Tuesday, 26 July 2011

Why do some boards hang on to compromised directors?


A board of directors is faced with a decision when one of its members becomes associated with shady behaviour at another company: should they safeguard the board's integrity and dismiss the compromised individual? It's not an easy decision to make, weighing up the member's value against the risks of keeping them on - particularly in complex situations like accounting fraud where there isn't a simple transgression but a broader lapse in responsibilities. Why do some boards act quickly to dismiss compromised directors, and others don't?

Amanda Cowen and Jeremy Marcel of the University of Virginia have some answers. They identified 63 companies pressured into issuing a 'downward restatement' – an admission that their finances had been represented as rosier than they actually were. The authors examined the decisions made by other companies who shared a director with one of these 63 companies, finding that a compromised director was on average dismissed from 28% of their other board seats. The impetus had a lot to do with external scrutiny, with companies most willing to dismiss when covered by many external analysts and by government rating agencies.

In addition, Cowen and Marcel found an example of “mid-status conformity”, the social psychological effect that mid-ranked players are most concerned that developing events could define them in the eyes of others, as unlike the top and bottom dogs, people haven't developed fixed ideas of what they are all about. Here the boards that had mid-level social capital - as measured by their total connections to other directors nationwide - were readiest to eject problematic directors.

The authors looked for a second mid-status effect based around human capital, but none was observed. I wonder if this may be the result of using an indirect measure, using facts such as whether the board contained active CEOs, rather than directly measuring genuine capabilities or perceptions within the industry.

We might feel a little cynical about these sets of motivations, but the authors point out that their findings show that “organizational interests shape dismissal decisions”, which is better than simply saving friends and jettisoning less popular individuals. It confirms that boards take their responsibility to shareholders seriously, and this constitutes their ultimate responsibility under corporate law. However, there are dangers in such a hard-nosed cost-benefit approach. “If directors can anticipate colleagues’ reactions to their conduct, such estimations may adversely affect their risk-taking or decision-making behavior. This anticipation may be especially problematic when directors perceive that the consequences of their behaviors are disconnected from the conduct itself and are instead determined by their colleagues’ needs to manage particular external relationships.”

ResearchBlogging.orgCowen, Amanda P., & Marcel, Jeremy L. (2011). Damaged Goods: Board Decisions to dismiss reputationally compromised directors Academy of Management Journal, 54 (3), 509-527

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