
contribute to a lower likelihood of fraud detection.17
5.3. Self-selection issue and propensity-score matching

approach
In order to further alleviate self-selection concerns, we construct a subsample by focusing on a group of firms in which
self- selection is less likely to occur. Following Intintoli et al. (2016), we restrict our analyses to a subsample of small firms
defined as firms in the smallest quartile of firm size (lnta). We estimate Models (3a) and (3b) in the subsample. Results
indicate that our primary results hold. Specifically, the coefficient on connect does not affect the probability of fraud
commission and is significantly negatively associated with the probability of fraud detection (coefficient = − 0.089, P-value
b 0.05).
Firm connectedness might be endogenous in that there are observable differences between firms with high versus low
director connectedness. We mitigate the selection bias due to observables using a propensity-score matching approach
18
(Tucker, 2010).
In particular, we construct a subsample consisting of observations with a similar propensity toward social connectedness. To
capture high (relative to low) social connectedness, we create an indicator variable (hi_connect) coded one if the value of
independent directors' connectedness (connect) is higher than the median value and zero otherwise.19 We then run a logit
model using hi_connect as the dependent variable, and all other right-hand variables included in Models (3a) and (3b) as
regressors, except for social connection variables. In so doing, we derive a firm's propensity score of having independent
directors that are more well- connected (i.e. with hi_connect equal to one). Next, we match observations based on the
computed propensity scores. Using nearest neighbor matching based on a caliper of 0.001 we obtain 11,505 observations with a
matched propensity toward independent director connectedness. We then re-estimate the bivariate probit model of fraud
commission and detection using propensity score-matched observations. Panel C in Table 6 reports the estimation results,
which are consistent with our prior findings.
In another robustness test we check whether the non-randomness in fraud incidents affects our findings. We construct a
subsample consisting of observations with similar likelihoods of fraud commission and detection while fraud actually occurs
in some of them. To empirically operationalize this we follow the same rationale of propensity score matching and obtain
predicted bivariate probabilities of fraud commission and detection using Models (3a) and (3b). Next, we form a matched
sample that includes observations with high predicted probabilities of fraud based on the estimates. In particular, we include
only firm-years with predicted probabilities above the median predicted probabilities of the full sample. This procedure
results in 8845 firm-years. We replicate prior analyses and the results are summarized in Panel D of Table 6, which suggests
that when using a sample that is constrained to observations with similar predicted probabilities of fraud commission and
detection, our primary findings remain consistent.
5.4. Reputational loss of well-connected

