Restructuring to Repair Legitimacy – A Contingency Perspective

• DOI: http://doi.org/10.1111/j.1467-8683.2009.00782.x
• Published date: 01 January 2010
• Date: 01 January 2010
• Author: Pengii Wang

Restructuring to Repair Legitimacy – A

Contingency Perspective

Pengii Wang*

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This study examines the effectiveness of restructuring in repairing legitimacy after a f‌irm is

punished for f‌inancial fraud.

Research Findings/Insights: We use the antecedents of fraud to distinguish between three types of f‌inancial fraud and

argue that different types of such fraud affect different dimensions of legitimacy. We also identify four types of restruc-

turing and adopt a contingency perspective to argue that the type of restructuring adopted should match the dimensions

of legitimacy affected for a successful legitimacy repair, which is proxied by a positive market response when the

restructuring is announced. Using a sample of Chinese listed f‌irms, we f‌ind that disassociation from illegitimate business

operations and creation of valuable business operations are more effective in repairing legitimacy after fraudulent f‌inancial

reporting. Disassociation from illegitimate organizational structures and creation of monitors are more effective following

embezzlement or stock market manipulation. However, no type of restructuring is effective following improper account-

ing practice. Market investors value creation of monitors more than they do disassociation from an illegitimate organiza-

tional structure, and attach the same value to disassociation from illegitimate business operations and creation of valuable

business operations.

Theoretical/Academic Implications: This study makes three contributions to the organizational legitimacy and corporate

crisis management literature. First, it links corporate crises arising from f‌inancial fraud to social legitimacy. Second, it

extends the number of restructuring types identif‌ied in the legitimacy literature to four, taking content and form as two

dimensions. Third, it links corporate crises arising from f‌inancial fraud to the effectiveness of responsive restructurings via

social legitimacy.

Practitioner/Policy Implications: Firms punished for f‌inancial fraud should signal restructuring according to the nature of

the fraud and address the pertinent dimensions of legitimacy.

Keywords: Corporate Governance, Financial Fraud, Social Legitimacy, Restructuring

INTRODUCTION

Organizational crisis management is an important topic

because an organizational crisis will negatively affect

the legitimacy of the organization, which may further

threaten the organization’s survival in the worst-case sce-

nario. In this sense, organizational crisis management is

simply the procedure by which the f‌irm seeks to repair orga-

nizational legitimacy. Although the last several decades have

seen a productive stream of research on crisis management

(e.g., Agrawal, Jaffe, & Karpoff, 1999; Elsbach & Sutton, 1992;

Livingston, 1997; Schlenker, 1980; Staw, Mckechnie, &

Puffer, 1983; Tedeschi, 1981), organizational crises have only

recently been examined from a social interactionperspective

(Breitsohl, 2009). Moreover, while image restoration strate-

gies have been incorporated into explanations of effective

crisis management, it remains unclear why some reactions

are useful in overcoming a certaintype of crisis, while others

are not.

This study seeks to understand organizational crisis man-

agement from a social interactive perspective by linking

organizational crises with the effectiveness of response strat-

egies via social legitimacy. Specif‌ically, we focus on the pun-

ishment of corporate f‌inancial fraud, a typical organizational

crisis that threatens the social legitimacy of the organization.

According to Zahra, Priem, and Rasheed (2005), corporate

f‌inancial fraud refers to deliberate action taken by manage-

ment at any level to deceive, con, swindle, or cheat investors

*Address for correspondence: Department of Business Policy, National University of

Singapore, 17 Law Link, Singapore 117591. Tel: (65) 9787 5876; E-mail: pengji.wang@

nus.edu.sg

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Corporate Governance: An International Review, 2010, 18(1): 64–82

© 2010 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2009.00782.x

or other key stakeholders. When the fraud is publicly

revealed and punished, the f‌irm will be penalized not only

through litigation, but also via a loss of social legitimacy. For

example, it will lose support from market investors, who

will no longer have conf‌idence in the f‌irm’s performance

and credibility (Karpoff & Lott, 1993). These effects will

lead to negative market response (Karpoff & Lott, 1993),

which is an indicator of a legitimacy crisis. The f‌irm must

take steps to repair its legitimacy to regain support from

market investors.

Prior literature on legitimacy suggests that to repair its

legitimacy, the f‌irm can either normalize its accounts or ini-

tiate a restructuring (Suchman, 1995). The account normal-

ization strategy is addressed in the impression management

literature, which stresses the importance of communication

following a crisis. Communication is effective when the

fraud is disclosed through the “bamboo telegraph” rather

than being publicly revealed (Schlenker, 1980; Tedeschi,

1981). When the fraud is publicly revealed, the f‌irm is better

advised to take substantive measures to signal the effort it is

making to reduce the likelihood of fraud occurring in future.

