When Should Corporate Governance Become More Vigilant?

Dalida Kadyrzhanova and Matthew Rhodes-Kropf have written a new working paper that I found intriguing.  They examined how corporate governance changes as firms enter periods of high performance, even perhaps periods of equity over-valuation (they use some interesting measures to examine potential over-valuation of equity).  They found that, "Firm performance seems most impacted by governance when firm and industry deviations are high."  

The scholars argue that, during periods of equity over-valuation, executives are most likely to pursue investments and other decisions that may maximize personal utility at the expense of shareholders.  They do so because they essentially have some slack - plenty of resources at their disposal, and presumably some credibility with investors given the high performance.  During these times, then, corporate governance should become more vigilant so as to protect shareholders from "misbehavior" by executives.  The paper has important implications for boards of directors.  We typically think that the board role is most important during a crisis, when performance is poor.   That is probably correct. However, this paper reminds us that the board also has to be careful during periods of abundance.  That may be the time when the seeds of future crises are planted, as managers make flawed decisions - putting excess cash flow to work in ways that are not in the best interests of shareholders.  

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Biased Samples Hike Executive Compensation

When company boards of directors set executive compensation, they often benchmark against peers to determine the appropriate pay levels.  Unfortunately, as this Business Week article by Zachary R. Mider and Jeff Green indicates, many firms choose "peers" that are much larger than them.  Bigger firms tend to pay their executives higher salaries.  Thus, choosing to benchmark against bigger companies creates heftier pay packages.  For instance, the authors report that:

Setting the CEO’s salary is one of the most important duties of a public company’s board. So CBS (CBS) directors decided to give Chief Executive Officer Leslie Moonves a $69.9 million pay package last year only after assessing the competitive market for senior executive talent. The board of directors, however, looked at companies that are, on average, more than twice as large as CBS and included many in businesses far afield from media.

CBS is not alone though. The practice appears pervasive in publicly held corporations.   According to the authors, four of five academic studies that they found on this subject demonstrated evidence of bias in the selection of peer groups by boards of directors.   Why do directors build these clearly biased peer groups?  They want to stay in the good graces of the CEO, and they are often executives themselves... and would like similar treatment when their compensation packages are set.

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Facebook and Instagram: Where was the Board?

The Wall Street Journal reports today that the Facebook Board of Directors was not involved until very late in the process with regard to the Instagram acquisition.  According to the article, "By the time Facebook's board was brought in, the deal was all but done. The board, according to one person familiar with the matter, 'Was told, not consulted.'"  Later in the article, it describes an amazing meeting that took place at Zuckerberg's home:

At around 6 p.m. that evening, Facebook board member Marc Andreessen showed up at Mr. Zuckerberg's house for a regular meeting. What he didn't know was that Mr. Systrom was in another room, getting his own board to sign off, people familiar with the matter said. Mr. Andreessen, whose venture-capital firm was the second to invest in Instagram, cutting a $250,000 check before the service launched, was surprised when Mr. Systrom walked into the room about an hour into his meeting with Mr. Zuckerberg, the people said.

You can imagine the reaction of corporate governance experts!    Most people have pointed to the fact that the Board and Mr. Zuckerberg will have to interact much differently when Facebook becomes public.  If not, minority shareholders will be quite concerned.  It's interesting, of course, because agency theory says that we ought to like it when CEOs own lots of shares of a company. In those cases, according to theory, there's less divergence of interests between shareholders and executives as opposed to publicly traded companies in which top executives own a tiny ownership stake.  The theory says that we like it when CEOs are playing with their own money, not other people's money.   While I generally agree with that theory, there are limits to the applicability in the real world.   In particular, the interests of minority shareholders need to be considered, particularly when a founder is CEO.   Good governance processes matter, even if we assume that the CEO generally is trying to do right by all shareholders.  Moreover, founder/CEOs rightfully should get held to a different standard when a company goes public.  

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Corporate Governance and a CEO Search at Avon

Avon recently announced that CEO Andrea Jung would be stepping down, but remaining at the firm as Executive Chairman.  The firm announced that a search for a new CEO would commence immediately.  Today the Wall Street Journal reports that two former Avon CEOs (including Jung's mentor and predecessor) have criticized the decision to have Jung remain as Executive Chairman for at least two years.  According to the Wall Street Journal,

Former Avon CEO James Preston, once one of Ms. Jung's closest mentors, took the unusual step of writing a letter to the board two days after the shake-up. He criticized Ms. Jung's leadership, stressed that departing CEOs should step aside and called on the board to replace her with someone with deep experience in the direct-selling world. "I have long held the belief that once a CEO leaves that position, he or she should make a 'clean break' and not question or second-guess the actions of his successor," wrote Mr. Preston, who ran Avon from 1989 to 1998, in the letter, dated Dec. 15, that was reviewed by The Wall Street Journal. "I have held true to that belief, even though in recent years I have become increasingly concerned—and saddened—by the declining fortunes of the company."

I found the Avon decision puzzling as well.   I wonder whether the decision will make it very difficult for Avon to find a top quality CEO.  What executive would want to take the job, knowing that the former CEO would be looking over their shoulder for the next two years?  It's particularly problematic, given that Avon has struggled lately.  Big changes will have to be made.  Will Jung prevent some of that change from occurring as fast as it should?  

The Board now has a major problem.  The fact that Preston's letter has become public puts pressure on the directors to clarify and justify their rationale for keeping Jung as executive chairman for two years.  They cannot ignore this issue.  They'll have to address it, or they jeopardize their ability to find a high quality CEO.  Moreover, a lack of response will raise more questions about the efficacy of corporate governance at the firm.  That could hurt the share price, as investors may be leery of investing in the company if they perceive governance to be weak. 

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