directors
We expect that reputational damages will be more severe for directors who are externally well connected when fraud is
revealed. One possible consequence is that they experience greater difficulty in finding other employment or directorships in
comparison to less connected directors.20 In this section we conduct a director-level analysis and focus on the
subsequent employment of independent directors who were sitting on the board of a fraud firm in the year of fraud detection.
We compare the number of directorships in other boards between well-connected directors and less-connected directors in
years after the fraud detection (from t + 1 to t + 5). Our results (untabulated) show that in the initial three years after fraud
detection there are no statistically significant differences in the number of directorships between these two types of directors,
21
possibly because firms were still in the fraud settlement stage during this period of time. Following that, we observe that
compared to their less-connected colleagues well-connected directors hold significantly fewer directorships in t + 4 (P-value
b 0.10) and t + 5 (P-value b 0.05), suggesting that reputational losses associated with fraud detection are material for well-
connected independent directors.
17
The findings may also suggest that directors with more “important” connections are more likely (and able) to leverage on their connections to minimize fraud
detection, assuming that directors' connections to influential firms in the markets indicate their superior capability of influencing the justice system and fraud
detection processes. We thus further examine whether “important” social connections affect the consequences of fraud. Our results show that in firms with
independent directors well connected to S&P 500 firms fraud remains undetected for a significantly longer period of time (P-value b 0.10), while the directors'
connections to S&P SmallCap
600 firms do not exhibit any significant power in explaining the duration of undetected fraud. But neither of the two types of ties shows a significant relationship
to the number of people being charged at fraud detection.
18
We acknowledge that the effectiveness of our propensity-score matching approach in addressing omitted variable and endogeneity problems is still open to
debate
(Angrist and Pischke,
2009).
19
We also employ alternate benchmarks of high social connections, including a median of director connections across all industries, and a mean of director
connections within and across industries. Board directors are considered highly connected if their connectedness (connect) is above the benchmark. Our results
remain robust using alternate benchmarks for high connectedness. Further, our results hold when we use a propensity score-weighting regression approach.
20
Prior evidence suggests that social connections improve re-employment opportunities even after forced departures (Faleye et al., 2014; Nguyen, 2012). We
base our
speculation upon strong evidence on the “burden of fame” and severe consequences of reputational losses as documented in both the literature and practices
(Fombrun,
1996; Fombrun and van Riel,
1997).
21
The average settlement duration in our sample is 2.8
years.
5.5. Omitted variables and alternative explanations
We address the possibility of omitted variables by including a range of additional variables to our models. CEOs may
leverage their connections in the fraud process (Khanna et al., 2015). Because well-connected CEOs may have a greater ability
to attract well-connected directors, a potential omitted variable to explain our findings relates to CEOs' external social
connectedness. Similar to our measure for independent directors' external connectedness, we construct CEOs' external social
connectedness measure (connect_ceo) by conducting a PCA of four social network measures of CEO connections: degree of
centrality; betweenness; closeness; and eigenvector centrality. We include connect_ceo in the bivariate probit model—that is,
Models (3a) and (3b)—and re-estimate the regressions. The results, reported in Panel A of Table 7, indicate that firms with
CEOs who are well-connected externally have a greater propensity toward engaging in fraud (coefficient = 0.029, P-value b
0.01), but a lower probability of fraud detection (coefficient = − 0.028, P-value b 0.05). More importantly, our prior findings on
the effect of independent directors' social connectedness on corporate fraud remain robust.
We also check the robustness of our findings toward managerial capability. In particular, we include an additional control
22
variable, Demerjian et al.’s (2012) managerial capability measure, into the bivariate probit model (mgr_ability) and
replicate the analyses. Our sample size reduces to 15,591 firm-years after including managerial ability. Panel B in Table 7
summarizes the results. Our findings on director connectedness stay consistent. Next, we investigate the robustness of our
findings after including the percentage of financial experts on the board (brd_finexp) because well-connected boards might lack
financial expertise to detect fraud. Panel C in Table 7 shows that our prior findings remain robust.
Our director connectedness measure may largely overlap with the concept of the busyness of directorships (Nguyen, 2012).
To address this, we control for board busyness (brd_busy) in the bivariate probit model. We capture board busyness by the
average number of outside boards an independent director sits on (Ferris et al., 2003; Fich and Shivdasani, 2006). The results
are reported in Panel D in Table 7 and indicate our prior findings still hold after controlling for busyness of independent
23
directors. In addition, the social exposure of directors may increase with their age. We include the average age of independent
directors on board in our models. The number of observations reduces to 11,077 firm-years. Our primary results (untabulated)
still hold.
Further, strong (weak) internal controls may coexist with inferior (superior) connectedness and contribute as an
alternative explanation for our findings. An effective internal control system potentially inhibits corporate misconduct and
