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Why Outsiders on Boards Can't Solve the Corporate Governance Problem

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Why Outsiders on Boards Can't Solve the Corporate Governance Problem Organizational Dynamics, Vol. 32, No. 2, pp. 180–192, 2003 ISSN 0090-2616/03/$ – see frontmatter ß 2003 Elsevier Science Inc. All rights reserved. doi:10.1016/S0090-2616(03)00017-2 www.organizational-dynamics.com Why Outsiders on Boards Can’t Solve the Corporate Governance Problem HENRY L. TOSI WEI SHEN RICHARD J. GENTRY n two recent trials involving organized At the same time, a Securities and I crime, it was alleged in one case that $50 Exchange Commission (SEC) suit charged million was obtained illegally and in the Tyco made improper loans to Kozlowski of other that $12 million was stolen. These more than $315 million. Another suit filed by amounts are ‘‘chump change’’ compared to the new management of Tyco seeks to recover the sums alleged to be taken if the indictment Kozlowski’s income and benefits since 1997 of Tyco International executives Dennis and the forfeiture of all his severance pay. This Kozlowski and Mark Swartz holds up in amounts to a salary and bonus of about $5 court. A New York grand jury charged them million a year and more than $330 million with a racketeering scheme involving stock from exercising stock options and selling fraud, unauthorized bonuses, and falsified stock grants. expense accounts to extract $600 million that, The two Tyco executives are only part of among other things, was used for apartments the cast of CEOs that include Bernie Ebbers in New York City, homes in Florida, jewelry, (WorldCom Inc.), Ken Lay and Jeffery Skilling and a birthday party for Kozlowski’s wife (Enron Corp.), and Gary Winnick (Global that was held in Sardinia. The Manhattan Crossing) who have come under heavy criti- district attorney contended that cism for extracting extremely large compensa- tion and fat perquisite packages while their Mr. Kozlowski and Mr. Swartz cre- companies were failing. But even CEOs of ated an elaborate, covert system firms who have not been accused of mislead- beginning in 1995 that he called the ing financial reporting and illegal payments, ‘‘top executives’ criminal enterprise,’’ such as Michael Eisner of The Walt Disney Co. which ...allowed them to spend and Jack Welch, the former CEO of General millions of dollars in company money Electric Co., have received a lot of attention for for personal expenses. The men then their high levels of pay and perks. As Paul covered their tracks by limiting the Krugman, who writes financial editorials for scope of internal audits and bypass- the New York Times points out ing the company’s legal department when filing disclosure documents ...modern CEOs set their own com- with the Securities and Exchange pensation, limited only by the ‘‘out- Commission. rage’’ constraint—outrage not on the 180 ORGANIZATIONAL DYNAMICS part of the board, whose members The core of this argument is that many of the depend on the CEO for many of their possible constraints on managers are elimi- perks, but on the part of outside nated when ownership is so widely dispersed groups that can make trouble. And that the gain to any individual stockholder the true purpose of many features of (through an increase in share value) is sub- executive pay packages is not to pro- stantially offset by the costs to take any action. vide incentives, but to provide These firms without large stockholders are ‘‘camouflage’’—to let CEOs reward called management-controlled firms. They themselves lavishly while minimiz- have no individual outside stockholder with ing the associated outrage. a holding of 5 percent or more of the stock. Firms that we have discussed above like Dis- While many critics of these practices ney, Enron, Tyco, and WorldCom fall into this blame boards of directors for not meeting category. Firms in which there is a 5 percent their fiduciary responsibilities and argue that outside equity holder are called owner-con- there should be more outside members of trolled. When a member of management boards of directors to stop such excesses and holds 5 percent or more of the outstanding ensure that stockholders are protected, we stock, firms are classified as owner-managed. don’t think this is much of an answer. The We studied how CEOs acquire power to facts are that some of the most egregious manage a firm for their personal interests cases occurred in firms with a majority of when stockholders are in a weak position. outside directors, such as Enron (80 percent We propose that CEO power is deeply outside directors), Tyco (65 percent outside embedded in the institutionalized structure directors), and Disney (60 percent outside of corporate governance and decisions that directors). Even WorldCom had a large per- both CEOs and boards make over time. The centage, though not a majority, of outside effect of these decisions is a complicated