Fall/Winter : Past Issues

Minding the Store
McCombs Researchers Add to Body of Knowledge about how Corporate Boards Work and What They Need to Watch
by Pam Losefsky and Sandie Taylor

A multifaceted issue, corporate governance piques the interest of business scholars as much as it concerns the American public. With a large number of McCombs School faculty engaging in research aimed to clarify best practices in corporate governance, we selected several to highlight. Their work contributes to our understanding of how corporate boards work and how they can work more effectively.

Board Diversity Doesn’t Change Board Behavior

While corporate board appointments still most often go to people with elite social and educational credentials who are demographically similar to members of the power elite, the number of appointments held by managers who lack such backgrounds has increased over time.

Considering such boardroom gains made by demographic minorities, management professor Jim Westphal wondered why board behavior, such as a tendency to conform to the opinion of the CEO on strategic issues,
is unaffected by the rising diversity.

Westphal conducted a study that suggests board members who lack elite credentials may have had to win their appointments through a particularly high level of ingratiatory behavior toward CEOs, and that this tendency carries forward into the boardroom. “The results reveal a form of social discrimination,” says Westphal, “in that managers who are demographic minorities must engage in a higher level of ingratiatory behavior in order to have the same chance of obtaining a board appointment.”

Westphal found that interpersonal influence behavior will substitute to some degree for the advantages of an elite background or demographic majority status. In other words, prospective board appointees who do not come from elite circles have no choice but to curry favor with the CEO in order to receive a recommendation. In addition to making the CEO feel that he or she should reciprocate the favors of a deferential manager, the behavior may make CEOs more likely to believe that such managers will conform to the social norms of the boards of large companies.

Board Member Friendships May Encourage Frank Assessments

Why do corporate boards of low-performing companies often fail to question problematic strategies? Management professor Jim Westphal believes that “pluralistic ignorance” is what often cripples effective action.

Pluralistic ignorance stems from the concept of the Abilene Paradox, articulated from an account of a family’s decision to travel to Abilene for dinner when, individually, no single person wanted to go.

Westphal found that within a board, the collective fear of voicing a minority opinion advocating strategy change can contribute to stagnation because individuals are unwilling to challenge a perceived group consensus. “Directors tend to underestimate the extent to which colleagues share their concerns, and this leads them to hesitate in expressing those concerns,” Westphal explains.

Expressing a dissenting opinion may involve social risk for board members, so they wait for others to indicate disagreement. Because boards are comprised of prominent individuals who control elevated
positions, financial decisions and other resources, few outside board members want to jeopardize their standing with inside directors. On the other hand, inside directors fear losing social esteem if they condemn strategies they have previously supported.

Pluralistic ignorance is reduced, Westphal found, when outside directors have a high level of demographic similarity and are friends. These factors moderate the perceived social risks of being distanced from the group or negatively evaluated when articulating different ideas. Members feel more comfortable around and supported by members they consider friends,
says Westphal.

CEO Perks Mean Less for Shareholders

Research by finance professor Jay Hartzell indicates that when CEOs act in their own self interest during merger negotiations, it is unlikely that they will remain as officers of the acquiring company. Rather, it appears that certain CEOs may be negotiating lucrative personal benefit packages as reimbursement for surrendering the power, prestige and compensation associated with their jobs.

“The combination of a large number of mergers and a friendlier negotiating environment [than the hostile take-over environment of the 70s and 80s] led us to ask what CEOs receive in order for them to agree so often to such transactions,” explains Hartzell. Collecting information on CEOs’ stock and option holdings and golden parachutes, Hartzell finds an average total post-merger gain for the CEOs in his study of between $8 and $12 million.

“The implication of the research is that some CEOs might compromise the interests of their own shareholders in pursuit of these benefits,” Hartzell says, noting that the study just looked at extreme cases. “They may possibly be negotiating less favorable acquisition terms in deals in which they personally fare well.” Hartzell says that boards need to take a close look at the treatment of the CEO when sifting through merger proposals.

“Buying firms may be able to get the deal done more cheaply by paying more cash to the CEO and less to shareholders,” says Hartzell. “On the other side, target
boards need to realize that the CEO has an incentive to take less for their shareholders if they get more out of it.”

Hartzell’s results indicate that the financial costs to shareholders of such CEO compensation arrangements could be substantial. The imbalance, which arises from a conflict of interest between CEOs and their shareholders, results in a wealth transfer from shareholders of the purchased firm to those of the buyer.

Institutional Shareholders: Good News, Bad News

While most shareholders agree that managerial compensation should be linked to corporate performance, in real life this is often not the case, with CEOs pulling down enormous salaries regardless of whether their companies run well or are run into the ground.

But recent research from McCombs School finance professors Jay Hartzell and Laura Starks indicates that companies with a greater degree of institutional ownership do seem to play a monitoring role over executive compensation. They find that as the percentage of institutional shareholdings rises, so does the sensitivity of executive compensation to changes in shareholder wealth. Moreover, firms with a higher concentration of institutional investors are associated with lower managerial compensation overall.

But not all institutions are willing or able to serve this function, according to related research conducted by Andres Almazan, another finance professor at
the school. “Our model illustrates how potential business relations with the firm and the liquidity of the firms’ stock can affect the intensity of institutional monitoring,” he says. In other words, if the institutional owner sees possibilities for business collaboration, it will be less effective as a monitor.

The message for shareholders concerned about board oversight of executive compensation seems to be this: look for companies who have large blocks of institutional owners who are not looking to the firms they invest in as customers.

“Insurance companies and banks are big owners of stock,” points out Hartzell. “But they might want to monitor less because it might hurt their ability to attract and retain customers; for instance, if a bank puts pressure on a CEO’s pay, then the CEO would be less likely to choose that bank for the firm’s business.”

To read the full text of these and other studies published by McCombs School researchers, visit: acsprod.mccombs.utexas.edu/publications/
 

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