hinders the occurrence of corporate fraud (Eilifsen and Messier, 2000). We obtain internal control data from Audit Analytics
(from 2003 to 2012) and our observations drop to 8502 firm-years. We replicate prior analysis in a subgroup with strong
internal control quality (where no internal control weaknesses are identified during the reporting period). In a separate
test, we control for audit going-concern opinions as the issuance of a going-concern opinion may be associated with internal
control deficiencies (Jiang et al., 2010). Untabulated results indicate that our findings remain robust in both tests.
5.6. Alternative model specification and variable choices
In our primary bivariate probit model, we include all control variables in the fraud commission regression in the
detection regression. As a robustness check, we exclude from the fraud commission regression all the variables related to
monitoring (bigN, lnanalyst, lnbsize, lnacsize, brd_ind, ac_ind, brd_own, brd_tenure, brd_coopt, and ceoduality), while the
variables in the detection model remain unchanged. The results are reported in Panel A of Table 8. In the alternative model
specification we obtain consistent results on the control variables and the results on connect stay inferentially unchanged. We
also examine the plausible effects of institutional ownership because the literature shows that institutional owners have
significant power and are thereby motivated to monitor firms' opportunistic actions (Shleifer and Vishny, 1986). The sample
size drops to 15,971. Our results (untabulated) remain robust and the institutional ownership variable shows no significant
explanatory power.
Furthermore, we examine the robustness of our findings to a different identifying variable in the bivariate probit model.
Following Khanna et al. (2015), we use stock options owned by the CEO (stockoption) as an alternative identifying variable
and include stockoption in the fraud commission model. We merge our sample with Execucomp to obtain information on stock
option compensation. Our sample size decreases to 11,320 firm-years. Panel B in Table 8 reports the results that show that our
prior findings remain robust. Further, as documented in prior work (Erickson et al., 2006; Khanna et al., 2015), we find that
CEO stock option holdings are associated with a greater tendency toward committing fraud.
We also test the robustness of our results to an alternate measure of social connectedness. Larcker et al. (2013) construct
a size-adjusted centrality measure using quintile ranks to control for the impact of firm size of the social network measures.
Similarly, we use an alternate measure of independent directors' social connectedness (connect_alt) whereby firms are ranked
into quintile based on firm size, and within each size quintile firms are sorted into different quintiles based on the four
centrality measures. As reported in Panel C of Table 8, our results remain robust.
5.7. Other robustness checks
We perform a series of other tests to examine the robustness of our findings. First, we check the robustness of our findings
by excluding civil lawsuit cases (Wang et al., 2010). The number of observations reduces to 16,872. Panel D of Table 8
presents the
22
The measure is available at http://faculty.washington.edu/smcvay/abilitydata.html.
23
We obtain consistent findings when including an additional variable to control for a CEO's external directorships.
164 427
Table 7
Results of robustness checks to alternative
explanations.
This table reports the results of robustness checks to alternative explanations. Panel A reports the results of a bivariate probit regression for corporate fraud that
controls for the external connectedness of the CEO (connect_ceo). connect_ceo captures CEO connectedness and is a composite measure of external connections of
CEOs computed based upon PCA of degree centrality, betweenness centrality, closeness centrality, and eigenvector centrality. Panel B presents the results of a
bivariate probit regression that controls for the effect of managerial ability (mgr_ability) on the commission (fraud) and detection of fraud (detect | fraud).
connect captures independent director connectedness. It is a composite measure of external connections of independent directors computed based upon
principal component analysis (PCA) of four centrality measures: degree centrality, betweenness centrality, closeness centrality, and eigenvector centrality.
Appendix A provides detailed explanations of the four centrality measures. mgr_ability is a measure for managerial capability derived in Demerjian et al. (2012).
Panel C reports the results of a bivariate probit regression that controls for the effect of board financial expertise (brd_finexp) on the commission (fraud) and
detection of fraud (detect | fraud). brd_finexp is the proportion of board with financial expertise. Panel D reports the results of a bivariate probit regression that
controls for the effect of board busyness (brd_busy) on the commission (fraud) and detection of fraud (detect | fraud). brd_busy is the average number of outside
boards that an independent director sits on. In all panels, the inclusion of controls and an identifying variable follows Table 3. In all panels, the dependent variable
in Column (1) is fraud, which is an indicator variable equal to one if firm observation shows an alleged fraud, and zero otherwise. The dependent variable in
Column (2) is detect | fraud, measured as an indicator variable equal to one if alleged fraud is detected, and zero otherwise. Consistent with Khanna et al. (2015),
the fraud detection date is the earliest of the following dates: (1) the date the firm announces an informal request by regulators for information relating to the
subsequent enforcement action; (2) the date the firm receives a notice of a formal order of investigation from regulators; or (3) the date of first regulatory
proceeding or civil class action lawsuit filed in the related enforcement action. Standards errors are robust, clustered by firm. ***, **, * refer to significance at the
0.01, 0.05, and 0.1 levels (two-tailed), respectively.
Panel A: external connectedness of CEO
Coeff. z Coeff. z
(1) (2)
connect 0.006 0.57 − 0.030** − 2.50

