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Behavioral Corporate Finance, Ceos, and Corporate Governance Florida State University Law Review Volume 32 Issue 2 Article 15 2005 Too Much Pay, Too Much Deference: Behavioral Corporate Finance, CEOs, and Corporate Governance Troy A. Paredes [email protected] Follow this and additional works at: https://ir.law.fsu.edu/lr Part of the Law Commons Recommended Citation Troy A. Paredes, Too Much Pay, Too Much Deference: Behavioral Corporate Finance, CEOs, and Corporate Governance, 32 Fla. St. U. L. Rev. (2005) . https://ir.law.fsu.edu/lr/vol32/iss2/15 This Article is brought to you for free and open access by Scholarship Repository. It has been accepted for inclusion in Florida State University Law Review by an authorized editor of Scholarship Repository. For more information, please contact [email protected]. FLORIDA STATE UNIVERSITY LAW REVIEW TOO MUCH PAY, TOO MUCH DEFERENCE: BEHAVIORAL CORPORATE FINANCE, CEOS, AND CORPORATE GOVERNANCE Troy A. Paredes VOLUME 32 WINTER 2005 NUMBER 2 Recommended citation: Troy A. Paredes, Too Much Pay, Too Much Deference: Behavioral Corporate Finance, CEOs, and Corporate Governance, 32 FLA. ST. U. L. REV. 673 (2005). TOO MUCH PAY, TOO MUCH DEFERENCE: BEHAVIORAL CORPORATE FINANCE, CEOS, AND CORPORATE GOVERNANCE TROY A. PAREDES* ABSTRACT In this Article, Professor Paredes considers the implications of be- havioral corporate finance, and of CEO overconfidence especially, for corporate governance. To date, corporate governance has focused on solving conflicts of interest and on motivating managers to work hard—in other words, on traditional agency problems. Corporate governance has not emphasized the need to remedy the kind of “good-faith mismanagement” that results when CEOs are overcon- fident, although well-intentioned and hard-working. In addition to detailing the effects of CEO overconfidence, Profes- sor Paredes theorizes that CEO overconfidence is actually a product of corporate governance. First, Professor Paredes explains that high executive compensation gives positive feedback to a CEO and sig- nals that the chief executive is a success. Studies show that positive feedback and recent success can result in overconfidence. Indeed, the very process of winning the tournament to become the top executive probably makes a CEO more confident. Stressing the possible link between CEO pay and CEO overconfidence offers a new behavioral approach to executive compensation that emphasizes the impact of executive pay on managerial psychology and decisionmaking. Sec- ond, a CEO-centric model of corporate governance is predominant in the United States as boards, subordinate officers, gatekeepers, judges, and shareholders defer to the chief executive, even in the post-Sarbanes-Oxley era. Professor Paredes suggests that CEOs can become overconfident as a result of the extensive corporate control concentrated in their hands and the fact that they are rarely seri- ously challenged. Professor Paredes concludes by considering how to change corpo- rate governance to manage CEO overconfidence. One possibility is * Associate Professor of Law, Washington University School of Law. Special thanks are owed to Amitai Aviram, Larry Garvin, Mitu Gulati, Chris Guthrie, Adam Hirsch, Jona- than Klick, Russell Korobkin, Kim Krawiec, Don Langevoort, Tim Malloy, Greg Mitchell, Phil Tetlock, and other participants at the 2004 symposium on The Behavioral Analysis of Legal Institutions: Possibilities, Limitations, and New Directions held at the Florida State University College of Law. Useful comments were also received from participants at a workshop at Loyola Law School. Finally, I would like to thank Brian Anton, Chris Bracey, Bill Bratton, Kathleen Brickey, John Drobak, Lyman Johnson, Peter Joy, Scott Kieff, Pauline Kim, Ron King, Joe Lehrer, James O’Loughlin, and Joel Seligman for helpful comments and discussions that assisted in writing this Article. Rob Denney (law school class of 2004) and Alexandra Gilpin (law school class of 2005) did a great job providing in- valuable research assistance. An earlier draft of this Article was circulated under the working title, Too Much Pay, Too Much Deference: Is CEO Overconfidence the Product of Corporate Governance? All mistakes, of course, are mine. 673 674 FLORIDA STATE UNIVERSITY LAW REVIEW [Vol. 32:673 to appoint a “chief naysayer” to the board whose job is to be a devil’s advocate. This Article also explores the possibility of stiffening the fiduciary duty of care to account for CEO overconfidence and con- siders giving shareholders greater say over takeover decisions and greater ability to bring derivative actions. In sum, Professor Paredes argues that corporate governance should move beyond managerial motives to account more for human psychology and for how manag- ers actually make business decisions. I. INTRODUCTION..................................................................................................... 