Today’s Headline: “The Public Does Not Trust Big Business”

   For decades now, we in the U.S. have analyzed, discussed and debated issues relating to corporate social responsibility and corporate governance.  Regulators regulate, legislators legislate, and business leaders, policymakers, and academics have spent, and continue to spend a great deal of time writing, speaking and thinking about the governance and social responsibility of big business.  Is anyone listening?  Has the protracted discussion about CSR and governance mattered?  It does not seem so.  Just look at the business section of today’s New York Times (March 14, 2014).

     One story reports that General Motors ignored serious problems with the ignition switch on some of its models.  The ignition switch problem seems to have caused airbags to fail.  Drivers and passengers died.  Some were seriously injured.  And GM now faces a public relations nightmare that it could have avoided.  In failing its consumers, GM may also have failed its shareholders if the publicity about the debacle impacts the company’s profits.  Also printed today is a story about Target and the financial harm suffered by Target shoppers because the company ignored alerts to suspicious activity generated by its computer security system.  Hackers infiltrated the company’s system and consumers suffered harms that could have been avoided if Target observed even minimal governance and social responsibility practices.  In another story revealing harm imposed on consumers by big business, a journalist observes that the Justice Department has failed to hold accountable large banks and their executives for engaging in massive mortgage fraud that included falsifying documents.  Most acknowledge that the fraud in which many banks engaged was a major factor in precipitating the 2008 financial crisis.  So this story is about more than harm to consumers.  It is a story of harm to the U.S. economy.  Another story in today’s Times is about harm to the financial markets themselves.  The 10^th former executive of SAC Capital will face insider-trading charges.  And, there is a story about harm to workers who allege that McDonalds and its franchisees engaged in fraud that left the workers underpaid.

     More than ten years after the massive fraud that brought down companies like Enron, WorldCom, Adelphia, and Tyco, badly governed and socially irresponsible companies continue to harm workers, consumers and communities.  This is true even after the passage of the Sarbanes-Oxley Act of 2002, and the 2010 Dodd-Frank Act.  In Enron’s aftermath, there was a great deal of discussion about whether the company was an outlier.  Observers tossed around the famously overused bad-apples metaphor.  Enron, WorldCom, Adelphia, Tyco, etc., were just a few bad apples, the argument went.  Yet, in 2014, we continue to grapple with what seems to be inadequate governance and deplorable social irresponsibility that too frequently occurs. 

     Also in the business section of today’s Times is an article about the reputational harm that some companies have suffered and recent attempts to improve corporate governance.  The journalist in this article declares that, “the public doesn’t trust big business”.   This public distrust is not a new phenomenon.  It is almost laughable to think that the public would feel any other way.  But it is laughable that we, the public, continue to invest in poorly governed and socially irresponsible firms.   Clearly, not all companies are irresponsible and badly governed.  It is up to us, the investors, to do some of the work and ask that our mutual and pension fund managers ask the kinds of tough questions that may uncover poor corporate governance practices and irresponsible behavior.

Diversity and the Boardroom 2014: Part III

Since I started writing about Diversity and the Boardroom 14 years ago I have often suffered from fatigue arising from the need to explain the basic concepts underlying the benefits of diversity. Here some basic points that too often seem missed: 1) diversity is not about morphological features such as skin color, hair, or geographic origins; 2) diversity has little if anything to do with the pseudo-science of race which has been proven again and again to be ill-founded; 3) the benefits of diversity arise from cognitive attributes such as different perspectives, experiences and insights; 4) as such diversity breaks down groupthink and affinity bias. All  of these facts mean that diversity is not about race or gender but rather information elaboration. Diverse groups bring broader cognition to the table, particularly when relevant diversity is plugged into any given institutional mission.

I recently came across an important study that essentially makes all of these points and highlights the multidimensional nature of diversity. A new study published in the Georgetown Law Journal finds:

The accepted wisdom—that a lawyer who becomes a corporate director has a fool for a client—is outdated. The benefits of lawyer-directors in today’s world significantly outweigh the costs. Beyond monitoring, they help manage litigation and regulation, as well as structure compensation to align CEO and shareholder interests. The results have been an average 9.5% increase in firm value and an almost doubling in the percentage of public companies with lawyer-directors.