connect_ceo 0.029*** 3.60 − 0.028** − 2.13
Controls Yes
Year dummies Yes
N 17,688
Panel B: managerial ability
Coeff. z Coeff. z
(1) (2)
connect 0.009 0.79 − 0.036*** − 2.81

mgr_ability − 0.202* − 1.67 − 0.147 − 1.53
Controls Yes
Year dummies Yes
N 15,591
Panel C: board financial expertise ability
Coeff. z Coeff. z
(1) (2)
connect 0.004 0.32 − 0.032** − 2.46

brd_finexp 0.020 0.07 − 0.291 − 1.07
Controls Yes
Year dummies Yes
N 14,551
Panel D: board busyness
Coeff. z Coeff. z
(1) (2)
connect 0.013 1.23 − 0.030** − 2.51

brd_busy 0.003 1.25 0.001 0.50
Controls Yes
Year dummies Yes
N 16,575
427 165
Table 8
Results of robustness checks to alternative
estimations.
This table reports the results of robustness checks to alternative estimations. Panel A presents the results of a bivariate probit regression that examines the association
between connectedness of independent directors (connect) on the commission (fraud) and detection of fraud (detect|fraud), using an alternative model specification.
connect captures independent director connectedness. It is a composite measure of external connections of independent directors computed based upon principal
component analysis (PCA) of four centrality measures: degree centrality, betweenness centrality, closeness centrality, and eigenvector centrality. Appendix A provides
detailed explanations of the four centrality measures. The definitions of control variables are provided in Appendix B. Panel B reports the results of a bivariate probit
regression that examines the effect of director connections (connect) on the commission (fraud) and detection of fraud (detect |fraud) using stock option (stockoption)
an alternate identifying variable. stockoption is the value of stock options (in billions) owned by a CEO (Khanna et al., 2015). Panel C reports the results of a bivariate
probit regression for corporate fraud that examines an alternate measure of external connectedness of independent directors (connect_alt). Following Larcker et al.
(2013), firms are ranked into quintile based on firm size, and within each size quintile, firms are sorted into different quintiles based on the four centrality measures.
Panel D reports the results of a bivariate probit regression that examines the effect of board connections (connect) on the commission (fraud) and detection of fraud
(detect|fraud) to the exclusion of civil action lawsuits. In all panels, the dependent variable in Column (1) is fraud, which is an indicator variable equal to one if firm
observation shows an alleged fraud, and zero otherwise. The dependent variable in Column (2) is detect|fraud, measured as an indicator variable equal to one if
alleged fraud is detected, and zero otherwise. Consistent with Khanna et al. (2015), the fraud detection date is the earliest of the following dates: (1) the date the
firm announces an informal request by regulators for information relating to the subsequent enforcement action; (2) the date the firm receives a notice of a formal
order of investigation from regulators; or (3) the date of first regulatory proceeding or civil class action lawsuit filed in the related enforcement action. Standards
errors are robust, clustered by firm. ***, **, * refer to significance at the 0.01, 0.05, and 0.1 levels (two-tailed), respectively.
Panel A: alternative bivariate probit model specification
Coeff. z Coeff. z
(1) (2)
connect 0.007 0.69 − 0.032*** − 2.65

size 0.176*** 7.66 0.192*** 7.83
tobinq 0.009 0.41 − 0.021 − 0.94
ebitda − 0.225 − 1.17 − 0.530*** − 2.88
growth 0.113** 2.07 0.041 0.82
lev − 0.014 − 0.09 − 0.273* − 1.75
vol_return 0.723** 2.09 0.187 0.60
ind_tobinq 0.231 1.03 0.046 0.18
ind_tobinq_sq − 0.056 − 1.39 − 0.009 − 0.18
stockturnover 0.070*** 4.46 0.103*** 8.02
mkt_ret − 0.034 − 1.11 − 0.122** − 2.49
icr − 10.307* − 1.97 1.055 0.71
hi_lit 0.333*** 2.72 0.130 1.41
bigN − 0.073 − 1.09
lnanalyst − 0.024 − 0.66
lnbsize 0.045 0.41
lnacsize − 0.170 − 1.58
brd_ind 0.285 1.15
ac_ind 0.042 0.17
brd_own − 0.170 − 0.25
brd_tenure − 0.006 − 1.06
brd_coopt − 0.309*** − 4.69
ceoduality − 0.069 − 1.61
chg_aud 0.204** 2.60
constant − 1.167*** − 2.73 − 1.960*** − 3.36
Year dummies Yes
N 17,688
Panel B: stock option as alternate identifying variable
Coeff. z Coeff. z
(1) (2)
connect 0.002 0.19 − 0.028** − 2.04

stockoption 0.948* 1.86
Controls Yes
Year dummies Yes
N 11,320
Panel C: alternate measure for connectedness
Coeff. z Coeff. z
(1) (2)
connect_alt 0.008 0.59 − 0.028* − 1.70
(continued on next page)

