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Corporate governance: The missing piece

Can company managers' repeated minor violations of the law or a strong focus on material possessions explain why we continue to see new corporate scandals? Yes, says Harvard Professor Aiyesha Dey, who points to several factors that owners and boards often overlook when appointing key management – with costly consequences.


In the early 2000s, in the wake of scandals within companies such as Enron and WorldCom, stricter rules for public companies and banks were introduced in the US. In 2002, the Sarbanes-Oxley legislation was introduced, the intention of which was to increase the requirements on companies' financial reporting, while at the same time sharpening the consequences for those who broke the rules. Also within the EU, a series of tightening of the financial regulations have been introduced.


Despite this, the world experienced a major financial crisis just a few years later with a number of, primarily American, banks and mortgage providers hiding financial problems. This got researcher Aiyesha Dey, recently promoted to full professor at Harvard Business School, interested.


– The question I asked myself was why this type of events continues to be repeated even though we are introducing ever stronger systems for corporate governance? Is it because the systems are not properly designed or are they too weak? Or is there something else that we are missing? Are there other parts of the equation that we should look at?

 Together with her colleagues, she began to investigate whether there could be explanations in the personality traits of the managers who reached the top of companies and banks. The research team began by selecting a group of just over 1,000 US companies and then assigned private investigators to check the presence of the companies’ CEOs in the criminal records of various states.


Aiyesha Dey, recently promoted to full professor at Harvard Business School


Criminal history


The results showed that 18 percent of the CEOs had historical penalties in their personal lives for everything from minor traffic offences to substance abuse and more serious crimes. In the next step, the researchers compared the findings with historical data for companies sanctioned by authorities for financial fraud of various kinds. The outcome showed that having a CEO with a criminal history more than doubled the probability of the company being indicted for fraud, often with the CEO him-/herself being directly involved.


– What surprised us the most was that the result was clear even when we only looked at minor crimes such as speeding violations. That more serious types of crime would have a significance was perhaps expected, but it turned out that even this type of minor violations was reflected in the data.


To test the material further, the outcome was compared with the CEO's trade with the company's own stock. Here, too, the results showed that the group with a criminal history, on average, made significantly more profitable but also more questionable trades. The researchers point out that this is not necessarily criminal insider trading, but were still able to establish a clear difference in behaviour compared to the group of CEOs with no historical criminal records.


Luxury consumption


The next step in the research was to see whether a CEO's materialistic orientation had an impact on a company's regulatory compliance. Here, the researchers chose to look at publicly available information regarding vehicle ownership of cars and boats as well as their own private residence. The selection was made with a focus on CEOs who had significantly more expensive assets compared to their peers, and had homes that stood out in terms of price compared to their neighbours in the immediate surroundings.


– This research found that companies with a more materialistic CEO also had an increased incidence of fraud cases, but the difference was that they were often not personally involved. Instead, we could see that this personality type seemed to contribute to an internal culture that increased the risks of various types of problems.


Potential explanations could be that these companies had weaker internal regulations and different types of aggressive and more favourable bonus programs, but also that the materialistic CEO would look more favourably on recruiting personal wealth-oriented people to other positions in the management group. In a special sample for banks, the researchers were also able to determine that staff in companies with this type of management made more aggressive insider deals in their own stock in the years before and during the 2008 financial crisis.


However, the research also saw that, on average, the materialistically oriented CEOs delivered better returns to the owners.


The board's responsibility


Aiyesha points out that this is a dilemma for an owner or a board, since an action-oriented person who has delivered good financial results historically is what you typically would look for. But she warns against looking too one-sidedly at the numbers and ignoring personality traits that can be harder to measure and assess.


– A board has a great responsibility towards the shareholders and other stakeholders. I am not saying that you should not recruit a person who has a criminal history or signs of material interests, they can of course bring a lot of positives as well. But I would also pay attention to these more subtle non-financial clues. The research shows that these can also have a bearing on a company's success and failures.


– It is important to be vigilant and aware because then it will also be easier to control and follow up. Creating awareness is important, it's the first step.


The elevated risks that the researchers see are based on behavioural psychology. The idea is that a person who is prepared to commit minor violations of the law in private situations also has a tendency to more easily accept breaking laws and regulations in other contexts. For a more materialistic personality type, the question becomes whether the person is prepared to go so far as to harm his surroundings, his own company or other stakeholders in order to promote his own wealth and status.


– It is a key question, how far is the person prepared to go in the pursuit of material status?


According to Aiyesha, the group of CEOs who do not have the materialistic profile show a behaviour that provides greater long-term values when decisions are made based on a consequential mindset where parties such as their own family, employees and investors are weighed in. It is not about short-sighted and greedy self-interest at the expense of others. Even when it comes to risk propensity, it's about recognising the differences that exist.


– How far is a CEO prepared to go for his own gain? Is the CEO willing to break the law or harm others to achieve his goals? Of course, a company must be able to take risks, but then strong structures for risk management are also needed. As a board, it is important to know when to pull the brakes. You can't drive a Ferrari without strong brakes. It is that balance that I think we must seek.


Personality trumps incentives


In her continued research, Aiyesha is interested in looking further at how we can develop today's system for corporate governance and at the same time make use of the knowledge we have about behaviour and personality types. Relying solely on new rules and incentives to prevent future corporate scandals is not enough.


– There has been a notion that it is possible to neutralise people's personality traits through corporate governance systems and various incentives, that the rules should make everyone behave in the same way. But what our research shows is that you can never completely remove these differences in personality.


When asked how she herself would act in a recruiting position, for example as chairman of a board, she unsurprisingly replies that she would focus a lot on the personality of the candidate. Not be content with looking at business results and the person's actions in public contexts.


– I would use a broader lens. I would like to talk to people who can tell me how the candidate treated his co-workers in previous workplaces. How did he or she talk to colleagues? The personal dimension would be important to me, because leadership comes with big responsibilities not just to shareholders but to multiple stakeholders, including employees. Leaders’ words and actions shape the values, behavioral norms and culture of organisations, and dictate how others act. It's about identifying clues that can give you an insight into the personality and character of an individual because it will have a big impact on that individual's decisions and actions later on.


Read more about Professor Dey's research:




You may also find this interview with Professor Henrik Nilsson of the Stockholm School of Economics interesting.

 

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