A 9.5 % valuation gain is huge. Can it really be so? Yes, and the finding is very robust:

In fact, based on an average of 10,000 or more observations from 2000 to 2009, we find a statistically and economically significant increase in firm value (as measured by Tobin’s Q) of nonfinancial companies that have a lawyer on the board. A lawyer-director increases firm value by 9.5%, and when the lawyer-director is also a company executive, the firm’s value increases by 10.2%. The result has been an almost doubling in the percentage of public companies with lawyer-directors from 2000 to 2009. (p. 415).

So why do lawyers add so much value? Well for one thing lawyer-directors are more likely to assure legal compliance, as demonstrated by the fact that "the presence of a lawyer-director significantly lowered the likelihood of stock-option-backdating litigation." (p. 452). "Lawyer-directors also have a risk-reducing effect on CEO compensation and the overall level of risk a firm will assume." (p.472).

In the end lawyers on boards add diversity:

Lawyer-directors bring special skills to the board that can affect board decisions and firm behavior. Experienced practitioners offer a perspective on litigation and regulation that can benefit the board’s deliberations. Moreover, trained in advocacy, a lawyer-director’s willingness to pursue a particular course of action—potentially at odds with others on the board—can bring a diverse and valuable perspective to board discussions. (p. 425).

Essentially lawyers provide boards with more elaborate information and knowledge than boards without lawyers. Just like gender and and race under-represented groups (of any gender or race) add to the cognitive mix of the group. A necessary extension of this is that white males may bring diverse perspectives and experiences to a board otherwise lacking white males. It is about cognition not morphological features.

Diversity and the Boardroom 2014: Part II

 

Notwithstanding the empirical benefits of diversity, America's boardrooms continue to be the last bastion of white male supremacy. As demonstrated above any progress in this area can only be termed glacial. As I noted in Diversity and the Boardroom 2012, it has been 50 years since discrimination was outlawed, yet there really is no sound explanation for continued under-representation on this front other than the reality of crony capitalism. The apex of the American economy is still dominated by an old boys club.

Since that posting, more empirical evidence has emerged that well-managed diversity in the boardroom enhances corporate performance. Thus, one recent study found performance reflected the benefits of diversity when a critical mass of women were present in the boardroom:

Based on critical mass theory and with the help of a hand-collected panel dataset of 151 listed German firms for the years 2000–2005, we explore whether the link between gender diversity and firm performance follows a U-shape. Controlling for reversed causality, we find evidence for gender diversity to at first negatively affect firm performance and—only after a “critical mass” of about 30 % women has been reached—to be associated with higher firm performance than completely male boards. Given our sample firms, the critical mass of 30 % women translates into an absolute number of about three women on the board and hence supports recent studies on a corresponding “magic number” of women in the boardroom.

This critical mass of women on the board is also associated with greater innovation according to another recent study:

Academic debate on the strategic importance of women corporate directors is widely recognized and still open. However, most corporate boards have only one woman director or a small minority of women directors. Therefore they can still be considered as tokens. This article addresses the following question: does an increased number of women corporate boards result in a build up of critical mass that substantially contributes to firm innovation? The aim is to test if ‘at least three women’ could constitute the desired critical mass by identifying different minorities of women directors (one woman, two women and at least three women). Tests are conducted on a sample of 317 Norwegian firms. The results suggest that attaining critical mass – going from one or two women (a few tokens) to at least three women (consistent minority) – makes it possible to enhance the level of firm innovation. Moreover, the results show that the relationship between the critical mass of women directors and the level of firm innovation is mediated by board strategic tasks.

And, finally, in the perhaps the most comprehensive study of diversity in the boardroom to date Credit Suisse looked at the performance of 2400 firms worldwide over a six year period. Credit Suisse found that:

in a like-for-like comparison, companies with at least one woman on the board would have outperformed stocks with no women on the board by 26 percent over the course of the last 6 years. However, there is a clear split between relative performance over 2005 to 2007 and the post 2008 performance. In the middle of the decade when economic growth was relatively robust, there was little difference in share price performance between companies with or without women on the board. Almost all of the outperformance in the back-test has been delivered post 2008, since the macro environment deteriorated and volatility increased.