166 427
Table 8 (continued)
Panel C: alternate measure for connectedness
Coeff. z Coeff. z
(1) (2)
Controls Yes Yes

Year dummies Yes
N 17,688
Panel D: excluding civil lawsuit cases
Coeff. z Coeff. z
(1) (2)
connect 0.013 1.15 − 0.036*** − 3.06

Controls Yes
Year dummies Yes
N 16,872
results, demonstrating that our prior findings hold when only including AAER cases. We also check the robustness of our
findings by including a Sarbanes-Oxley Act (SOX) indicator as the internal control environment generally improves afterward
(Patterson and Smith, 2007; Rittenberg and Miller, 2005). We further examine the plausible effects of director turnover by
including an indicator variable for the incidence of director turnover during the year. We also adopt alternative definitions
for industries (i.e. Fama–French 48 industries). Our results remain consistent across various tests.
5.8. Types of connections
In the main analysis we construct the connectedness measures based on independent directors' employment history. The
literature suggests that social connections established via shared memberships at social clubs and social groups, as well as alumni
relationships, also play a significant role in explaining individual behavior (Engelberg et al., 2012, 2013; Hwang and Kim, 2009). In
this section, we examine the possible effects of different types of social connections. In particular, we focus on degree centrality and
categorize social connections into work-related relationships, educational ties, and friendship ties (i.e. social ties established via
shared social events or shared memberships in charities, clubs, etc.). We estimate the de-trended degree centrality measure for all
three types of connections following the procedure outlined in Faleye et al. (2014). We then replace the connectedness measures in
the bivariate probit model—that is, Models (3a) and (3b)—with the employment-related, educational, and friendship ties. Our results,
presented in Appendix C, indicate that employment-related and friendship connectedness play a significant role in explaining the
processes of fraud detection. Specifically, independent directors who are well connected via director employment-based (P-value b
0.01) and friendship ties (P-value b 0.05) have a lower probability of fraud detection while educational ties do not provide a
significant power in explaining fraud detection.24
6. Conclusion
Corporate fraud is a huge concern to society (Free and Murphy, 2015). We investigate the effect of independent directors'
social connectedness on the likelihood that a firm commits fraud and the likelihood of detecting fraud given occurrence of
fraud. Our results show that although independent directors' connectedness has no significant associations with fraud
commission, it relates to a significantly lower rate of detection. Further, we explore how the consequences of fraud relate to
directors' social connectedness as well as the plausible contagion effects of fraud between firms via interlocking directorates.
We show that independent directors' connectedness is associated with a longer duration of undetected fraud and fewer people
are charged with fraud. In addition, we also find that corporate fraud is contagious and a firm's propensity of engaging in
fraud increases when it shares interlocking directorates with a fraud firm. It is likely that regulators expect such contagion
effects as the likelihood of fraud detection is also higher when board directors are connected to a fraud firm.
Our findings yield important implications for regulators and practitioners. We show that there are unintended consequences
associated with appointing independent directors who are well connected externally. Public scrutiny alone might not function
effectively in deterring the occurrence of corporate fraud because, given information asymmetry on corporate behaviors, self-
interested corporate individuals are able to disguise their self-serving or even illegal activities. Regulators should be aware of the
plausible adverse consequences associated with independent directors' connectedness when considering how to improve the anti-
fraud community's ability to prevent,
24
As a practical matter, BoardEx provides limited information on directors' graduation years. We follow prior literature and remove the date restriction
(Bruynseels and Cardinaels, 2014). Nevertheless, this practice introduces noise to our measure of educational ties.
427 167
detect, and remediate corporate fraud. Future research may examine the channels employed by well-connected directors to deter
fraud detection. For example, literature shows that social connections with regulators, lawyers, and politicians are important
factors that influence fraud detection and the consequences of fraud (Correia, 2014; Dorminey et al., 2012; Sutherland, 1944).
Further research that explores the important types of social connections can potentially provide strategies that regulators can
employ to prevent the development of fraud.
Appendix A. Social connectedness

