Keeping up appearances

2010

Faced with criticism about poor corporate governance, it would be nice to think that any responsible CEO – especially those running large public companies - would seek to make real improvements that sooth the markets' fears.

But new research has found that far from taking substantive steps to improve the governance of their companies, many CEOs respond to such criticism by trying to hoodwink equity analysts into distorting their firm's market value.

The study of 1,300 CEOs, directors and analysts by James Westphal of the University of Michigan and Melissa Graebner of the University of Texas at Austin paints a depressing picture of the lengths to which CEOs will go to manage the impressions of Wall Street analysts and just how effective these deception tactics are.

Intensive efforts by CEOs to sway analysts increases the likelihood of a subsequent stock upgrade by some 36 per cent, the study found, and reduces the likelihood of a downgrade by some 45 per cent.

And crucially, this has nothing to do with the reality of company management. It's all a matter of impressions.

"Corporate leaders respond to negative analyst appraisals of their firms not by instigating substantive board reforms that improve corporate governance but by initiating changes in board composition and engaging in verbal communications with analysts that give the impression of board reform without actually changing board behavior," the authors said.

"Our findings suggest how impression management about the board can distort the market value of the firm, ultimately reducing the allocative efficiency of the capital market," they added.

A particularly common tactic is for CEOs to play on the belief that greater board independence from management improves the quality of corporate governance. But rather than appointing directors who really are independent, CEOs pressurise the nominating committee to appoint directors who friends of the chief.

As the report puts it, "when CEOs have social influence over the nominating committee, negative analyst appraisals prompt the nominating committee to favour director candidates who give the appearance of independence but who are unlikely to actually exercise control due to their social ties to the CEO."

Westphal and Graebner found that what commonly happens is that negative analyst appraisals give powerful CEOs the incentive to seek out the appropriate stockpickers and present them with evidence of their boards' increased independence, with resultant improvement in subsequent appraisals.

And even though the correlation between formal board independence and actual board control is virtually nonexistent, it doesn't take a particularly strenuous selling job by CEOs to have an effect on analysts.

Astonishingly, when the researchers asked analysts about the "relevance of social ties between CEOs and directors, they routinely acknowledged that such ties could be important but that they simply do not focus on them."

The study, published in the February issue of the Academy of Management Journal, is the latest in a body of research by Professor Westphal and colleagues that highlights a litany of ways in which CEOs try to outwit financial analysts and institutional investors.

For example, one study found that, almost as often as not, top managements announce plans pleasing to analysts and investors (such as stock buybacks or long-term incentives for executives) and then fail to follow through - deriving the benefit of market approval of their plans without having to implement them.

Another study by Professor Westphal found that the more a firm's earnings dip below consensus forecasts, the more personal favours top executives bestow on analysts covering the company. Two personal favours in the wake of a low earnings report reduces the likelihood of a downgrade by half.

While it would be easy to point a finger of blame at stock analysts for failing to look hard enough at the governance practices of the companies they are examining, the obvious way to combat such abuses, as Professor Westphal pointed out, would be for the social relationships of board members to the CEO to be included as part of the standard information provided in basic company literature.

"If the CEO is a college classmate of a director or they worked together for the same firm or they are board members of the same organization, these relationships are probably going to affect a company's governance.

"Why should it be hard for stock analysts or investors or other interested parties to get access to that information? Certainly there's a strong case for transparency here."

Obvious, perhaps. But as far as corporate governance goes, CEOs seem as keen to avoid transparency as vampires are to avoid sunlight.