When should a board be unfriendly with their chief executive? According to new research, boards should give CEOs a hard time if they suspect he or she is an “empire builder”, willing to launch investment projects that sacrifice firm value but increase their own pay-off. The study also offers a warning about the perils of overboarding.
The report from researchers in the Czech Republic and the US concludes that “unfriendly” boards are likely to receive better information from CEOs on investments, while “friendly” boards are presented with details that are just convincing enough to dissuade members from doing their own digging. The authors, Martin Gregor and Beatrice Michaeli, conclude: “That is why shareholders benefit from nominating as unfriendly a board as possible in the presence of an empire-building CEO.”
The conclusions come after applying some complex mathematical modelling to a scenario in which an empire-building chief executive presents a case for an investment project to a board. The conclusions cast some light on the problem of whether boards should take information provided by CEOs at face value, or whether they should set about their own leg work.
The paper also provides some useful insights for chairs and shareholders concerned with how they balance the relationship between boards and chief executives.
Convincing details
Gregor and Michaeli’s first finding is that empire-building CEO are likely to prepare an “imperfectly precise report that discourages learning by the board”. The trick applied by crafty CEOs is to provide just enough detail to convince boards all the right information has been collated and “induces sufficiently informative beliefs”.
The authors find that CEOs will prepare a “more informative report” when “faced with a less friendly board”. This is because unfriendly boards will approve a projectonly if the probability of increasing value is “sufficiently high”. Thus: “Because an unfriendly board receives more precise reports, its commits fewer errors and so approves fewer but more profitable projects,” say the authors.
But why do boards accept poor reports? Firstly, the CEO’s report may look convincing and there may be an assumption that the chief executive is only using commonly available information: why bother looking it up again?
Secondly, gathering their own information could be a a discouragingly costly exercise for non-executives. But they might also too pressed for time. The authors write: “One possible explanations could be that busy boards (i.e., boards consisting of directors with multiple positions) have higher marginal costs of learning.”
Busy boards
That will have a particular resonance for those concerned about the number of board positions non-executives hold, a sensitive topic for corporate governance afficionados and investors alike.
Directors distracted by several other board positions are likely to be “inattentive” according to Gregor and Michaeli, and therefore more “friendly” to problematic CEOs.
Concerns about overboarding are well rehearsed. Proxy advisers ISS and Glass Lewis both said they would continue to vote against “overboarded” directors during 2020. According to Glass Lewis, “directors should have the necessary time to fulfil their duties to shareholders. In our view, an overcommitted director can pose a material risk to a company’s shareholders, particularly during periods of crisis.”
In September it emerged that overboarding had prompted BlackRock, the world’s largest investment manager, to vote down a record number of directors during the year.
The tale of the “friendly, unfriendly” board offers a useful warning. Boards should be alert when receiving reports from their CEOs and ensure they know the personality they are dealing with and the calculations they make. Shareholders and chairs might also want to take greater care with overboarded directors before ushering them through the boardroom doors.