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. This happened in the cases of Al position? Instead of trying to examine actual Dunlap when he was hired as CEO at Sun- contracts, we analyzed what happened when beam, and of Ronald L. Zarrella, the chief a new CEO was appointed in management- executive of Bausch & Lomb. Dunlap failed controlled and owner-controlled firms. Our to inform Sunbeam about two jobs from which intuition was that CEOs in owner-controlled he had been fired in the 1970s. Zarella claimed, firms would have less freedom to construct a falsely, that he had received an M.B.A. from strong self-defense strategy, while the con- New York University. Furthermore, even tract for CEOs in management-controlled though certain aspects of the employment firms would leave them with a range of arrangements can be very precisely defined opportunities to strengthen their position (e.g., compensation arrangements, golden after appointment. Our results showed that parachutes, and nonpecuniary benefits), it is those who became CEOs in management- simply impossible to know and cover all con- controlled firms were, indeed, able to negoti-

182 ORGANIZATIONAL DYNAMICS ate employment arrangements with more approach this. One is through the selection generous terms than those who became of directors and the second is through tactics CEOs in owner-controlled firms. For exam- of interpersonal influence. ple, Selecting the right directors is one of the first 1. Their compensation was higher, and steps. What the new CEO wants is a ‘‘rubber- there was less compensation risk, especially stamp’’ board that doesn’t outwardly appear when they were also appointed board chair. to be one. Generally what this means is that 2. They were able to acquire enough the CEO, controlling the appointment of influence to exert the most control in setting board members, will populate it with the their own compensation. firm’s current or former executives and 3. They had more control over appoint- friends. For example, more than half of the ments to the board of directors after they 16 board members at Disney in 1997 had were appointed. personal or professional ties to CEO Michael 4. They were able to implement diver- Eisner or to the company. They included Eis- sification strategies that were more likely to ner’s personal lawyer, the principal of an reduce their own employment risk. elementary school that Eisner’s children had 5. If they were not also appointed board attended, a Disney-commissioned architect, chair when they initially took the position, three former Disney executives, Michael Eis- they did get the position later in their tenure. ner himself (as chairman of the board), and So, from the beginning, in management- three current Disney executives. controlled firms, CEOs start with an ‘‘agree- Institutional investors and corporate ment’’ that provides them with substantial governance activists are trying to curb this discretion over areas in which they can craft practice. They are calling for board reform the protective shield they prefer. There is less that will lead to an increase in independent monitoring and incentive alignment, exactly outside or nonemployee directors who have in the situation where we think they are no personal or professional ties with the needed most to combat the opportunistic CEO. This has resulted, we think, in a sig- CEO. When the deal is completed, the new nificant increase in the proportion of outside CEOs in management-controlled firms have directors on corporate boards in recent years. set the stage, because they have a contract Indeed, most corporate boards now seem to that provides them with more effective con- be ‘‘dominated’’ by outside directors. How- trol than the board of directors. ever, this doesn’t mean that the board will do any better in protecting shareholder inter- ests. The reason is that CEOs may skillfully Second, Reduce Threats From manage the director selection process in the Board and Other Senior ways that create an image of board indepen- Executives dence, pleasing investors and governance After being appointed, the first thing the new activists, while still having a supportive CEO will do is to fortify his or her position board that seldom challenges their decisions. against internal threats. These come from Using some relatively powerful, but two places: the board itself and the top man- subtle political tactics, the CEO can have a agement team. board that appears independent of manage- ment, but actually promotes the CEO’s dis- Managing the board of directors. Because cretion and entrenchment. One of these the board of directors is responsible for tactics is to nominate outside candidates monitoring managerial decisions and asses- who have similar backgrounds and experi- sing the performance of the CEO, managing ences as the CEO, especially candidates who the board of directors is a critical move in the are CEOs themselves elsewhere. Because of CEO’s effort to acquire and institutionalize their similar backgrounds and experiences, discretion. There are at least two ways to these outside directors are likely to identify