Clearly, more work is needed to understand the underlying mechanisms of diversity benefits and the best means of unlocking the benefits of diversity. In particular, it is difficult understand the critical mass needed for the full optimal level of diversity benefits in terms of gender diversity versus ethnic diversity. Learning to manage diversity in the boardroom may take years to fully understand. After all virtually no firms have a critical mass of African Americans (or other ethnic minorities) on the board. Nevertheless, I no longer think it tenable to maintain that the business case has not been established.

Further, those on the wrong side of this issue will ultimately be proven even more wrong in coming years. The OCC, the FDIC, the Fed, the NCUA, the SEC and the CFPB jointly released proposed standards for assessing the diversity policies of regulated entities under section 342 of the Dodd-Frank Act. The standards are available in full here. Among the items the joint standards address are board and senior management diversity. This means that many regulated entities will be assessing their diversity practices under the scrutiny of federal regulators across the entire business enterprise, including the boardroom. As such diversity is sure to increase beyond its current crony capitalism constraints in the boardroom. This in turn will create a more robust foundation for diversity research.  

In my opinion, this will simply illustrate more powerfully the truth behind the fundamental logic of diversity as a key driver of innovative and critical thinking.

Diversity and the Boardroom 2014: Part I

In 2000, I published Diversity and the Boardroom and in 2001 I followed up with A General Theory of Cultural Diversity. Since then I have written about diversity repeatedly and I have closely followed developments in the best learning on diversity management and the potential of diversity in terms of group cognition and functioning. I consistently argued that the best means of interpreting the impact of the value of diversity in the boardroom was through the lens of diversity management as a general means of improving innovation and group cognition. In my view, there is simply incontrovertible evidence that diverse groups (meaning groups which include a wide array of perspectives and experiences) necessarily outperform homogenous groups in terms of inquiry and innovation.

Therefore, it is no surprise that yet another recent study found this exact benefit of diversity:

A growing body of research is making links between diversity and the economic performance of cities and regions. Most of the underlying mechanisms take place within firms, but only a handful of organization-level studies have been conducted. We contribute to this underexplored literature by using a unique sample of 7,600 firms to investigate links among cultural diversity, innovation, entrepreneurship, and sales strategies in London businesses between 2005 and 2007. London is one of the world's major cities, with a rich cultural diversity that is widely seen as a social and economic asset. Our data allowed us to distinguish owner/partner and wider workforce characteristics, identify migrant/minority-headed firms, and differentiate firms along multiple dimensions. The results, which are robust to most challenges, suggest a small but significant “diversity bonus” for all types of London firms. First, companies with diverse management are more likely to introduce new product innovations than are those with homogeneous “top teams.” Second, diversity is particularly important for reaching international markets and serving London's cosmopolitan population. Third, migrant status has positive links to entrepreneurship. Overall, the results provide some support for claims that diversity is an economic asset, as well as a social benefit.

Another recent study corroborates this finding by looking at diversity inside the firm and linking it to patents:

In this paper, we investigate the nexus between firm labor diversity and innovation by using data on patent applications filed by firms at the European Patent Office and a linked employer–employee database from Denmark. Exploiting the information retrieved from these comprehensive data sets and implementing proper instrumental variable strategies, we estimate the contribution of workers’ diversity in cultural background, education and demographic characteristics to valuable firm’s innovation activity. Specifically, we find evidence supporting the hypothesis that ethnic diversity may facilitate firms’ patenting activity in several ways by (a) increasing the propensity to (apply for a) patent, (b) increasing the overall number of patent applications, and (c) by enlarging the breadth of patenting technological fields, conditional on patenting. Several robustness checks corroborate the main findings.

Of course, as always, diversity must be well-managed which means, among other things, that managers must attend to goal orientation, as this recent study shows: 

As workforce diversity increases, knowledge of factors influencing whether cultural diversity results in team performance benefits is of growing importance. Complementing and extending earlier research, we develop and test theory about how achievement setting readily activates team member goal orientations that influence the diversity-performance relationship. In two studies, we identify goal orientation as a moderator of the performance benefits of cultural diversity and team information elaboration as the underlying process. Cultural diversity is more positive for team performance when team members' learning approach orientation is high and performance avoidance orientation is low. This effect is exerted via team information elaboration.