Suchman (1995) identif‌ies two types of restructuring strat-

egies aimed at repairing legitimacy: creating a monitoring

mechanism and disassociation from key individuals, pro-

cesses, structures, etc. Later studies follow Suchman (1995)

and examine whether f‌irms implement more leadership

changes or improve their monitoring systems after revela-

tions of fraud. However, empirical results are not entirely

consistent with the f‌inding that f‌irms predominantly adopt

monitoring and disassociation strategies: some empirical

studies have lent support to such a prediction (Farber, 2005;

Gerety & Lehn, 1997; Livingston, 1997), while others have

not (Agrawal et al., 1999; Fich & Shivdasani, 2005).

These inconsistent results could be attributed to two

reasons. First, prior studies may not have recognized that

there are several distinct types of f‌inancial fraud, each of

which may hurt different dimensions of legitimacy. For

example, some f‌inancial frauds may hurt the f‌irm’s moral

legitimacy, as a result of which the market will challenge the

f‌irm’s intentions. Others mayhurt the f‌irm’s pragmatic legiti-

macy, following which the market will lose conf‌idence in the

f‌irm’s ability to providevalue. The response strategyadopted

should match the distinct legitimacy dimension requiring

attention for an optimal effect (Suchman, 1995). Second, the

response strategies examined in prior studies are limited to

organizational restructurings, which may be more effective

for some types of fraud, but not for others. To repair legiti-

macy following other types of fraud,organizations may need

to restructure other aspects of their operations.

This study seeks to f‌ill the gaps in the literature identif‌ied

above. Mainly drawing from literature on f‌inancial fraud

and organizational legitimacy, we adopt a contingency per-

spective to examine the effectiveness of restructurings in

repairing legitimacy after f‌irms are punished for different

types of f‌inancial fraud. We identify four dimensions of

organizational legitimacy: regulative, pragmatic, moral, and

cognitive legitimacy. We then argue that the detection of

f‌inancial fraud may hurt different dimensions of organiza-

tional legitimacy, although all forms of f‌inancial fraud hurt

regulative legitimacy. We examine the diverse range of ante-

cedents of f‌inancial fraud: one of the antecedents of fraudu-

lent f‌inancial reporting, which hurts the f‌irm’s pragmatic

legitimacy, is performance pressure; one of the antecedents

of embezzlement and stock market manipulation, which

damages the organization’s moral legitimacy, is insider

interests; improper accounting practice, which hurts the

regulative legitimacy of the f‌irm, is not motivated by either

performance pressure or insiders’ intentions to seize ben-

ef‌its that properly belong to the f‌irm or to other stakehold-

ers. We also regard content and form as two dimensions in

identifying four types of restructuring aimed at responding

to a legitimacy crisis: disassociation from an illegitimate

organizational structure, disassociation from illegitimate

business operations, creation of monitors, and creation of

valuable business operations. We argue that the type of

restructuring implemented should match the dimension(s)

of legitimacy requiring attention for a successful legitimacy

repair, which is proxied by a positive market response when

the restructuring is announced.

Taking Chinese listed f‌irms punished for f‌inancial fraud

(fraud f‌irms) and matched nonfraud f‌irms (nonfraud f‌irms)

as our sample, we f‌irst conduct an event study to compare

the market response with restructuring announcements

made by the fraud f‌irms and the nonfraud f‌irms. We then

use ordinary least squares (OLS) regression models to

examine whether and how the market response to a restruc-

turing announcement depends on the nature of the f‌inancial

fraud. Our results show that the four types of restructuring

lead to a more positive market response for the fraud f‌irms

than for the nonfraud f‌irms. Disassociation from illegitimate

business operations and creation of valuable business opera-

tions are more effective restructuring strategies for f‌irms

punished for fraudulent f‌inancial reporting, which hurts

f‌irms’ pragmatic legitimacy. Disassociation from illegitimate

organizational structures and creation of monitors are more

effective strategies for f‌irms punished for embezzlement or

stock market manipulation, both of which hurt f‌irms’ moral

legitimacy. However, no form of restructuring is effective in

repairing legitimacy following improper accounting prac-

tice. Market investors value creation of monitors more than

they do disassociation from an illegitimate organizational

structure, while they attach equal value to disassociation

from illegitimate business operations and creation of valu-

able business operations.

THEORETICAL BACKGROUND

Dimensions of Legitimacy Crises

The extant literature posits several classif‌ications of organi-

zational legitimacy. For example, Scott (1995) proposes that

there are three types of organizational legitimacy: regula-

tive, normative, and cognitive. Regulative legitimacy is

derived on the basis of compliance with legal or quasi-legal

requirements in which the possibility of sanctions coerces

organizations into adherence to rules. Normative legitimacy

has a moral basis in that it mirrors perceived appropriate-

ness in terms of norms, which govern what is importantand

how things should be done. Cognitive legitimacy ref‌lects the

extent to which an organization and its activities are cultur-

ally supported and conceptually correct, i.e., the degree to

which a f‌irm’s actions are taken for granted.

RESTRUCTURING TO REPAIR LEGITIMACY 65

Volume 18 Number 1 January 2010© 2010 Blackwell Publishing Ltd