183 with the firm’s management, especially the the rationale and to build support for their CEO. Another is for the CEO to examine each strategic decisions. It is also pretty common candidate’s history as a director and inten- to see CEOs attribute good firm performance tionally steer clear of those who have experi- to their leadership and strategy. When firm ence on vigilant boards, those who support performance is weak, CEOs may defend the separation of the CEO–board chair posi- themselves by blaming other ‘‘incompetent’’ tions and the use of performance-based CEO executives, or external factors out of their compensation. These tactics can result in a control, such as slow market growth and board that is less likely to monitor the CEO fierce competition. actively or to challenge the CEO’s decisions CEOs may also use ingratiation tactics and be more willing to grant high compensa- with outside directors. For example, CEOs tion to the CEO. may publicly express agreement with direc- Influencing director selection is even tors’ opinions even when they do not agree, or easier if the CEO has negotiated a favorable exaggerate how much the directors have con- employment contract as well as obtained the tributed to the success of the firms. Further, board chair position. The reason is that, even CEOs may increase director compensation to when there is an independent nominating acknowledge their contributions, or pay committee composed exclusively of outside directors more in cash than in company stocks directors, it is often the norm of corporate to reduce their compensation risks. At some boards that the nominating committee companies, outside directors even get lucra- obtains the CEO’s approval for each new tive consulting fees. For example, in addition board candidate. A well-articulated justifica- to his duties as an Enron director, John Urqu- tion for this practice is that firm leadership hart was paid $493,914 in 2000 for providing and performance will suffer when the CEO consulting service to Enron. Interpersonal and the board cannot work together. While tactics like this help CEOs build a ‘‘good this may be true, it nevertheless gives the working-relationship’’ with the directors. CEO great influence over director selection, Indeed, such CEO interpersonal influence which makes it difficult for a board to remain tactics have been found to be positively truly independent of the management and related to the increase in the firms’ level of the CEO. diversification and the increase in the CEO’s Interpersonal influence tactics are a second total compensation, and negatively related to way of dominating the board. Suppose that the change in the proportion of long-term the nominating committee is truly indepen- incentive grants in CEO compensation, all dent, and the CEO has no role in the director of which are to the CEO’s advantages. selection process. Does this mean that the board will be able to effectively control the Managing senior executives. Another way CEO and be more effective in corporate gov- for CEOs to institutionalize power is to ernance? Not necessarily. The CEO may manage their senior executives who may resort to interpersonal influence tactics in be significant threats. Inside directors have his or her dealings with board members. been recently shown to be the most serious Because of the complexity and uncertainty challengers of CEOs. This may appear inherent in strategic decision-making, out- counterintuitive, because many believe that side directors tend to believe that CEOs have senior executives are political allies of the superior firm-specific knowledge and exper- CEO—beholden to him or her for their tise, and CEOs are able to exploit this percep- positions within the firm. However, there tion to their own advantage. Studies have can be disagreement, interest conflict, and shown how this can be done even when there tension between senior executives and the are independent outside directors. In such CEO. This is especially true for those senior situations, CEOs communicate more with the executives with CEO aspirations. Unlike directors outside board meetings to explain outside directors, who have limited time

184 ORGANIZATIONAL DYNAMICS and firm-specific knowledge, senior execu- there are other senior executives on the tives have a much better understanding of board, independent outside directors can the firm’s environment and operations. get information about the firm without going They may challenge the CEO’s strategies, through the CEO. This can significantly blow the whistle, and express their discon- weaken the CEO’sinfluence over outside tent with the CEO to the board of directors. directors. Unfortunately, proponents of These actions could affect the CEO’s improving corporate governance often have authority and diminish his/her discretion. a negative view of having senior executives, Probably the most common approach other than the CEO, on the board. Instead, used by CEOs in managing senior executives these advocates favor outside directors and is to take advantage of their control over oppose promoting senior executives to the executive promotion decisions. Through board, because they believe these executives selectively promoting supportive and loyal are on the CEO’s side. Taking advantage of executives, CEOs can build a strong coalition this belief, CEOs not only can reduce the at their firms and reduce the risk of challenge potential threat from senior executives, but from their senior executives. While merit, also make themselves look more favorable to competence, and performance are often shareholders by not promoting senior execu- articulated as determinants of promotions, tives to their boards. interpersonal relationships are at least of equal importance. CEOs not only tend to Third, Implement Corporate promote executives they like, but also may Strategies That Insulate the CEO try to force out those who may threaten their leadership positions. Once the employment contract is in place, CEOs can also use their control over and the CEO has also won the political battle compensation decisions to gain support of that sets the board and top management their senior executives. For example, they team in place, the CEO is now in a position may increase their senior executives’ com- to implement strategies that may further pensation without any apparent economic enhance his or her position. A firm’s strate- justification. There is evidence that upper- gies influence its performance, which in turn level managers in management-controlled may have a great impact on the CEO’s job firms were paid, on average, 8.2 percent more security. Our research suggests that CEOs in than their counterparts in owner-controlled management-controlled firms manage early firms. Further, the pay difference between in their tenure to reduce their employment managers at these two types of firms is exag- risk by managing the strategic choices of the gerated as a function of the managers’ orga- firm. Following the installation of a new nizational level. That is, the higher the CEO, unrelated diversification is increased managers’ organizational level, the larger in management-controlled firms, while per- the pay difference between levels. Interest- formance-enhancing related diversification ingly, despite the large pay premiums is higher in owner-controlled firms. This is enjoyed by the upper-level managers at firms probably because related diversification has without large-block shareholders, their firms fewer short-term benefits for the CEO than did not perform better. unrelated diversification. There is a more subtle way for CEOs to Unrelated diversification is a strategy of reduce the threats from senior executives— acquiring businesses that have little connec- limit the number of senior executives on the tion with the firm’s current products or mar- board. The presence of senior executives on kets. When the firm is operating in a single the board narrows the power gap between industry, its financial performance is greatly these executives and the CEO. Further, it affected by the fluctuations of the industry. In weakens the CEO’s control over the informa- contrast, having a portfolio of businesses in tion to independent outside directors. When unrelated industries helps stabilize the firm’s