Certainly, not every study finds the benefits of diversity. That is not surprising. I have always maintained that diversity must be well-managed. Tokenism, hostile environments, and marginalization will not unlock the benefits of diversity.  Just throwing people from diverse backgrounds together will not alone lead to enhanced financial performance. Nevertheless, there is powerful evidence of the benefits of diversity (critical thinking, deeper inquiry, innovation, etc.) when diverse voices are empowered and incentivized to act in groups productively.

In my next post, I will review recent evidence on the value of diversity in the specific context of the boardroom.

The 17th Annual Rainbow PUSH Wall Street Project Economic Summit: African Americans and Corporate Board Membership

     In his book, TheReckoning, Randall Robinson described a story told to him by the Reverend Jesse Jackson, Sr. When Jackson was running for President of the United States, he encountered an elderly white woman in the lobby of a hotel.  The woman pressed a dollar into his hand and said, “I never would have been able to lift those heavy bags.  Thanks again and here’s a little something for you.”

     I attended the 17thAnnual Rainbow PUSH Wall Street Project Economic Summit this week at the Sheraton Hotel in New York City.  Reverend Jesse Jackson, Sr., Founder and President of Rainbow PUSH, opened one of the first days’ panels entitled “Opportunities for Minorities on Corporate and Non-Profit Boards.  John Rogers, Jr., CEO & Chief Investment Officer of Ariel Investments moderated the discussion with the General Counsel of McDonald’s Corporation; the Senior Vice President and Community Affairs Manager of Government and Community Relations at Wells Fargo Bank; the Founder and CEO of Women in the Boardroom; and the President and CEO of The Prout Group, Inc., a small boutique executive search firm.

     The panel discussion was substantive and insightful.  Panelists discussed a Black Enterprise magazine publication that lists the companies with no African Americans serving on their boards.  They explained that smaller and mid-size firms are less diverse than Fortune 500 firms, and discussed the fact that almost all if not every board of a technology company is all white.  While listening to the discussion I thought about the media attention paid to the fact that when Facebook and Twitter went public, they did so with an all-male board.  Soon after both companies completed their IPOs, a woman was nominated and elected to each board.  I rarely, however, hear discussion of, or public outcry about boards that are all white, or boards that have no African Americans or Latinos.

     When I left the panel discussion for a moment, while walking toward the hotel’s main lobby, I overheard an exchange between a young white woman and an African American man dressed in a suit and tie.  “Do you work here?”, she asked him.  When he said “no”, she did not look embarrassed.  She looked annoyed.  She rolled her eyes to the ceiling, perhaps frustrated by her inability to get someone who worked at the hotel to direct her to where she needed to be.

     The conference attendee’s exchange with the young woman, and Jesse Jackson’s encounter as described by Randall Robinson, are familiar experiences for many Black and Latino professionals.  I call them professional misidentifications and I write about them in a book chapter entitled “Workplace Racial Discrimination” in “Law and Economics:  Toward Social Justice”, edited by Dana L. Gold.  I have experienced many of these misidentifications.  Dressed in a white robe, I, an African American woman, was mistaken for a bathroom attendant at a spa.  While visiting the Central Park Conservancy garden a woman thought I was a park attendant even though the park attendants wear green uniforms.  (I was wearing blue that day.)  At a movie theater, while I waited for a friend, a man approached me and brusquely asked where the men’s room was.  “Why would I know where the men’s room is?”, I responded.  “Because you look like you work here.”, he said.

     Many Black Americans experience these professional misidentifications.  I have heard stories from Black lawyers mistaken for mailroom workers, or defendants; Black doctors mistaken for orderlies; black business executives mistaken for secretaries.  These exchanges offer insight into the assumptions that some white Americans make about the type of work that African Americas do, and where they belong.  It is likely that these assumptions impact public reaction to corporate boards that have no African Americans serving.  African Americans belong in hotel lobbies helping with luggage and helping guests get to their desired location.  African Americans clean parks, spa bathrooms and movie theaters.  African Americans serve white Americans.  They do not serve on corporate boards.

