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Corporate directors who participate in governance reforms are ostracized by members of other boards

August 1, 2003

For more information, contact: Benjamin Haimowitz, HHaimowitz@aol.com

POWER ELITE STYMIES REFORM

New study, based on survey of over 2,000 directors and CEOs,finds widespread pattern of sanctions keeps board members in line

Ten years ago, in a cover story entitled "The King is Dead," Fortune magazine hailed the phenomenal rise of institutional shareholders and confidently predicted they would "clip the power of corporate management."

Yet, the years since have provided not only a series of scandalous abuses of corporate executive power but other, less dramatic evidence that reforms anticipated a decade ago have gone largely unrealized. For example, the number of independent board chairmen or independent nominating committees has remained stubbornly low, while the number of companies with poison pills, much beloved by underachieving executives, has remained stubbornly high.

Now, research presented at the 2003 annual meeting of the Academy of Management (Seattle, Aug. 3-6) finds a major reason for stalled reform in unspoken sanctions by board members against reforming directors -- actions not tangible enough to get into a newspaper or company annual report.

The findings have particular pertinence at a time when the SEC and other agencies are considering changes in rules regarding corporate governance, including procedures for selection of board members.

In a study entitled "Keeping Directors in Line: Social Distancing as a Control Mechanism in the Corporate Elite," James D. Westphal and Poonam Khanna of the University of Texas, Austin, find a widespread pattern of what they call "social distancing" among corporate boards.

According to Westphal and Khanna, social distancing means that "directors who acquiesced to external pressure from institutional investors and other stakeholders ...are less likely to be invited to informal meetings; other directors are less likely to solicit their opinion on strategic issues or to build on their comments and suggestions in meetings; and other directors are more likely to engage in gossip about people and events with which [target directors] are not familiar."

In sum, "it appears that deviant directors who have violated the interests and integrity of the corporate elite experience a kind of informal ostracism in which they are excluded, to some degree, from the work of the board and from social interaction and association with other directors."

Moreover, the authors find, this ostracism is generally effective. "The results consistently indicated that directors are less likely to participate in changes that threaten the interests of the corporate elite if they have recently experienced social distancing."

Such social pressures, the authors state, are exerted on behalf of a "central interest [in protecting] the autonomy and final decision-making authority of top managers themselves." Westphal and Khanna cite "considerable, qualitative evidence that senior managers and directors of large, established companies possess a shared 'classwide rationality' or group consciousness as members of a unified business elite...The norms [of this elite] are thought to reflect the priorities of senior executives...because a majority of outside board members at large U.S. companies are themselves top managers at other larger firms."

The study's findings draw on responses to two survey questionnaires, the first sent in January 1999 to outside directors and CEOs of companies listed in a national index of 500 industrial and service firms and the second sent in February 2001 to outside directors of index companies. Some 1098 directors from 417 firms and 197 CEOs furnished usable responses to the first questionnaire, and 1057 directors in 421 firms responded to the second questionnaire, which included questions about director support for elite-threatening actions during the two years following the initial survey.

In the initial survey, Westphal and Khanna furnished outside directors and CEOs with a list of board outsiders and asked them to respond to eight questions about each of them (plus, in the case of the director respondents, to provide the same information about themselves). The questions probed various aspects of social distancing, for example, how many informal meetings apart from board sessions the person was invited to in the past year, to what extent during the past year other directors asked this person's opinion of strategic issues [not at all...somewhat...very much so], to what extent directors tended to build on this person's comments, to what extent they talked in this person's presence about people he or she probably did not know.

To assess reliability of responses, the investigators compared the self-report of a given director with the answers given about him or her by another director on the board and by the CEO. To explore possible reasons for a director's being ostracized, they determined by means of their surveys and publicly available records whether the director had participated within the previous two years in one of four governance changes at another company: 1) separation of the positions of CEO and board chairman; 2) creation of an independent board nominating committee; 3) repeal of a poison-pill takeover defense; and 4) CEO dismissal.

In analyzing the relationship of these actions and ostracism, Westphal and Khanna controlled for a number of factors that could affect social distancing or subsequent participation in elite-threatening governance changes, such as demographic dissimilarity, common board ties, director stock ownership, and director status -- for example, whether the individual sits on boards of big, prestigious companies or serves as an executive of one.

The investigators found participation in elite-threatening actions to have a strong effect in eliciting social distancing and for social distancing to have a strong effect in discouraging participation in elite-threatening actions. High status, they found, reduced the likelihood of social distancing, meaning that boards tend to be more tolerant of reformist activity by high-status directors than they are of less exalted board members.

In a measure of the power of social distancing, it was found that "neither director [stock] ownership nor the level of ownership by institutional investors increased the rate of director participation in elite-threatening actions that reflect independent board control over management...Thus, our findings suggest that the deterrent effect of social distancing outweighs the effect of economic incentives and external pressures to participate in deviant actions...findings [that] can help explain why the so-called shareholder revolution in corporate governance has stalled in recent years."

As a supplement to their surveys, the authors conducted spontaneous interviews in which board members confirmed the power of social distancing. Interviewees stated that when directors sit on boards that reduce management power, they "can expect to be ostracized," "people are less interested in working with [them]," "it will be harder to have as much influence [on other boards]", they will "get the silent treatment," "the cold shoulder," etc.

Interviewees expressed no qualms about holding an individual director responsible for governance changes voted by an entire board. An interviewee noted that "one director can definitely keep it from happening. A board isn't going to go against management like that if all the [outside] directors aren't willing to support it."

Seventeen of 19 interviewees agreed that social distancing would be aversive to directors, so that someone experiencing it "is going to want to correct that situation," "restore his credibility," "regain respect," etc. Several offered stories about directors they knew personally (in one case the interviewee himself) who had experienced aspects of social distancing and who had, as one put it, been "careful to follow board etiquette" thereafter.

The Academy of Management, founded in 1936, is the largest organization in the world devoted to management research and teaching. It has nearly 14,000 members in 90 countries, including some 9,000 in the United States. The academy's 2003 annual meeting drew some 6,000 scholars and practitioners to Seattle for more than 1,000 sessions on a host of issues relating to corporate organization, the workplace, technology development, and other management-related subjects.

Media Coverage:
CNBC. Closing Bell. (Tuesday, August 05, 2003).
Reuters. English News Service. Reformist directors get the big chill, study finds. (Sunday, August 03, 2003).
The Washington Post. The Corporate Cold Shoulder. (Sunday, August 17, 2003).

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