Blind Spots, Biases and Other Pathologies in the Boardroom

Kenneth A. Merchant

• Publisher: Business Expert Press
• Year: 2010
• ISBN:
  9781606490716
• Topic: Business
• Subtopic: Corporate Finance
• Index: Business

In this book we argue that as a first step it is important to recognize these group dynamics and the problems they cause. Some of them can be minimized through, for example, properly designed decision processes. Others are more complicated. But all of them need to be recognized and understood so that we can properly shape our expectations of the degree and quality of oversight corporate boards of directors can provide, and so that we can turn our energy toward the many group level factors that could improve board performance going forward.

Chapter 1

Oversight by Groups of Board Members

In January 2001, CEO of Tyco International Dennis Kozlowski received an employment contract from his board. Like many CEOs, Kozlowski had served most of his tenure (almost 8 years) without one. However, by 2000 he was asking for a contract. More specifically, he was asking for one that included a clause stating that conviction of a felony was not grounds for termination unless it was materially injurious to the company and if “three quarters of the board then voted to oust him.”¹

Although many CEOs have negotiated contracts with generous terms, it was unique to include a felony as something that would not amount to “just cause” for termination. But neither this nor the strange timing of the contract request seemed to catch board members’ attention. It is now speculated that the contract was desired only after Kozlowski knew he was under investigation for sales tax evasion.²

Four years later, Kozlowski was convicted of misappropriation of hundreds of millions of dollars in corporate funds from Tyco, falsifying business records, and violating business law. He was sentenced to up to 25 years in prison. Tyco, an inspiring tale of free market business success and once the most admired company in America, was for a good portion of the decade a name synonymous with the most egregious examples of corporate greed and fraud.³

How could this happen? How could a board of directors approve a contract that removed its power to terminate a CEO even in the case of criminal activity? How could the board of a growing and reputable global conglomerate become so disconnected from its governance role and exhibit such seemingly bad judgment?

The aim of this book is to shine a light on the dynamics and group processes of boards of directors and to describe, particularly, how these dynamics can cause perhaps nearly inevitable failures. These failures will occur even in boards that are seemingly well constructed—for example, of the right size and containing a good mix of highly qualified board members.

The spate of scandals, performance problems, and corporate failures of recent years have caused increasing attention to be focused on boards of directors. This is as it should be. Corporate governance is critically important, and boards of directors are at the heart of the corporate governance process. But the subject of board dynamics and particularly what happens inside the boardroom is almost never explored, largely because the actual board deliberations are seen to be highly sensitive and confidential. But understanding group processes is fundamental to understanding why board failures like Tyco happen. In the following pages, we describe how even “good” boards can develop blind spots, decision-making biases, and other pathologies precisely because boards are—and must operate as—groups.

Corporate governance encompasses the entire set of mechanisms and processes by which business corporations are directed and managed. Good corporate governance helps ensure achievement of long-term objectives, satisfying shareholders and other stakeholders (e.g., creditors, employees, customers, suppliers, local community), while complying with legal and regulatory requirements. It helps corporations create economic value and enhances investor confidence, which is essential for the effective functioning of a market economy.

While there is no single, well-defined, agreed-upon model of good corporate governance, everyone agrees that effectively functioning boards of directors are essential. As observed in one publication of the National Association of Corporate Directors (NACD), boards are “the central mechanism for oversight and accountability in our corporate governance system.”⁴ They are generally considered the front line of defense. As the duly elected representatives of the shareholders, boards have both the ultimate decision-making authority in the corporation and the ultimate accountability.

Boards are charged with governing the organization through broad policies, objectives, and oversight. Among other things, they play important roles in ensuring that the corporation complies with all laws and regulations; in selecting, appointing, and evaluating the CEO; and in ensuring that resources are acquired and managed effectively and efficiently to guarantee the continuity and success of the organization. The ideal is for boards to challenge managers to strive for high performance, to introduce them to both new business opportunities and contacts, to coach them as necessary, and to hold them accountable. To make this happen, dialogues with management should be open and constructive. Boards should be proactive so as to avoid crises before they happen. Resulting decisions should sometimes be bold, involving significant risk taking, but always carefully considered and implemented.

Because of the central role played by boards of directors, major corporate governance failures, which can be errors of either commission or omission, must be, at least in part, failures of boards of directors. Investors, potential investors, regulators, and indeed all corporate stakeholders are right to be concerned with how boards of directors perform. We have seen that ideal board behavior and performance do not always happen.

Much has been written about board failures, and the identified causes are many. Some boards are too large; others are too small. Some boards have the wrong composition. They contain members who are not independent of management, who lack requisite knowledge, or who have personal conflicts of interest. There are some “bad apple” directors who miss meetings, who are unprepared, inattentive, or both when they do attend, who do not understand the duties and responsibilities of a board member, who are self-serving, or who have the wrong personalities. Some board members are intimidated by management and are too weak to speak up, and conversely, others try to dominate discussions and decision making.