web directors (45 percent). These boards, like within which CEOs are able to protect them- others dominated by outsiders, often act like selves from attempts by stockholders to have they are members of the emperor’s court, their voices heard. We believe there are four either approving the CEOs’ actions or not major phases in a CEO’s power consolidation being terribly interested in what the CEOs process. They are do, so long as they are able to hold on to their 1. Negotiating a favorable employment board status. contract; Stockholders are faced with two pro- 2. Reducing threats from the board and blems. The first is moral hazard: the CEO other senior executives; may take advantage of his/her position to 3. Implementing corporate strategies pursue self-interests rather than shareholders’ that insulate the CEO; and interest. The second is information asymme- 4. Controlling the CEO compensation try: the CEO and the top management team processes. may withhold important information from shareholders and the board of directors. What happened at Enron, Tyco, WorldCom, and HOW CEOs GET AND USE many other corporations are perfect illustra- POWER tions of these two problems. They are not easy problems to solve. The reason is well- First, Negotiate a Favorable stated in the theory of managerial capitalism, Employment Contract which argues that there is no ‘‘justification for assuming that those in control of a ... Good CEOs are difficult to find and are in corporation will also choose to operate it in high demand. Finding a new CEO is a critical the interest of the owners,’’ particularly in the task, fraught with difficulty and risk because case that stock ownership is widely dispersed. of the complexity involved and the signifi- 181 cant impact the CEO can have over the firm. tingencies beforehand. After being hired, the When the firm is performing poorly, execu- CEO can exploit the resultant loopholes in the tive search consultants are asked to find a employment contract. This is particularly true CEO to resurrect the firm. When the firm is when the CEO, after taking the position, is not successful, they are asked to find someone subject to appropriate monitoring by the with the competencies to maintain it. In board of directors. The latter is one of the either case, the task is neither easy nor simple reasons why adding more outside directors because of the complicated requirements of to the board, as many have suggested to the CEO job. resolve the governance problem, is not likely This creates an interesting paradox for to have the effect of controlling the CEO. potential CEOs. On one hand, firms are Trying to fathom the employment con- usually anxious to fill a vacant CEO position, tract is not an easy task. While the law requires no matter what the reason for the vacancy. that CEO employment contracts be publicly This puts the preferred candidate in a rela- available, they are difficult to access for two tively strong position. On the other hand, we reasons. First, it is impossible to track all of the know from studies that new CEOs are in a contracts down. Much of this information is tenuous position during their early years in not reported in publicly available documents, office. For these reasons alone, it makes per- such as proxy statements or annual reports. fectly good sense for potential CEOs to try to Second, firms are reluctant to disclose these negotiate an employment contract that pro- contracts. When Nell Minow, the editor of The tects and solidifies their position from these Corporate Library, a web site that focuses on stakeholders before they accept the job. corporate governance, sent letters to 500 firms During this negotiation, the rational asking for their CEO’s employment contract, a thing for the firm’s representatives is to struc- presumed public document, she was able to ture the employment contract in ways that obtain only 124 such contracts (posted at will reduce the CEO’s capacity to take actions www.thecorporatelibrary.com). Most compa- that will benefit him or her personally at costs nies did not even respond to her request; to stockholders. At the same time, the candi- others chastised her for asking (e.g., Occiden- date is likely to be seeking more ‘‘wiggle tal Petroleum Corp. and Union Pacific room’’ after the job starts. This creates a Resources Group Inc.), and several told her, bargaining situation in which, in our judg- directly, that they would give her nothing ment, the CEO can negotiate a very favorable (e.g., Apple Computer Inc., Gateway Inc., employment contract in the management- and Polaroid Corp.). controlled firm. Given such difficulties, how could we get One reason is that the CEO candidate may an idea about what such a CEO employment withhold information that would have a nega- contract would look like when the CEO can- tive impact on the firm’s decision to employ didate is in a relatively strong negotiating him or her.
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