185 financial returns and provides management allocations to top executives show that Gold- with a cushion against the negative impacts man Sachs allocated shares in more than 100 of economic downturns in a single industry. IPOs to eBay Inc.’s chief executive Margaret These stable returns, while lower than they Whitman. might have been otherwise, relieve stock- Unfortunately, this unrelated diversifica- holder pressure on the CEO. tion strategy does not benefit shareholders In addition to the reduced employment anywhere near the level it can reward man- risk and increased job security, the CEO can agement. First, shareholders can diversify benefit from this unrelated diversification their investment portfolios themselves by strategy in several other ways. First, it investing in firms operating in different enables the CEO to increase the firm’s rev- industries. This will leave them with more enues tremendously over a short period of investment choices and opportunities. Sec- time. By acquiring unrelated businesses, the ond, and more important, research has CEO can easily double or triple the firm’s shown that companies engaging in unrelated revenues and then boast of such growth as a diversification strategies under-perform major accomplishment. Second, with the their peer firms. While General Electric, increase in the firm’s size and diversification which owns businesses ranging from televi- level, the CEO can demand an increase in sion networks to jet engines, has enjoyed compensation because he/she can argue considerable success with this strategy, it is legitimately that his/her job of managing an exception rather than the norm. the firm has become more complex and dif- ficult. Research has consistently shown that Fourth, Control the CEO CEO compensation is far more closely corre- Compensation Processes lated with firm size than with firm profits, a topic we will discuss in more detail in the When the CEOs power is institutionalized, it next section. is reflected in what happens between the Third, the CEO may enjoy increased CEOs and the boards of directors when the status in the business community, derived CEO’s compensation is set. We conducted a from the growth of the firm size. Larger firms study of various organizational actors and generate more publicity for their manage- stakeholders in the CEO compensation pro- ment, and CEOs reap substantial benefits cesses. What we found helps illuminate the from being the head of a large organization, discussion about CEO pay. First, the pay- such as access to corporate jets or exclusive setting process in management-controlled club membership. In addition, becoming firms is not as closely monitored by the more respected in the business community board, and there is much less pay risk than can lead to more invitations to participate in in owner-controlled firms. Second, in man- paid speaking engagements. So, we see that agement-controlled firms, the CEOs them- CEOs benefit from growing the firm not selves and management consultants have only by their compensation schemes but significantly more influence over their pay also through reputation and celebrity asso- than in owner-controlled firms, where the ciated with being the leader of a growing major stockholders are the most influential, company. followed by the board of directors and the Finally, a more current and in some ways compensation committee. What happened at more insidious benefit from running a large WorldCom is a good example of CEO com- firm is the attention of service providers. pensation in management-controlled firms. Among others, investment banks have allo- According to an interim report prepared by a cated relatively large numbers of initial pub- court-appointed corporate examiner, former lic offering (IPO) shares of other firms to a CEO Bernard Ebbers used his unusually CEO for the prospect of business with his or strong influence over WorldCom’s board to her firm. For instance, disclosures of IPO push through lucrative annual compensation