Even with the right composition of members, boards operate with some difficult constraints. The required tasks and legal responsibilities are dauntingly broad and often ambiguous. For example, it is a challenge for board members to maintain the appropriate level of engagement, thereby providing effective oversight without stepping over the “micromanaging” line to meddle in affairs that are best left to management. And boards must rely heavily on management for information, they have little or no direct staff support, and they meet infrequently for only short periods of time.

But these problems of board size, composition, information, timing, and the overall difficulty of the job are not at all what this book is about. In this book we show how seemingly ideal boards, those with “best practice” size, composition, and structure, with enough staff support, and with enough time to consider issues carefully, can still fail to provide good governance, simply because they fall victim to some problems inherent in all groups. That is, all groups of individuals who are trying to work together for the common good are subject to some destructive group dynamics that cause blind spots, biases, and other decision-making pathologies. Recognizing these problems is a first necessary step. Only then can steps be taken to avoid the problems, or at least to minimize their consequences.

The Power of Groups

In theory, corporate oversight could be provided by an individual, perhaps just a single oversight executive who has authority over the CEO. But even if corporate oversight by a single individual were legally permissible—which it is not—it would not be optimal.

Providing corporate oversight by a group of individuals has many advantages. First, it is not wise to grant supreme power to a single individual because it is too easy for that power to be misused. Second, the aggregate knowledge, skills, insights, and business contacts that a board group can apply to the issues at hand are far greater than those possessed by any individual. Third, the combining of ideas in an oversight group tends to minimize the biases and prejudices that might be present in any individual. Unchecked, these biases could be seriously detrimental. And, importantly, where they function well, the value provided by a group is greater than the sum of the values contributed by each of its individual members. Board members who are functioning as a team inform, stimulate, and challenge each other.

Corporate Governance Ideals

What does ideal corporate governance, and board composition and behavior, look like? No general agreement exists, and hard empirical evidence is sparse. But advice abounds. Corporate governance and, more specific for our purposes, board “best practices” have been identified in many articles and books and also by activist investors, including pension funds like California Public Employees’ Retirement System and some private investment firms, such as Pershing Square Capital Management. Many ideal board characteristics, and even some sets of best practices intended as largely complete, are also revealed in the evaluation criteria used by a number of outside agencies that rate corporations’ governance structures and processes. The most prominent of these agencies are RiskMetrics Group (RMG), which acquired Institutional Shareholder Services (ISS), The Corporate Library (TCL), Audit Integrity, and Governance Metrics International (GMI). Several of these agencies use fairly lengthy lists of best practices to make their ratings. For example, RMG’s Corporate Governance Quotient (CGQ) ratings assess firms’ governance in eight areas: (a) board structure and composition, (b) audit issues, (c) charter and bylaw provisions, (d) laws of the state of incorporation, (e) executive and director compensation, (f) qualitative factors, (g) director and officer stock ownership, and (h) director education. ISS uses a total of 64 variables both individually and sometimes in combination to develop the CGQ rating. On the other hand, TCL’s rating is more subjective and considers just a few factors that are considered to be key indicators.

Research has shown that the differences between some of the ratings are huge; a 2008 study done at Stanford University found that the correlations between the various formal ratings are close to zero.⁵ To illustrate the disparity with specifics, recently several major corporations, including General Electric, Pfizer, and Wyeth, were given perfect “100” scores by ISS but given “D” ratings by TCL. Some other companies, including Home Depot, Lockheed Martin, 3M, and Xerox, were given perfect “10” scores by GMI but rated as “F” by TCL.

This same Stanford study also tested the ability of the governance ratings to predict important outcomes such as performance, accounting restatements, and shareholder suits. All the ratings failed this test. The findings revealed all the ratings had weak (i.e., economically trivial) to nonexistent predictive power, except that RMG’s ratings had negative predictive power. That is, the firms rated by RMG as being well governed actually had poorer performance indicators—more class action lawsuits, lower return on assets, and lower stock price performance.

These ratings provide numerical illustrations of how far we are from having complete agreement as to what constitutes best corporate governance practice or even an understanding of what leads to effectiveness. Still, there are some micro areas of agreement that provide elements of what will be, eventually, a better developed theory of how to provide effective corporate governance. Some of these areas of agreement relate directly to boardroom practices.

Generally Agreed-Upon Ideals

In this section, taking from all or most of these sources of corporate governance advice, we summarize what we consider to be the most salient, noncontroversial prescriptions regarding board composition, structure, and behavior. We take these prescriptions as a starting point for our discussions. Our presentation here is brief because discussing and analyzing these prescriptions is not our focus. Our main thesis in this book is that even if all these so-called best practices are followed, boards still face some inherent blind spots, biases, and other pathologies that can cause failure.