measures
Our connectedness construct consists of four individual measures. First, we measure degree centrality which is defined by
Freeman (1979) as “the number of direct contracts (or adjacencies) for a point, pk”. Expressed in a formula, degree of
centrality of pk is:
n
DEGREE pk ¼ ∑i¼1 aðpi ; p Þ
k
Betweenness centrality measures how well a point possesses a vital location in connecting other points to each other
(Freeman,
1979). The betweenness of centrality of pk
is:
k
BETWEENNESS p k ¼ ∑ ∑ n
s t
where nkst = 1 if vertex k lies on the shortest path between s and t, and zero if not.
Closeness centrality measures how easily or quickly pk can reach another point in the network through connections. The
formula is:
168 427
n−1
CLOSENESS pk ¼ n
∑i¼1 dðpi ; pk Þ
where d(pi, pk) = the number of ties in the geodesic linking pi and pk.
Eigenvector centrality follows Bonacich (1972) that provides a refined definition of degree centrality: pk is more connected
when its direct contacts are well-connected as well. The following formula measures the connectedness of pk based on the
connected of its direct links:
n
λ CENTRALITYpk ¼ ∑i¼1 gðpi ; pk ÞCENTRALITYp
i
where λ is the proportionality factor and g(pi, pk) = 1 if pi and pk are linked, and zero otherwise. Then the formula for
eigenvector centrality of pk is:
λ EIGENVECTORpk ¼ G EIGENFACTOR
Panel A: Pearson/Spearman correlations between centrality measures (under/above the diagonal).
Degree Betweenness Closeness Eigenvector
Degree 1.000 0.974*** 0.971*** 0.954***

Betweenness 0.878*** 1.000 0.934*** 0.929**
Closeness 0.566*** 0.446*** 1.000 0.977***
Eigenvector 0.905*** 0.791*** 0.573*** 1.000
***, **, * refer to significance at the 0.01, 0.05, and 0.1 levels (two-tailed), respectively.
Panel B: Principal component analysis.
Comp. 1 Comp. 2 Comp. 3 Comp. 4
Degree 0.554 − 0.134 − 0.012 − 0.822

Betweenness 0.504 − 0.459 0.609 0.406
Closeness 0.384 0.876 0.268 0.112
Eigenvector 0.540 − 0.058 − 0.747 0.384
Eigenvalue 3.074 0.694 0.165 0.066
% var. explained 76.86 17.36 4.12 1.66
Cumulative % 76.86 94.22 98.34 100
Panel C: Descriptive statistics.
Degree 17,688 45.529 4.000 26.000 64.000 57.550

Betweenness 17,688 2962.870 5.740 454.968 2752.03 6857.211
Closeness 17,688 0.311 0.324 0.383 0.418 0.167
Eigenvector 17,688 0.102 0.006 0.060 0.145 0.128
Appendix B. Definitions of variables
Variable Definitions Sources

names
Fraud-related variables
fraud Indicator variable equal to one if firm observation shows an alleged fraud, and zero otherwise. SECs AAERs, SSCAC,
detect | fraud Indicator variable equal to one if alleged fraud is detected, and zero otherwise. Consistent with Khanna et al. LexisNexis, and Google
(2015), the fraud detection date is the earliest of the following dates: (1) the date the firm announces an
informal request by regulators for information relating to the subsequent enforcement action; (2) the date
the firm receives a notice of a formal order of investigation from regulators; or (3) the date of first regulatory
proceeding or civil class action lawsuit filed in the related enforcement action.
fraud_dur Period in number of years between the beginning and detection of alleged fraud.
settle_amt The natural logarithm of settlement amount paid by a firm in million USD.
num_charged Number of people charged in a litigation or enforcement action.
Firm connectedness variables

connect Independent director connectedness. Composite measure of external connections of independent directors BoardEx
computed based upon principal component analysis of four centrality measures: degree centrality,
betweenness centrality, closeness centrality, and eigenvector centrality. See Appendix A for detailed
calculation of the four centrality measures.
connect_alt Alternate measure of external connectedness of independent directors. Following Larcker et al. (2013), firms
are ranked into quintile based on firm size, and within each size quintile, firms are sorted into different
quintiles based on the four centrality measures.
nonfraud_lock Number of connections that independent directors have to non-fraud firms through past employment.
fraud_lock Number of connections that independent directors have to fraud firms through past employment.
hi_connect Indicator variable equal to one if connect is higher than median, and zero otherwise.
s&p500 “Important” connections. Number of employment-based connections independent directors of a focal firm
has to firms in the S&P 500 index.
smallcap “Less important” connections. Number of employment-based connections independent directors of a focal
firm has to firms in the S&P SmallCap 600 index.
connect_ceo CEO connectedness. Composite measure of external connections of CEO computed based upon principal
component analysis of four centrality measures: degree centrality, betweenness centrality, closeness
centrality, and eigenvector centrality. See Appendix A for detailed calculation of the four centrality measures.
connecthat Predicted values from the first-stage regression results of 2SLS in Column (1) Panel A Table 6.
connecthat2 Predicted values from the first-stage regression results of 2SLS in Column (2) Panel A Table 6.

