by Cydney Posner
In this column from Sunday’s NYT, Gretchen Morgenson discusses a recent academic study, “Will Disclosure of Friendship Ties between Directors and C.E.O.s Yield Perverse Effects?,” which “suggests that lax oversight can result when a director of a company is friendly with the chief executive overseeing it.” Standing alone, that’s not exactly a surprising finding. More surprising is the finding of the research that, contrary to conventional wisdom, not only does transparency not cure conflicts of interest, it may in fact exacerbate the potential negative consequences of the conflict: “The experiment found that when social relationships were disclosed as part of director-independence regulations, board members didn’t toughen their oversight of their chief-executive pals. Rather, the directors went easier on the C.E.O., perhaps believing that they had done their duty by disclosing the relationship.”
As described in the column, the study selected a group of directors with an average of 30 years of business experience and service on multiple boards. Two-thirds of the participants were told to assume for purposes of the experiment that they had a personal or social relationship with the CEO, and half of those were told that they had disclosed their relationship to the board, management and shareholders. The hypothetical situation posed involved a shortfall in earnings that would impact CEO compensation. In the hypothetical, “the only option given to the directors to make up the shortfall — and thus help the C.E.O. get a bonus — was to cut the company’s $40 million budget for research and development. As they weighed this possibility, they were told that for every $1 million cut in that budget, there would be a 1 percent increase in the chance that the company would lose ground to its competitors.” [Presumably, the directors were told that this type of budget cut was a legitimate way to remedy the shortfall for accounting purposes.] To meet street expectations of profitability, the directors needed to cut R&D by only $5 million, but to meet the threshold for payment of the bonus, a $10 million cut to R&D was required. The results showed that, of the directors that were to assume a personal relationship with the CEO, “46 percent said they would cut research and development by one-quarter or more to ensure a bonus payout to their pal. By contrast, only 6 percent of directors with no personal ties to the chief executive agreed to reduce research and development to generate a bonus. That’s to be expected. [It is?] An astonishing 62 percent of directors who disclosed a friendship with the C.E.O. said they would cut $10 million or more from the budget — the amount necessary to generate a bonus. Only 28 percent of the directors who had not disclosed their relationship with the executive agreed to make the cuts necessary to generate a bonus. Only one director with no ties to the executive agreed to cut the budget by $10 million or more.”
The academicians conducting the study “were surprised that so many directors said they’d be willing to put the company at risk to ensure a bonus for their pal…..Even more disturbing,… was that so many directors seemed to think that disclosing their friendships with the C.E.O. gave them license to put the executive’s interests ahead of the company’s.” The column concludes that regulators need to be cautious that disclosure of conflicts alone “does not eliminate its potential to create problems.” In addition, investors need to be more active in ferreting out personal relationships and recognizing the “potential traps” they can create.