These are among the boardroom characteristics about which there seems to be general agreement:

1. Shareholder rights. The corporate governance structure and processes should protect and facilitate the exercise of shareholder rights. Shareholders should have the right to be sufficiently informed about, and sometimes to participate in or at least express their views about, key corporate decisions. Governance structures and practices should be transparent to shareholders. Insider trading and abusive self-interested behavior should be prohibited. Minority shareholders should be protected from abusive actions of controlling shareholders. Anti-takeover devices should not be used to shield management and the board from accountability.

2. Board member behavior. Board members should be well informed and act in good faith, with due diligence and care, in the best interest of the company and the shareholders. While directors must necessarily rely on management for information about the company, board members must ensure that they have the requisite information to develop their own sense of priorities and views. They must devote both the time and attention needed to fulfill their responsibilities.

3. Board size. The board of directors should not be too small or too large.⁶ Although three is a practical minimum board size, in most cases a board of three members is too small. This is because committees must have three outside board members. Thus, if the entire board includes only three members, every board member would have to be independent, and every board member would have to serve on every board committee, which could mean quite a heavy workload.

• Large boards have the potential advantage of including members with varied industry, technical, and leadership expertise, which opens up the possibility for more business opportunities. In addition, the additional resources spread the workload over more people and potentially allow for more detailed discussions of issues.

• There is evidence, however, that firms with relatively small boards perform better than firms with very large boards.⁷ The larger the board, the more unwieldy it becomes to involve each board member actively in the discussions. Some experts suggest that the optimal board size is perhaps in the range of seven to nine. But the optimal size certainly varies with the size and complexity of the company. For example, because of the need to include some industry experts, a large conglomerate probably needs a larger board than does a smaller firm in a single line of business.

4. Board composition. Many characteristics of the individual board members are important. The rule that a majority of the board members must be independent of management and the company is now institutionalized in various government and stock market regulations. In addition, some board members should have specialized expertise, which includes knowledge of the industry and management functions that are important to the company, such as finance, marketing, and logistics. More generally, the board members should be energetic and attentive, traits that are perhaps more likely in directors who are younger and less busy.

5. Board structure. Some discussions and decision recommendations should be delegated to committees. Committees tend to comprise the board members who have the most relevant expertise. Since committees are smaller in size than the full board group, it is easier for all committee members to participate in detailed discussions of issues. Specialized issues can be researched and vetted in the committees, and the committees’ recommendations can be approved by the full board. At a minimum, three critical board committees should be established: nominating/governance, audit, and compensation. Other committees can be established, as necessary. The committees should meet regularly and on an additional as-needed basis. To ensure that the full board is properly informed, communication processes between committees and the full board must be effective.

6. Board leadership. Management should not have control over the board’s agenda. One easy way to ensure that the board controls its own agenda is to have an independent board chair; that is, the roles of CEO and chair can be separated. But some boards maintain control of the agenda by having it set by a “lead outside director.” The board should hold regular executive sessions (i.e., without management present), though meeting management is also important. The board should be properly engaged. This requires effective leadership from a leader who uses orderly processes to allow each director to contribute his or her unique talents and perspectives to the issue at hand.

7. Board focus. The work of the board should be mostly future oriented. It is tempting for boards to spend a great deal of time on administrative formalities or focused on reviews of financial statements and other reports of what has happened in the past. These are the easy governance tasks. But boards should spend most of their time focused on the future. That is where they add value.

8. Board evaluations. The board should evaluate itself regularly. Improvements should be made as necessary. Board membership, structures, and processes should evolve with the needs of the company.

This list of good-practice characteristics is certainly not complete. It does, however, provide a sense of the types of areas that we will not be discussing further in this book. We want to proceed by assuming that the board is well constructed and organized so that we can focus on the group decision-making pathologies that can occur in the boardroom anyway.

It should be noted that some individual characteristics are not important, at least by themselves; significant differences are and will always be found among boards that are functioning effectively. For example, boards can function effectively with many different operating styles. Some apparently effective boards are quite formal, with meetings in an elaborate boardroom, every board member in business attire, and strict adherence to rules and procedures. Other boards are at the opposite extreme, with meetings held in a more casual setting, board members dressed “comfortably,” and discussions more chaotic. Som...

Table of contents

• Blind Spots, Biases, and Other Pathologies in the Boardroom
• Preface
• Chapter 1 Oversight by Groups of Board Members
• Chapter 2 Group Influences on Individual Behavior
• Chapter 3 Group Cognitive Limitations
• Chapter 4 Group Polarization
• Chapter 5 Groupthink
• Chapter 6 Group Habitual Routines
• Chapter 7 Group Conflict
• Chapter 8 Power, Coalition Formation, and Politicking
• Chapter 9 Group Productivity Losses
• Chapter 10 Conclusion
• Notes
• References