      I returned to the Wall Street Project Summit the next day and I had a chance to conduct a short interview with Jesse Jackson.  I’ll tell you about the interview and more about the conference in my next post.

The Value of ERM

In prior posts, I have extolled the virtues of a professionalized, independent and comprehensive risk management function that ultimately rests with board of directors. The goal of this vision of Enterprise-Wide Risk Management (ERM) is the accurate disclosure of risk to investors which in turn implies that the enterprise is operated and governed in accordance with the risk profile supplied to investors. I have termed this the "Holy Grail" of corporate governance because this should avert the massive risk-mismanagement that drove all elements of the Great Financial Crisis of 2008 ranging from AIG's reckless gambling on subprime mortgages to the knowing predatory lending carried out by Angelo Mozilo at Countrywide. If the market had adequate disclosure of the true risks (including leverage) undertaken by firms like AIG, Countrywide, Lehman, Fannie Mae and others (see video above), then such activities would have led to the swift de-capitalization these firms and much of the crisis would have been short-circuited.

Yet, this fails to account for all the benefits of sound ERM programs. Articulating and managing the risks facing the firm, on a comprehensive basis, is apt to minimize net agency costs and enhance financial performance. Recent studies conclude that high-quality ERM programs enhance financial performance and firm value.

Thus, for example, a new study in the Journal of Risk and Insurance finds:

that the use of economic capital models [to measure insolvency risk] and dedicated risk managers improve operating performance. Requiring the dedicated risk manager report to the board of directors or to the chief executive officer (CEO) also increases value. The following combination of enterprise risk management initiatives yields the greatest increase in firm value: a simple economic capital model, a dedicated risk manager that is a cross-functional committee, and requiring the risk manager report to the board or CEO.

This paper is significant because it highlights the best ERM practices for unlocking enhanced value. For purposes of structuring corporate governance, the key finding is that a dedicated risk officer operating through a risk management committee that includes cross-functional expertise which has direct board or CEO access is associated with the most effective ERM programs in terms of financial performance. 

Another very recent study in Contemporary Accounting Research made a similar finding:

Using ERM quality ratings of financial companies by Standard & Poor's, we find that higher ERM quality is associated with greater complexity, less resource constraint, and better corporate governance. Controlling for such characteristics, we find that higher ERM quality is associated with improved accounting performance. Results show a market reaction to signals of enhanced management control from initial ERM quality ratings and rating revisions, and a stronger response to earnings surprises for firms with higher ERM quality. Focusing on the recent global financial crisis, our analysis suggests that there is no relation between ERM quality and market performance prior to and during the market collapse. However, returns of higher ERM quality companies are higher during the market rebound. Overall, results reveal that firm performance and value are enhanced by high-quality controls that integrate risk management efforts across the firm, enabling better oversight of managers' risk-taking behavior and aligning that behavior with the strategic direction of the company.

The empirical record has now clarified that ERM adds value, and firms that implement high-quality ERM programs outperform firms that do not. There is also growing evidence that firms with superior ERM capability weather crises better than firms with less ERM capability. The gains from sound ERM programs can boost firm value (measured through Tobin's Q) as much as 20 percent.

Of course, each firm has unique risks and therefore risk management needs. But the ideal ERM mechanisms are becoming clearer for larger firms or firms with higher complexity. Further, for sophisticated financial firms it appears that the steps the Fed and the OCC have taken to insist on greater ERM capabilities in the financial sector are backed by solid empirical data. Certainly improvements are possible, but the banking agencies are definitely moving in the right direction. All of these recent developments (new regulatory insights and new empirical data) should cause all public firms to rethink their corporate governance structures.

CEOs do not favor ERM initiatives because ERM necessarily limits CEO autonomy over risk management (and manipulation). Beyond that small group of individuals robust ERM initiatives mean more stable financial markets and superior corporate performance. Policymakers, judges, legislators and board directors should fully embrace ERM programs and encourage greater ERM capabilities.