size The natural logarithm of total assets. Compustat
tobinq The market value of common equity, plus the book value of total liabilities, divided by the book value of total
assets. ind_tobinq The median of tobinq in an industry in a given year. Industry is defined by the first two digits of SIC
codes. ind_tobinq_sq A quadratic term of ind_tobinq.
ebitda Earnings before interest, taxes, depreciation, and amortization, divided by the book value of total assets.
growth The five-year average annual sales growth rate.
lev The sum of short- and long-term debt, divided by the book value of total assets.
icr Industry concentration ratio, defined as the sum of the percentage market share (in sales) of the top four
firms among all firms in Compustat in each industry-year. Industry is defined by the first two digits of SIC
codes.
vol_return The volatility of daily stock return during the year. CRSP
stockturnover The ratio of the total number of shares traded during the fiscal year t to the total number of common shares
outstanding.
mkt_ret The annual buy-and-hold stock returns.
hi_lit Indicator variable equal to one if firm belongs to the list of industries (with high litigation risk), and zero Compustat
otherwise.
SIC lists include 2833 to 2836, 3570 to 3577, 3600 to 3674, 5200 to 5961, 7370 to 7374, or 8731 to 8734.
chg_aud Indicator variable equal to one if there is auditor change during the year, and zero otherwise. Audit Analytics

lnanalyst Natural logarithm of one plus the number of analysts following the firm during the year. I/B/E/S
bigN Indicator variable equal to one if a firm's annual reports are audited by a Big N auditor, and zero otherwise. Audit Analytics
lnbsize Natural logarithm of number of board members. BoardEx
427 169
170 427
(continued)
Variable Definitions Sources

names
lnacsize Natural logarithm of number of audit committee members.

brd_ind Proportion of independent directors on the board.
ac_ind Proportion of independent director in the audit committee.
brd_coopt Proportion of directors on the board appointed during CEO's tenure.
brd_own Percentage of outstanding common shares held by all directors on the board.
brd_tenure Average tenure of directors on the board.
ceoduality Indicator variable equal to one if a CEO also chairs the board, and zero otherwise.
brd_busy Average number of outside boards that an independent director sits on.
brd_finexp The proportion of board with financial expertise.
stockoption Value of stock options (in billions) owned by a CEO. Execucomp
pastindustries Number of past industry sectors in which the director worked in. BoardEx
mgr_ability Managerial capability measure derived in Demerjian et al. (2012). Demerjian et al. (2012)
Appendix C. Types of social connections
Following Faleye et al. (2014), we capture the types of social connections as follows: connect_pro is the detrended degree
centrality measure of professional social connections; connect_fri is the detrended degree centrality measure of friendship
social connections and connect_edu is the detrended degree centrality measure of educational social connections. All other
variables are as defined in Appendix B.
Coeff. z Coeff. z
(1) (2)
connect_pro 0.004 0.20 − 0.067*** − 2.66

connect_fri − 0.030 − 0.95 − 0.088** − 2.26
connect_edu 0.031 1.22 0.057 1.62

size 0.190*** 5.95 0.181*** 6.57
tobinq 0.006 0.28 − 0.021 − 0.87
ebitda − 0.262 − 1.34 − 0.476** − 2.41
growth 0.106* 1.95 0.037 0.70
lev − 0.061 − 0.38 − 0.226 − 1.45
vol_return 0.511 1.50 0.288 0.94
ind_tobinq 0.270 1.20 0.143 0.55
ind_tobinq_sq − 0.063 − 1.53 − 0.024 − 0.48
stockturnover 0.066*** 4.01 0.098*** 7.16
mkt_ret − 0.037 − 1.13 − 0.127** − 2.48
icr − 8.920* − 1.75 1.002 0.53
hi_lit 0.341*** 2.65 0.158* 1.66