186 ORGANIZATIONAL DYNAMICS packages for himself worth an average of directors, a $4.3 million compensation pack- $25.7 million from 1999 to 2001, as well as age in 2000, a year in which the bank lost 9 personal loans of more than $408 million. percent of its value and announced plans to Our findings translate into, we believe, eliminate 10,000 jobs. One of our studies, as very different approaches to the way that well as others, showed that when CEOs con- CEOs are evaluated. Our reasoning is based trolled the firm, the size of the firm was more on the fact that the CEO’s task is complex, strongly related to CEO pay than was firm ranging from making strategic choices that performance, and increases in size were would be reflected in the firm’s financial related to increases in both total pay as well performance to taking a leadership role in as bonuses and incentives. On the other influencing and motivating others in the hand, in owner-controlled firms, firm perfor- firm. However, the precise nature of the mance was the best predictor of CEO pay, relationship of the CEO’s decision-making and changes in firm performance were more skills and leadership approach to measurable strongly related to changes in CEO pay. firm outcomes is very difficult to specify. The resulting ambiguity permits room for discre- tion by boards in choosing which criteria will LESSONS LEARNED be used in evaluating the CEO for pay pur- poses. Let us be especially clear. We do not believe Our research shows that the choice of that many executives enter business intent on criteria, and the justification for the choice, bilking their shareholders or duping their depends upon where the power lies. With boards. Nor do we believe that the general strong equity holders, the board is likely to case of CEOs taking advantage of their posi- choose risky results-based criteria such as tion in ways that are as egregious as the return on assets (ROA), return on equity recent corporate scandals is common. How- (ROE), and the value created for stockholders ever, it is obviously the case that CEOs in the equity markets (e.g., earnings per require, and perhaps demand, a great deal share). When the CEO is powerful, boards of autonomy to make and implement the tend to focus on less risky behavior-based decisions and strategies they develop for a criteria, like leadership and managerial com- firm. Unfortunately, the more managers petencies. If the CEO has created a favorable obtain autonomy from the board, the weaker relationship with the board, it is likely that it the board becomes. This happens as a com- will share the CEO’s ideals and strategic plex web of factors develops that influences vision. This can result in biased performance the relationship between the CEO and the evaluations. Poor firm performance can board. Over time, the CEO begins to acquire easily be attributed to uncontrollable external more and more control over the board’s forces and good performance to the CEO’s composition, the firm’s strategic direction, leadership. The reason is that these evalua- and his or her own compensation. To correct tions will follow the positive feelings that the this, boards must participate more actively in board has for the CEO. Positive outcomes by the operations of the companies they moni- liked people are attributed to the person, tor. Encouraging this participation may be while negative outcomes are attributed to very difficult, but we think that some things the context, or the situation. This means that can be done that will improve the board’s a board that has a positive, favorable rela- ability to monitor management. tionship with a CEO will select criteria favor- able to the CEO. The resulting effects on pay How to Make Boards More are favorable to the CEO. For example, at Responsive to Shareholders Bank of America, the board awarded its now- retired CEO Hugh McColl, who sat on three The mantra for most critics of the current boards with five other Bank of America state of corporate governance is the rather