674 II. ANALYTIC FRAMEWORK: AN OVERVIEW OF CORPORATE DECISIONMAKING ....... 683 A. A Brief Introduction to Corporate Decisionmaking .................................... 683 B. CEO Overconfidence..................................................................................... 689 III. DOES CORPORATE GOVERNANCE CAUSE OVERCONFIDENCE? ............................ 702 A. Too Much Pay ............................................................................................... 702 1. The Conventional Story ......................................................................... 702 2. The Behavioral Approach ...................................................................... 713 B. Too Much Deference...................................................................................... 721 1. Subordinate Officers .............................................................................. 722 2. Gatekeepers............................................................................................. 723 3. Boards of Directors................................................................................. 724 4. Shareholders .......................................................................................... 732 5. Courts ..................................................................................................... 734 6. In Sum .................................................................................................... 734 IV. MANAGING CEO OVERCONFIDENCE.................................................................... 736 A. Metacognition ............................................................................................... 739 B. “Chief Naysayer”........................................................................................... 740 C. Tougher Fiduciary Obligations.................................................................... 747 D. Greater Shareholder Say.............................................................................. 757 V. CONCLUSION ........................................................................................................ 762 I. INTRODUCTION Comcast Corporation’s stock traded down eight percent on the day the company publicly announced its unsolicited offer to acquire The Walt Disney Company for $66 billion, including the assumption of debt.1 As the market digested the deal in the days following its an- nouncement, Comcast’s stock continued to fall, and the company ul- timately shed over $9 billion of shareholder value by the end of the week.2 Maybe investors just needed time to appreciate the putative benefits of merging Disney’s content with Comcast’s distribution net- work.3 On the other hand, maybe investors were right to bid Com- 1. Peter Loftus & Janet Whitman, Street Sleuth: Arbs Are Wary on a Comcast Play, WALL ST. J., Feb. 12, 2004, at C3. On the announcement of Comcast’s bid, Disney’s stock shot up fifteen percent and ended up trading above the bid price by over three dollars a share. Id. 2. David Harding & Sam Rovit, The Mega-Merger Mouse Trap, WALL ST. J., Feb. 17, 2004, at B2. 3. For a good summary of events surrounding Comcast’s bid, see Bruce Orwall & Pe- ter Grant, Mouse Trap: Disney, Struggling to Regain Glory, Gets $48.7 Billion Bid from Comcast, WALL ST. J., Feb. 12, 2004, at A1. 2005] TOO MUCH PAY, TOO MUCH DEFERENCE 675 cast’s stock down after the Disney bid. Investors not only voted with their money by shying away from Comcast’s shares, but they openly questioned the rationale for the deal and worried aloud that Comcast would overpay.4 Investors worried that Comcast’s senior manage- ment was unrealistically optimistic about the prospects for a com- bined Comcast-Disney, given the operational and cultural integration challenges that any strategic mega-merger must overcome for the combination to succeed.5 Even if the deal could have been supported at Comcast’s initial bid, a higher price for Disney might not have been sensible; yet investors knew that it might be hard for Comcast and its CEO, Brian Roberts, to walk away from the table once the bidding began.6 A vast literature shows that people tend to be overconfident. As De Bondt and Thaler have noted, “[p]erhaps the most robust finding in the psychology of judgment is that people are overconfident.”7 Peo- ple tend to be too optimistic about outcomes they believe they control and to take too much credit for success while blaming other factors for failure or underperformance. Not surprisingly, people tend to be- lieve that they exert more control over results than they actually do, discounting the role of luck and chance. It is not new to suggest that business executives,
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