Posted by R. Christopher Small, Co-editor, Harvard Law School Forum on Corporate Governance and Financial Regulation
In our recent NBER working paper, Powerful Independent Directors, we find that independent directors who are powerful elevate shareholder wealth—in part at least by preventing value-destroying decisions such as economically unsound merger bids and excessive free cash flow retention, by meaningfully linking CEO pay to firm performance, and by forcing out underperforming CEOs. Independent directors who are not powerful do none of these things. These findings may explain why a robust link between independent directors on boards and firm value has proved so elusive; and thereby reconcile Fama’s (1980) thesis that independent directors can maximize shareholder valuations by advising and, where necessary, disciplining or replacing CEOs with the observation of Bebchuk and Fried (2006) that independent directors often do no such thing.
The incidence of weak independent directors suggests that CEOs may select them for impotence. Post mortems of corporate governance shipwrecks suggest this has not changed greatly in many boards, often describing corporate cultures that equated dissent with disloyalty. For example, an Enron executive describes an “atmosphere of intimidation” in which many could see problems looming, but none dared confront the CEO (Cohan 2002).
We posit that more powerful independent directors are less apt to be “yes men” because their social networks provide information that lets them more reliably identify CEO waywardness and influence that lets them more effectively challenge a wayward CEO. This thesis draws support from the social psychology literature showing that voiced dissent can interrupt unthinking obedience to authority (Milgram, 1967), conformity to group behavior (Asch, 1951), and other firms of “groupthink” (Janis, 1971) so as to elicit rational decision-making. Milgram posits that humans reflexively obey authority, citing Darwin’s (1871) thesis that such a reflex elevated the survival odds of prehistoric hominids and therefore may well be biologically innate. Dissent against an authority figure better effect such an interruption if voiced by a more credible alternative authority (Milgram 1967, 1974). We suggest that more powerful independent directors constitute a more informed and credible alternative voice of dissent against a wayward CEO, and can thus more reliably interrupt “groupthink” in the full board or relevant board committee. This has implications for corporate governance research, public policy, and business ethics.
These findings extend the use of social power measures in finance pioneered by Hwang and Kim (2009), who show that CEOs with strong social ties to their independent directors have more scope for self-interested behavior. Our findings utilize social power measures in an entirely different way that highlights director heterogeneity (Ferris, Jagannathan, and Pritchard, 2003; Faleye, Hoitash, and Hoitash 2012) by showing heterogeneous director social power to be economically important. They also underscore Bebchuk and Fried’s (p. 4) call for behavioral models of director decision-making on the grounds that “various social and psychological factors—collegiality, team spirit, a natural desire to avoid conflict within the board team, and sometimes friendship and loyalty” can render independent directors impotent. Our findings suggest that such models might develop Kahneman’s (2011) thesis that people default to “rule of thumb” decision making (thinking fast) and only resort to the more metabolically costly alternative of identifying, estimating and analyzing possible outcomes and their probabilities (thinking slow) after thinking fast fails to converge. In this setting, the rule of thumb of obedience to authority (supporting the CEO) fails to converge if equally credible rival authorities (a sufficient number of sufficiently powerful independent directors) disagree. However rational actors are not entirely precluded as information cascade models might also be extended to represent such behavior.
To the extent that shareholder value maximization is a public policy objective, corporate governance regulations might be evaluated for their ability to instill optimal dissent. Obviously, corporate boards cannot become debating societies. Adams, Almeida, and Ferreira (2005) and others rightly note that CEOs selected for expertise necessarily know things that others do not know, and that excessively powerful boards might unduly curtail trailblazer CEOs. The findings above suggest that reforms to the director nomination and selection processes and boards might be evaluated, in part at least, for their propensity to screen out “yes men” while protecting legitimate CEO discretion.
Finally, these results suggest a framework for interpreting business ethics in corporate boards. Hirschman (1970) explains that people, confronted with unethical or inept behavior in an organization, have three response options: exit, voice, and loyalty. By selecting independent directors for impotence, a discreditable CEO leaves them only two choices: resign or become a loyal “yes man”. As Milgram (1974) discusses at length, the “loyalty” option typically does not nullify the individual’s ethical sense. Milgram’s subjects administered electric shocks to a stranger (a confederate) when ordered to do so, and explained their actions as “doing my duty”, “doing what was expected of me”, “loyalty to the experimenter”, and “not making a scene” in exit interviews. Milgram describes this behavior as an agentic shift—a deontological (duty-based) norm displacing a teleological (outcomes-based) norm, rather than as a suspension of ethical norms. In other words, “yes men” directors come to view themselves as more ethical if they better fulfill their duty to support their CEO. Discussions of business ethics on boards might usefully consider the economic implications of deontological ethics and the feasibility and implications of fostering teleological ethical thinking by directors.