bigN − 0.326*** − 3.76 − 0.245*** − 2.98
lnanalyst 0.030 0.70 0.005 0.11
lnbsize 0.050 0.31 0.041 0.30
lnacsize − 0.015 − 0.11 − 0.144 − 1.08
brd_ind − 0.558 − 1.63 0.153 0.48
ac_ind − 0.356 − 1.58 − 0.129 − 0.48
brd_own − 0.747 − 0.80 − 0.397 − 0.56
brd_tenure − 0.006 − 0.67 − 0.006 − 0.76
brd_coopt 0.291*** 3.66 − 0.055 − 0.69
ceoduality 0.043 0.65 − 0.070 − 1.28
chg_aud 0.143* 1.71
constant − 0.649 − 1.18 − 1.503** − 2.42
Year dummies Yes
N 17,688
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Journal of Corporate Finance 45 (2017) 401–427

Contents lists available at ScienceDirect

Journal of Corporate Finance

Corporate fraud and external social connectedness of

2. Related literature and hypothesis

2.1. Related literature

2.1.1. Social connectedness and

2.2. Hypothesis development

2.2.1. Fraud commission

2.2.2. Fraud detection

2.2.3. Consequences of fraud

2.2.4. Contagion effects of board

H4. Ceteris paribus, interlocking directorates affect corporate

3. Data, sample, and empirical

3.1. Data and sample selection

3.2. Empirical model for fraud commission and

3.2.1. Bivariate probit model

Fraud detectioni ¼ XD;it β þ μ ð1bÞ

Observeit ¼ Fraud commissionit Fraud detectionit ð2Þ

PðObserveit ¼ 1Þ ¼ PðFraud commissionit Fraud detectionit ¼ 1Þ ¼ PðFraud commissionit ¼ 1ÞPðFraud detectionit ¼

PðObserveit ¼ 0Þ ¼ PðFraud commissionit Fraud detectionit ¼ 0Þ ¼ PðFraud commissionit ¼ 0ÞPðFraud detectionit ¼

Lðα; β; σ Þ ¼ ∑ log½PðObserveit ¼ 1Þ þ ∑ log½PðObserveit ¼ 0Þ ð4Þ

Panel A: distribution by year in number of ﬁrms

Year Total fraud

13 Oil and gas extraction 933 5.3 874 59

Panel A: full sample descriptive statistics (n = 17,688)

Variables N Mean P25 Median P75 SD

connect 17,688 0.000 − 1.003 − 0.342 0.607 1.756

Firm economic characteristics

Corporate governance and monitoring variables

Panel B: comparison of fraud and no fraud samples

fraud = 1 (n = 944) fraud = 0 (n = 16,744) Test of mean Test of median

Mean Median SD Mean Median SD t z

connect 0.246 − 0.241 2.085 − 0.014 − 0.346 1.735 4.42*** 2.64**

Firm economic characteristics

(continued on next page)

Panel B: comparison of fraud and no fraud samples

fraud = 1 (n = 944) fraud = 0 (n = 16,744) Test of mean Test of median

Mean Median SD Mean Median SD t z

lev 0.225 0.208 0.190 0.202 0.166 0.200 3.48*** 4.80***

Corporate governance and monitoring

Panel C: comparison of high and low social connections

connect N median connect b median Test of mean

brd_busy 8308 4.803 0.019 8267 4.676 0.020 4.610***

Panel D: fraud detection sample descriptive statistics (n = 407)

Variables N Mean P25 Median P75 SD

fraud_dur 407 3.389 1.000 3.000 5.000 2.404

3.3. Empirical models for consequences of

4. Main results and discussion

4.1. Corporate fraud and independent director connectedness

4.2. Consequences of fraud

Fraud detect | fraud

connect 0.011 1.03 − 0.031** − 2.57

Firm economic characteristics

Corporate governance and monitoring variables

Panel A: duration of undetected fraud

Coeff. t Hazard ratio z

connect 0.309*** 2.65 0.872*** − 3.43

Firm economic characteristics

Corporate governance and monitoring variables

Panel B: individuals charged

connect − 0.475*** − 3.70

Panel B: individuals charged

ebitda 0.859 0.60

connect 0.246 − 0.241 2.085 − 0.014 − 0.346 1.735 4.42* 2.64

lev 0.225 0.208 0.190 0.202 0.166 0.200 3.48* 4.80*

connect 0.309* 2.65 0.872* − 3.43

pastindustries 0.342 141.35* 0.342 141.35*

Degree 1.000 0.974* 0.971* 0.954***