187 simple suggestion for more outside directors. the de facto appointments above, might lead This, we believe, is not enough because, as to a board in which different perspectives we pointed out earlier, these outsiders may can be more fully articulated, evaluated and be more beholden to the CEO than inside implemented. directors. Instead, the real problem is that 4. Move some aspects of board selection boards must have representation from real outside the firm. Some of the cronyism issues stakeholder–stockholders. Otherwise, it is might be resolved if some aspects of select- too easy for CEOs to engage in the sorts of ing board members are externalized, moved machinations that we have described to outside the organization to an independent secure and institutionalize his or her power. firm. A reputable law firm, bank, or con- Here are some ways to deal with this: sultancy could handle the talent pool of 1. Require real individual shareholder re- directors and place individuals on boards presentation. To secure the interest of under- where their skills will be valued and represented groups, we recommend that utilized. This independent firm might in- every board have one de facto representative crease assurances that knowledgeable peo- appointed to represent individual share- ple are nominated. It can also manage the holders. The largest individual shareholder election in ways that might prevent the of the firm not involved with the operations current management from obtaining proxies of the company or a competitor will hold from indifferent investors that can be used this position. Selecting the largest of the to implement management’s preferences. ‘‘small’’ independent investors will ensure a voice of shareholders on every board. Fix the Compensation Problem 2. Institutional shareholder representation. A second de facto position on all boards will We know that the criticism of excessive CEO represent the largest institutional share- compensation is not new to the recent Enron holder. Institutions are often extremely and WorldCom years. It is only the case that savvy investors, but their guidance is not in the recent years there were more public often heeded. In addition, institutional and, perhaps, more excessive examples. Sim- shareholders have proven themselves to be ply, the compensation issue must be some of the most involved and active addressed, not only for CEOs but also for monitors of business decisions. Providing board members. institutions a voice will force managers to 1. Readjust director compensation. Just as explain their strategy to sophisticated in- managers deserve compensation for their vestors who monitor business decisions time and effort, so do directors. Typically, everyday. A stronger vetting process for directors are part-time overseers of the strategic initiatives will restrict managers company who earn only a small percentage from manipulating the corporation for their of their total income from any one particular own gain. board appointment. As a result, manage- 3. Create a balance of inside/outside mem- ment is more involved in the corporation, bers. Boards and managers tend to prefer to while the board becomes more and more select individuals they know to be compe- removed the longer a CEO stays at the top of tent and easy to work with. However, this a firm. We think that the issue is how to can often lead to cronyism and weak increase the active participation of directors, monitoring by the board, encouraging the beyond simply attending meetings and kind of board structure for which Enron and rubber stamping management decisions. Disney have become known. Despite the call One way to do this is for directors to for more outside directors, there is some hold a larger stake in the success and failure evidence that says that insiders have posi- of the firms. In too many instances in the tive effects. We advocate a balance of largest firms, directors’ fees are excessive insiders and outsiders that, in concert with and are not linked to their performance or

188 ORGANIZATIONAL DYNAMICS the performance of the firm. Lower fixed fees loan. This practice gives managers all the should be the order of the day and the wrong incentives, and many executives remainder of director compensation based abused the practice for stock market spec- on whether their choices regarding manage- ulation. Loans to executives give managers ment and strategic direction are correct. This no incentive to remain with the company could be done with stock options, arranged after the loans are ‘‘forgiven.’’ Loans pro- so that each year the directors stand to make vide the firm only a guarantee that the more from the long-term success of the executive will not quit before the loan is company than from short-term gains. Pro- forgiven, rather than a commitment the gressively increasing option grants is a manager will perform his duties conscien- common way to compensate top executives tiously. Managers and other executives in a firm, and the technique should be ought to acquire loans at banks, and the applied to directors as well. Directors bear practice of offering loans to employees the ultimate responsibility for a firm’s should be abolished entirely. success, and they should bear the risk of its failure along with the management they hire. Clarify Reporting 2. Focus CEO compensation.Recently, stock option plans and ‘‘incentive’’ compen- The only way to restore investor confidence sation schemes have become the buzzword in and prevent the illicit actions of management management compensation. Compensation in the future is through clear and honest committees seem to believe that encouraging financial reporting at all levels of the orga- managers to increase the stock price means nization. Mystifying financial reporting only increasing the firm’s value. However, as best complicates investor’s attempts to assess the shown by many ‘‘dot-com’’ companies, competence of management. It allows man- encouraging managers to run up the stock agers to ‘‘game the system.’’ Current corpo- price encourages them to focus on selling the rate reporting is a mash of footnotes and corporation’s stock rather than increasing incomplete truths that only serve to con- the firm’s intrinsic value. found investors. While the Federal Account- Stock options were originally devel- ing Standards Board deserves some blame oped to encourage managers to focus on the for the bewildering web of accounting reg- long-term, but boards have recently begun to ulations, companies need to remember that give out stock options with exercise dates as good faith-reporting should be done in good close as 2 years away. Stock options are only faith. It is the responsibility of the board to effective for maximizing shareholder value if demand conservative accounting treatment the exercise date is far enough into the future for all transactions in which the company is and the exercise price is relatively high. We involved. The board must protect investors believe that forcing managers to hold their from managers who would use loopholes in stock options till retirement or some other the accounting system to manipulate perfor- longer time period will encourage them to mance numbers, and thus the stock market. pay less attention to short-term stock price The best way for a corporation to seem hon- responses and focus on long-term perfor- est is to actually be honest. mance. 3. Eliminate loans to officers. Using ‘‘for- givable’’ loans to secure the employment of CONCLUSION managers was a common practice prior to the disclosure of Tyco’s excessive use of the Managers and board members are human. practice. Companies would offer loans to Sometimes, despite trying to be ethical, they executives to purchase the company stock or behave in ways that most people would as part of a ‘‘signing’’ package. After a consider unethical. Benefiting at the expense period of time, the board could forgive the of shareholders who have trusted you to earn

