Board 'Control' Often Is an Illusion
Most changes to corporate boards after negative events turn out to be superficial, but analysts buy it.
ANN ARBOR, Mich. — Anyone who pays attention to the stock market has seen the scenario: A company releases poor earnings and announces some changes, including new board members. The CEO talks extensively about the new board makeup and the oversight it will exert over management.
Such changes often prompt stock analysts to issue more positive reports, and the company's stock price climbs back up.
But what has really changed? In many cases, not much, at least as far as board control is concerned, according to new research by Professor James Westphal that was published recently in the Academy of Management Journal. He and co-author Melissa Graebner have found that merely having new, independent members does not result in more board control over management.
In their paper, "A Matter Of Appearances: How Corporate Leaders Manage The Impressions Of Financial Analysts About The Conduct Of Their Boards," Westphal and Graebner show board members may have no formal ties to the company by way of employment or business dealings, but are nonetheless socially connected to top management. That doesn't mean they're necessarily golf partners, but they often are part of the same demographic and share similar views.
"In general, when firms release negative earnings or something else controversial, they're more likely to make these symbolic changes to the board," says Westphal, Robert G. Rodkey Collegiate Professor of Business Administration and professor of strategy. "They increase formal independence without increasing the board's social independence, and that typically does not increase control. You generally need both to ensure more control over management."
The research shows that while cries for corporate responsibility have been growing louder since the scandals at Enron and WorldCom, little is changing in corporate board oversight when you scratch beneath the surface.
A Matter of Influence
Part of the reason so many seemingly independent board members have social ties to management is because CEOs usually have at least some role in selecting new board members, Westphal says. Most publicly traded firms have nominating committees made up of independent directors with no formal ties to the company. But the CEO will at least get to see the list of nominees at some point.
The CEO is likely to suggest candidates with similar backgrounds or those who hold similar views, and those social ties inhibit board control over management. This remains the case despite the late '90s trend toward creating independent nominating committees.
"I'm a little surprised the level of CEO influence hasn't changed more over time," Westphal says. "I'm surprised at how ineffective board committee reforms have been.
After the independent directors are selected, the CEO often will trumpet the new board members' autonomy to analysts or the press — or both — and will attest to the board's control over management for the benefit of shareholders. Westphal calls this "impression management."
The authors use that term because their analysis shows little change in the areas of actual control, as reported by the directors themselves. There's little evidence of changes to executive compensation policies, the likelihood of dismissing top managers during times of poor performance, or the exercise of board control over strategic decision-making.
Yet the practice continues because it works. Westphal's study — via surveys and archival data — shows that stock analysts will tend to issue more positive reports after these board changes and the CEO's campaign of impression management, despite the fact that board control and oversight remain the same.
"It's a relatively easy sell because stakeholders, especially the financial analyst community, tend to equate formal board independence with control," Westphal says.
Stock analysts, by their own admission, pay more attention to formal independence than social independence, Westphal says. Some simply don't consider social independence, while others realize it plays a role but don't have the time or the resources to track it.
"Even though, intellectually, they realize it's important when pointed out to them, I think they still tend to underestimate the importance of social connections," Westphal says.
Further complicating the issue, the positive analyst reports create their own momentum. As the firm's stock starts an upward spiral, analysts face increasing peer pressure to march in step with each other. Being the lone holdout maintaining a negative view of a stock on the upswing can be an uncomfortable spot.
"To be the one analyst going against the grain is risky," Westphal says. "I think, like most of us, analysts tend to be risk averse."
For more information, contact:
Bernie DeGroat, (734) 936-1015 or 647-1847, email@example.com