Click for Academy of Management home page

Academy of Management

CEOs respond to stock analysts' low appraisals by having personal friends appointed to the board under the guise that they are independent directors

January 1, 2010

For more information, contact: Benjamin Haimowitz,

With banking chieftains at pains to assure an outraged public that fat bonuses to top executives will be paid in long-term securities instead of cash, impression management is at a premium in the banking industry today. No need for bank shareholders to fret, though: according to a new study, managing appearances is an activity at which corporate chiefs are eminently successful.
The new research, in the February issue of the Academy of Management Journal,  finds that CEOs in many industries are highly adept at managing impressions among a particularly important group -- stock analysts. Intensive efforts by CEOs to sway analysts, the study finds, increase the likelihood of a subsequent stock upgrade, on average, by about 36% and reduce the likelihood of a downgrade by about 45%.
And, most striking of all, success here has nothing to do with the reality of company management. It's all a matter of impressions about company management.
"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," conclude the study's authors, James D. Westphal of the University of Michigan and Melissa E. Graebner of the University of Texas at Austin.
"Our findings," they add, "suggest how impression management about the board can distort the market value of the firm, ultimately reducing the allocative efficiency of the capital market."
The study adds to an extensive body of research by Prof. Westphal and colleagues that documents the ability of top executives to habitually outwit and outmaneuver such powerful groups as financial analysts, corporate directors, 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. In essence, corporate managers have their cake and eat it: they derive the benefit of market approval of their plans without having to implement them.
And the new research in AMJ complements a report co-authored by Prof. Westphal in the journal's October 2008 issue that also probed executives' relationships with stock analysts. The 2008 study revealed that the more a firm's earnings dip below consensus forecasts, the more favors top executives bestow on analysts covering the company. Two personal favors in the wake of a low earnings report reduces the likelihood of a downgrade by half, the study found.
Now the new report focuses on a less blatant but almost equally effective tactic of CEOs -- namely, invoking the concept of board independence, the notion that equates good corporate management with non-employee directors whose only business relationship with the firm is their board membership. As the authors put it, "The notion that greater board independence from management improves the quality of corporate governance viewed as conventional wisdom among members of the financial community... Analysts are aware that increases in formal independence have been generally well received by members of the financial community in the past, and consequently perceive that it is safe to interpret [increased independence] as an indication of improved corporate governance in the present."
So strong is the belief in board independence, Westphal says, that it doesn't take a particularly strenuous selling job by CEOs to have an effect on analysts. A mere average effort at persuasion increases chances of subsequent upgrade by 22% and lowers the likelihood of downgrade by 29%. And, as indicated earlier, those percentages rise to 36% and 45% respectively with intensive selling efforts.
The problem with formal board independence, the authors observe, is that it offers only a superficial view of board members' relationship to the CEO. In their words, "Powerful leaders can give the impression of enhancing the board's control capacity, without actually increasing its propensity to exercise adding directors who lack formal ties to the firm but who do have friendship ties to management."
And that is, in fact, what commonly happens, the study finds. Westphal and Graebner map a sequence of events in which 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. Each step in the sequence is statistically significant. Thus, negative analyst appraisals are significantly related to subsequent increases in formal board independence and to expanded CEO interactions with analysts that enable them to call attention to the change. And those two developments are significantly related in turn (individually and, even more so, in combination) to subsequent improvement in analyst appraisals, whether expressed as earnings forecasts or recommendations to buy, sell, or hold.
Equally telling is a relationship that is miniscule -- the virtually nonexistent correlation between formal board independence and actual board control as evidenced by directors' criticism and aggressive monitoring of management and revision suggestions in response to management plans. Negative analyst appraisals, the study finds, may lead to an increase in formal board independence but has little or no effect on actual board control, and actual board control bears little or no relationship to the nature of subsequent analyst appraisals.
The key reason for this disjunction is that the CEO uses his or her influence with the board nominating committee to have directors added to the board who are formally independent of management but are actually friends of the chief. As Westphal and Graebner put it, "When CEOs have social influence over the nominating committee, negative analyst appraisals prompt the nominating committee to favor director candidates who give the appearance of independence but who are unlikely to actually exercise control due to their social ties to the CEO."
The findings emerge from surveys of some 1,300 CEOs of large public companies and of outside directors of those firms and analysts covering them. CEOs and analysts were asked about the frequency of the discussions concerning board independence that they had with each other during the year prior to the survey and about the intensity of those discussions; CEOs and directors were probed about the actual amount of board control that actually existed during that year.  Analyst appraisals of the company were recorded for the quarters before and after that period.
Why does the mere appearance of board independence have such influence on supposedly sophisticated analysts? 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. When asked why, they typically suggested that it would be too time consuming to gather information between CEOs and directors...When asked whether information from the CEO about board behavior could be misleading, one analyst told us, 'Could the CEO be exaggerating about [board control]? Maybe. But it's the best information I have, and he did give the right answer, not the wrong answer.'"
Prof. Westphal finds the last 10 words particularly revealing. "Obviously, the CEOs were pushing the right ideological buttons, a phenomenon our research has encountered over and over again in CEO interactions with powerful constituencies. In addition, as we note in the study, the CEOs were clever to make claims on behalf of another party -- namely, the board -- which is generally more effective than self-promotion."
Still, the professor acknowledges some surprise at the analysts' ready acceptance of such a self-interested narrative. "After all, there was no shortage of earlier research questioning the contribution of formal board independence to good management and distinguishing between formal and social independence," he says. But rather than lament stockpickers' lack of in-depth analysis of corporate governance, he proposes a solution to the problem the study uncovers:
"Why not include data on the social relationships of board members to the CEO as part of the standard information provided in basic company literature," he asks. "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."
The new study, entitled "A Matter of Appearances: How Corporate Leaders Manage the Impressions of Financial Analysts about the Conduct of their Boards," is in the February/March issue of The Academy of Management Journal.  This peer-reviewed publication is published every other month by the academy, which, with about 18,000 members in 103 countries, is the largest organization in the world devoted to management research and teaching. The academy's other publications are the The Academy of Management Review, The Academy of Management Perspectives and Academy of Management Learning and Education
Media Coverage:
Management-Issues.Com. Keeping Up Appearances. (Monday, February 08, 2010).
SeekingAlpha.Com. The Importance of Corporate Governance and Independence. (Thursday, February 18, 2010).
The Economist. Stockpickers suckered. (Saturday, February 06, 2010).

Academy of Management
Member Services
Academy of Management
Online Opportunities
Academy of Management