189 them a return on their investment is unethi- Recent scandals are only further evidence cal. Often times, managers do not intend to that boards are frequently unable or unwill- behave this way—they behave unethically ing to decide what is appropriate compensa- unintentionally or are reacting to the incen- tion or behavior for management. The tives or the opportunity to act unethically. corporate governance system needs reform, This drives them to make decisions that are and we have offered some suggestions to ultimately not in the best interest of the consider in the process. shareholder. Regardless of how many shares an investor owns, every dime that manage- ment takes from the company is money that could have been returned to investors.

190 ORGANIZATIONAL DYNAMICS SELECTED BIBLIOGRAPHY

The theory of management-controlled firms ery and B. Wernerfelt, ‘‘Diversification, and the impact of shareholder oversight is Ricardian Rents, and Tobin-Q,’’ Rand Journal best articulated in M. C. Jensen and W. H. of Economics, 1988, 19, 623–632; P. G. Berger Meckling, ‘‘Theory of Firm—Managerial and E. Ofek, ‘‘Diversifications Effect on Firm Behavior, Agency Costs and Ownership Value,’’ Journal of Financial Economics, 1995, 37, Structure,’’ Journal of Financial Economics, 39–65; and J. D. Westphal and E. J. Zajac, 1976, 9, 305–360, and R. L. Marris, The Eco- ‘‘Substance and Symbolism in CEOs’ Long- nomic Theory of Managerial Capitalism (New Term Incentive Plans,’’ Administrative Science York: Free Press of Glencoe, 1964). Quarterly, 1994, 39, 367–390. The impact of managers controlling the The impact of managerial control on boards that oversee them has been thor- compensation is explored in H. L. Tosi, L. oughly examined by James Westphal and Gomez-Mejia, M. L. Loughry, S. Werner, K. Edward Zajac. In particular see, J. D. West- Banning, J. Katz, R. Harris, and P. Silva, phal, ‘‘Board Games: How CEOs Adapt to ‘‘Managerial Discretion, Compensation Increases in Structural Board Independence Strategy, and Firm Performance: The Case From Management,’’ Administrative Science for the Ownership Structure,’’ Research in Quarterly, 1998, 43, 511–537, and E. J. Zajac Human Resources Management, 1999, 17, and J. D. Westphal, ‘‘Director Reputation, 163–208. CEO–Board Power, and the Dynamics of Some important current information is Board Interlocks,’’ Administrative Science found in A. R. Sorkin, ‘‘Two top Tyco Execu- Quarterly, 1996, 41, 507–529. tives Charged with $600 Million Fraud Literature in finance, economics, and Scheme,’’ The New York Times, 13 September management discusses the motives and 2002, A1; and P. Krugman, ‘‘The Outrage impact of unrelated diversification. The inter- Constraint,’’ The New York Times, 23 August ested reader should examine: C. A. Montgom- 2002, A17.

Henry L. Tosi is the McGriff Professor of Management at the University of Florida and Visiting Professor of Organizational Behavior at SDA- Bocconi (Milan, Italy). He has extensive international experience, having held appointments at LUISS (Rome, Italy), the University of Catania (Sicily), and the University of Modena (Modena, Italy). His research focuses on CEO compensation and corporate governance and has been published in Administrative Science Quarterly and The Academy of Management Journal. Wei Shen is an assistant professor of strategic management at the Warrington College of Business, University of Florida. He received his Ph.D. in business administration from Texas A&M University. His research has been published or accepted for publication by the Academy of Management Journal, the Academy of Management Review, and the Strategic Management Journal.

191 Richard J. Gentry is currently a Ph.D. student in the management department of The University of Florida. He has also studied interna- tional corporate strategy and international human resource management at the Rijksuniversiteit Groningen. His research interests include economic approaches to corporate strategy and corporate governance.

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