Adding more outside directors may worsen corporate fraud, deception

While many corporate reform advocates urge companies to add outside board members to guard against corporate fraud and deception, that approach may actually exacerbate an already massive problem of directors being too cozy with the very people they’re supposed to be overseeing, researchers say.

From University of Florida:

Adding more outside directors may worsen corporate fraud, deception

GAINESVILLE Fla. — While many corporate reform advocates urge companies to add outside board members to guard against corporate fraud and deception, that approach may actually exacerbate an already massive problem of directors being too cozy with the very people they’re supposed to be overseeing, University of Florida researchers say.

“Simply putting someone on a board who’s an outsider who has some status because of political or business connections or whatever, doesn’t ensure stockholder representation,” said Henry Tosi, a professor of management at UF’s Warrington College of Business who conducted the research. “The appearances are such that it does, but our research shows that’s not the case.”

The findings are particularly relevant as they come in the wake of a July 15 Securities and Exchange Commission report citing the need for tougher rules regarding the selection of corporate directors.

Drawing on years of their own research on various aspects of CEO pay and corporate governance and other studies, UF researchers set out to determine how chief executives are able to so completely control corporate processes ? often without much regard for the interests of the stockholders. That control has set the stage for scandals of the magnitude of Enron and WorldCom, said Tosi, whose findings are published in the current issue of Organizational Dynamics.

“Some of the scandals that occurred make some of the things that happened with organized crime look virtually unimportant ? miniscule,” Tosi said. “In this article, we talk about how what organized crime gets indicted for is chump change compared to some of these corporate issues.”

UF researchers found many top managers are able to skillfully manipulate the ability to manage the director selection process to create an image of board independence ? pleasing investors and governance activists ? while still retaining a supportive board that seldom challenges their decisions, Tosi said.

In fact, some of the most egregious recent cases occurred in firms with a majority of outside directors, such as Enron ? 80 percent outside directors, Tyco ? 65 percent outsiders, and Disney ? 60 percent, the research found.

From the time they first seek a job as a company’s top manager, some CEOs begin a concentrated effort to gain total control over the company and other top managers, Tosi said. More significant, the research found, they also strive to hold sway over the boards that are supposed to be overseeing them and representing the interest of stockholders.

Their methods include negotiating generous compensation packages and the ability to control director selection and pay, and managing the compensation and promotions of other senior executives who may pose threats to them. CEOs also work to insulate themselves from risk and boost their power and prestige through unrelated diversification of the company, which may provide tremendous short-term increases to a firm’s revenues but often isn’t the best long-term strategy for the company or its stockholders, Tosi said.

That is particularly true in management-controlled companies ? such as Tyco, Enron, WorldCom and Disney ? where outside stockholders hold no more than 5 percent of the stock, he said.

“From the beginning, CEOs in management-controlled firms start with an agreement that provides them with substantial discretion over areas in which they can craft the protective shield they prefer,” Tosi said. “Basically, they (CEOs) craft it so they have more control than the board, and there is less incentive for board members to monitor the CEO at the exact same time that it’s needed most.

“These boards, like others dominated by outsiders, often act like they are members of the emperor’s court,” Tosi said, “either approving the CEO’s actions or not being terribly interested in what the CEOs do, so long as they are able to hold on to their board status and pay.”

In 2002, the average annual pay for members of boards of directors was $154,000 at the nation’s 200 largest companies, according to a director compensation report compiled by Pearl Meyer and Partners of New York, which has been studying director compensation since 1989. And while last year’s figure was relatively flat compared with previous years, the research firm predicted board pay would increase as much as 20 percent this year with a potential total rise of 50 percent or more over the next several years.

“It’s in their (directors’) own interest to remain on the board, and the best way to do that is to ensure that you have a good relationship with the constituency that determines who’s on the board, and all too often that’s the management and not the equity holders,” Tosi said. “So the relationship very often ? is quite cozy between the CEO and the boards members, and in extreme cases like we’ve seen recently, they don’t monitor what happens in the firm so long as things look good.”

Instead of adding outside directors, Tosi and his UF colleagues on the study, Wei Shen and Richard Gentry, suggest giving stockholders more direct and meaningful representation on boards. One option: requiring every board to have an external stockholder with some reasonable share of stock but with no direct involvement with the company’s managers or executives. They also suggest board representation for institutional investors.

“There is such an integrated web of factors that reinforce the CEOs capacity to control the context in ways that allow them to basically take advantage of their position in ways that many think have negative effects on stockholders,” Tosi said. “If there were more real shareholder representation, then these things are less likely to happen.”

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1 thought on “Adding more outside directors may worsen corporate fraud, deception”

  1. The real problem with corporate governance is the lack of an effective procedure by which Directors can be held personally accountable for their actions, e.g., voted out of office and replaced by candidates nominated by Shareholders. Shareholders (the true owners of Corporate America) should have the legal right to nominate truly independent Director-candidates and cause the names of those candidates to appear on the Company’s ballot.

    The present system to select/nominate corporate Directors is rife with conflicts of interests. For all practical purposes, Management selects Director-candidates and causes them to be “elected.” Management uses Shareholders’ assets to conduct proxy solicitation efforts on behalf of the candidates that Management selects. There is little likelihood that Management will desire, select or support candidates who are inclined to ask “tough questions” on behalf of the Shareholders. Further, Directors, who do not cooperate with Management, will not be asked to serve an additional term. Those Directors know the score. Yet, while dependent on Management for their longevity, Directors still have a fiduciary duty to ALL Shareholders to monitor Management?s actions. The end result is that Directors are very much beholden to the CEO who brought them to the dance! Could there be a more obvious conflict of interests?

    Individual Shareholders should be able to act as their own watchdogs when it comes to improving corporate governance.

    Committee of Concerned Shareholders


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