Sunday, March 7, 2010

Executive Independence Misdirection

A recent study of 1,300 corporate executives conducted by James Westphal and Melissa Graebner, and reported in The Economist, found that “chief executives commonly respond to negative appraisals from Wall Street [analysts] by managing appearances, rather than making changes that actually improve corporate governance.” Instead of honestly appointing independent directors to corporate boards, the study found that executives hire directors with whom they are “socially close” while trying to persuade analysts that these hires are totally independent. This misdirection seems to work, as firms that make an effort to persuade analysts that board changes boost independence results in upgrades in the firm’s stock rating 36% of the time. Analysts are upgrading under false pretenses.

Why do analysts fall for the executive’s misrepresentation? Most analysts say they do not have the time to look into executive’s social connections, the study found.

19 comments:

  1. Crony capitalism at its finest. Inviting friends to join the Board and then masking it as an independent move. What a joke.

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  2. I agree with the previous comment. This is a joke; however, it is very common. Both officers and directors owe fiduciary duties to their respective corporations. Included in these duties, is the duty to act in the best interest of the corporation. While it's possible that a CEO's best friend could be qualified for the position of director, he/she could also lack qualifications. By choosing someone not because they would be a positive asset, but because its your friend, is a breach of the fiduciary duty of care.
    If a director knows that his companion isn't the best "fit" for the job he/she should continue to look for a more qualified individual. Until the analysts began to look deeper into this problem, friends will continue to hire friends, while the qualified individuals are overlooked. This reminds me of a common phrase "It's not what you know, but who you know."

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  3. Perhaps the analysts do not look into these social connections because the analysts are part of the same elite social circle. And, if they are not part of it, they want to be.

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  4. I agree, the BoD should be composed of people with business experience and/or particular knowledge and be entirely independent of the CEO. But the BoD is often gamed from many angles. Board members representing mutual funds will often curry favor with company executives in order to secure business, including access to pension funds, for the investment firms they work for. Others are there as pay off to political interests, in an effort to gain and maintain influence over public contracts. In fact, corporations will often hire the relatives of prominent politicians for this same reason. In many ways, these incestuous relationships are like those between trail lawyers and judges.

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  5. What an excellent comment by Cheryl L. Wade. Heres another scenario that I feel is relevant. Analyst walks into a company to talk to someone on the board as they so regularly do. And by the officers remarks and spirits can tell that the company is heading into a good direction. Goes back and reports a buy for 4-8 points higher than usual. Well, if no material information is given its not insider trading but what an area of grey. Somethings cant be regulated and appointing your friends I feel will def. be one of those things.

    Aaron Passy STU

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  6. Shanai Harris:
    The answer is simple as to why analysts fall for the misrepresentation, because they want to. Even journalists are required to do a reasonable investigation as to the truthfulness of a story they're going to report, and analysts should be required to do the same. However, if that was to become the new standard it would undermine the projected growth of our market. Never mind the theory of like-minds has actual merit and should be revealed to the masses. Whether or not that prompts new standards, remains to be seen.
    Shanai Harris

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  7. The thought of honesty within the corporate governance world is laughable at best. Corporate executives act like most people do socially; they use groupthink to make decisions and making the decision of who shall sit on the board should fall within this jurisdiction. Most people tend to place people who they are “socially close” with into positions where they could see themselves. Even if you look at a position such as President of the United States, you see that most of the people who President Obama selected were people who he had already known; people who he was “socially close” to.

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  8. Wall Street is the ultimate "old boys club." I don't agree with the practice, but how do you police nepotism? The securities industry has some reporting requirements involving working with people you are related to (for instance disclosures in an IPO, and many companies have policies regarding hiring or working with family, but when you're not related, it seems like you can get away with anything. I was just studying the Disney case about Eisner hiring his pal Orvitz. The Board of Directors knew about the relationship and should have scrutinized his credentials and the employment agreement. Outside analysts would first have to discover there was a relationship. Instead, they should just conduct their analysis with a critical eye as to whether the individual hired is adequately qualified, is performing his or her job effectively, and if the compensation arrangement is appropriate.

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  9. Colleen Kerins St. Thomas UniversityMarch 11, 2010 at 11:46 AM

    There is the old saying "you shouldn't live to work, but work to live."
    The case of Eisner and Ovitz is a prime example of "socially close" work relationships gone bad as Eisner merged his life and his work to the detriment of the shareholders.
    Although it would seem logical at first to hire people you have a relationship with, obviously it will not only hurt their personal relationships, but more importantly the relationships the corporation has with its owners.
    There needs to be some sort of corporate analysis while hiring these "socially close" individuals. There needs to be not only an initial analysis of to the persons capabilities (i.e. Ovitz) but also an analysis as to the "what if" situation and whether the persons on the board are able to take corrective actions including discipline or other actions need to be taken towards the "socially close" individual.

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  10. This is not surprising. Of course executives are going to appoint their friends -- it is in their best interests to have someone who agrees with them and is on their page, instead of some independent outsider who might ruffle everyone's feathers. It's interesting that analysts don't have "time" to look into social circles, when it is so influential on who gets appointed to boards. They should probably make the time.

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  11. Playing the devil's advocate, it only makes sense. It is human nature to gravitate to those that would have the same interest as yours and to things that are familiar. By looking for those within your social circle, you have more of a guarantee that your interest will be honored because in essence, there is more at stake. Hiring an independent runs the risk of unwanted changes and ideas. People often fear change. Furthermore, there is the stereotype that those with money like to keep the money "within the family". This insinuates the idea that CEOs will offer family and friends within their social circles more opportunities because they are already entwined in the lifestyles and allows the money/opportunities to remain "within the family".

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  12. They can make the rules, they can break the rules... its their game. I agree with majority of the responses that this is no surprise. But can we really blame them? We've all heard the saying "Its not what you know, Its WHO you know." Considering the high stress levels and risk of these positions, executives bet on what they know-- their friends. The executives are in search of loyalty and positive results, and in situations when there is little time to cultivate the needed level of trust and confidence, they can only rely on their friends. With this being said, I can see who such an appointment may cause an issue. Some friends may not be as willing to go against the "hiring" friends point of view or plans even when it is clearly a bad idea. But if the friend is qualified and a true friend to the hiring party, they will fulfill their duties to the corporation and loyalty to their friend without question. Although this "socially close" hiring concept may eliminate opportunities to those without these high-level contacts, it does provide the hiring party with what they are in search of-- security and confidence in a new hires ability to perform at the needed level.

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  13. I agree with Ms. Canada.

    Many individuals put former school mates, vendors, professional service providers and social acquaintances on the board. A big problem arises when individuals fail to ensure that they are choosing the right talent for the company, not just "socially close" people. It is not at all surprising that they choose "socially close" individuals.

    I don’t believe that the analyst necessarily fall for the misrepresentation. I believe that they accept it.

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  14. Sorry to sound redundant but I agree with the previous posts. This makes sense to me though because this is usually how things are done. Even now, as we are looking for jobs post law school, we are attempting to network and use our connections to get jobs. There may be more at stake since it is a corporation's board of directors that we are talking about but do we expect this "who you know" practice to end because the pay grade is higher. If anything, it probably gets worse because as Ms. Canada said, they want someone around that will agree with their views of the company.

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  15. I think that the analysts excuse is a cop out. I am sure that they could look further into the relationships if they really desired to. It is evident that they have ulterior motives. I'm sure there is a connection between the analysts and the chief executives who continue placing their friends as directors on these corporate boards. As we have recently studied fiduciary duties in our Business Associations class, this seems to be a perfect example of how these duties are regularly breached in the corporate world today. I would have to agree with everyone above that there definitely seems to be some truth to the saying that its not what you know but who you know. Having their friends in high places has proved to be beneficial for getting things done so they will continue to do this until someone steps in to correct the problem.

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  16. Coming from a developing country myslef where hiring your son, duaghter, cousin and sister is the norm, I have to wonder, how corporate America is any different. It amazes me how America can so blatantly point fingers at other nations, telling them what they are and aren't doing wrong while it turns a blind eye to its own problems.
    This study has publicized what has been going on for years, and likely, what the analysts themselves knew as well; what I hope comes out of it is that these analysts themselves be now required to make the time to "look into executive social connections," mainly because it is their job.

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  17. Well, if these analysts don't have enough time to investigate the background of the person being hired then I seriously suggest firing these analysts. As a law student, if I gave any of my professors the excuse of "I didn't have enough time," I would get embarressed in front of my class. My professors would tell me that I have to find time, that in the real world an employer isn't going to take that excuse. heck some professors may even kick me out of class if I didn't have enough time to prepare my work, and this is just in school. Hey if these analysts firms want to hire someone that will do his due diligence and find out a person's background, and they want to pay a formitable amount of money, feel free to contact me.

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  18. Well its a little ridiculous for a company of analysts to come up with the excuse they they do not have enough time to find out social connections of an individual. I'm not saying they have to find everything out, but at least make a strong effort.

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  19. This problem is a matter of poor corporate governance that is largely going unregulated. Executives routinely elect friends and family to the board without any ramifications. The fact that the analysts fail to do a simple background check is an example of how casually people are taking this very serious matter. A corporations actions can potentially have a greater impact on the public than some nations. To ensure that these corporations are run ethically, they must be regulated and held to a higher standard than they are now. The purpose of the analyst was to discover if the board is electing 3rd parties. That is their job and they have failed to do so. It is a shame when the public cannot trust those who control so much.

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