Cracking the black-box:
An in-depth case study on the influence of contractual and
reputational factors on actual board decision making.
Master Thesis
Annelinde Verhallen – 10317503
Amsterdam, June 22, 2014
MSc. in Business Studies – Strategy University of Amsterdam – ABS
Version: Final
“One must recognize that human beings will always make mistakes.
That should be our starting point in designing organizational
structures.”
Content
Abstract ... 7
1.
Introduction ... 8
2.
Literature review ... 12
2.1 Agency theory ... 12 2.2 Alternative theories ... 152.2.1. Resource dependence theory ... 16
2.2.2. Social network theory ... 16
2.2.3. Stewardship theory ... 17 2.3 Behavioral theories ... 18 2.4 Propositions ... 21 2.4.1 Liability Risk ... 22 2.4.2 Liability insurance ... 26 2.4.3 Reputational risk ... 27 2.4.4 Managerial Responsibility ... 29
2.5 Research model & question ... 32
2.6 Contribution to literature ... 34
3.
Research methods ... 36
3.1 Research setting ... 37
3.1.1. Case selection ... 37
3.1.2. Embedded units of analysis ... 39
3.2 Research techniques ... 40
3.2.1 Observations ... 41
3.2.2. Interviews ... 43
3.2.3 Secondary data: legislation documents, local knowledge and archival data. ... 44
3.3 Data analysis ... 45
3.3.1 Data reduction ... 45
3.3.2 Challenging the empirical data ... 47
4.
Analysis ... 48
4.1 Changes in decision making since the financial crisis ... 48
4.2 Higher liability risk ... 50
4.2 Directors’ and Officers’ liability insurance... 56
4.3 Reputational risk ... 60
4.3.1 Reputation of Company X ... 61
4.3.2 Personal reputation risk ... 62
4.3.3 Influence of reputational risk on managerial responsibility ... 66
4.4 Managerial responsibility ... 69
4.4.1 Positive influence of managerial responsibility on decision making ... 69
4.4.2 Negative influence of managerial responsibility on decision making ... 70
5.
Discussion ... 75
5.1 Results ... 75
5.2 Contribution to literature ... 82
5.3 Significance of results ... 85
5.3.1 Reliability of the results ... 86
5.3.2 Validity of the results ... 86
5.4 Implications for further research ... Fout! Bladwijzer niet gedefinieerd.
6.
Conclusion ... 88
References ... 89
Appendices ... 92
Appedix I - Case descriptions ... 93
Case 1: Risk Management department ... 93
Case 2: IT and Change department ... 97
Case 3: Business Support department ... 99
Case 4: Pensions department ... 101
Case 5: AOV department ... 104
Appendix II - Observation guide ... 107
Appendix III - Interview guide ... 108
Appendix IV - First thoughts about the empirical data ... 110
Appendix V - Coding scheme ... 114
Appendix VI - The case study database... 139
1. Consultations, observations and interviews ... 139
Abstract
Many scholars are researching the subject of corporate governance. One specific research stream focusses on behavioral theories of the firm in order to find a proper alternative for the age old ‘agency theory’ assuming (among others) perfect rationality among human beings. Despite the fact that many studies have been conducted it still remains unclear in literature how boards of directors actual behave. What does the black box of board behavior look like? And how do their actions influence decision making? This study provides insights in that black box by performing an in-depth case study on how board decisions are influenced by contractual and reputational risks within the Dutch financial industry through ‘fly on the wall techniques’. This industry represents an interesting case regarding these factors as they play a major part in the everyday practice of financial institutions since the ‘great recession’ of 2007 started. Furthermore, this research provides additional insights by researching the Dutch industry instead of the Northern American countries on which previous research within this field solely focused.
It is found that directors within the financial industry are highly aware of their reputational risk. This awareness is increased by the events following from the financial crisis, like the negative media attention on directors about perceptions of their mismanagement. It appears that it causes more balanced decisions and raises the perceived level of accountability among directors. It is also determined that the raise in liability risk, stemming from a raise in lawsuits and the strengthened regulatory supervision on directors’ personal behalf, creates more awareness of accountability as well. It stimulates directors to formalize their decisions and consulting experts and countervailing powers in decision making. Together, reputational risk and liability risk creates higher awareness of managerial responsibility among directors. The measured effects seem to have both positive and negative implications on the quality of one’s
1.
Introduction
The financial crisis. It is the summer of 2007.
‘The Great Recession’ started within the mortgage market of the Unites States. In the years that followed multiple financial institutions worldwide faced financial difficulties. Their financial systems were not strong enough to deal with the large depreciation of assets and the stock price crashes. Large institutions like Lehman Brothers were considered to be ‘too big to fail’. One now knows for sure that there is nothing that could be further from the truth.
The bankruptcy of several financial institutions and the position governments were forced into as they had to provide large capital injections to save some banks and insurance companies from bankruptcy in order to save the financial markets, raised the subject of corporate governance again. Questions about how firms can align interests of managers and investors rose. The thinking about alignment of interests stems from 1932, when Berle and Means wrote about the separation of ownership in their book: The Modern Corporation and Private Property. Based on their thoughts, the agency theory was developed. The governance systems of today, are built upon the principles of the Agency theory (e.g. Roberts et al., 2005; Huse, 2005; Daily and Cannella, 2003). The governance systems and models within the financial industry are built upon these established assumptions and multiple theorists argue that this gave rise to the financial crisis as they do not provide a proper prediction of reality.
As theory faces multiple shortcomings within the current neoclassical assumptions, scholarships on corporate governance are seeking for behavior based alternatives in literature. A specific research stream shows interest into the functioning boards of directors as a corporate governance institution (van Ees et al., 2009). The role of boards of directors is expanded and broadened from only monitoring to mediating and from only shareholders to
firm’s stakeholders in order to provide a more accurate picture of reality. However there is a serious lack of empirical research on actual board behavior (e.g. Daily, et al. (2003), Gabrielsson and Huse, (2004), van Ees et al. (2009)). According to Huse (2005) there is a lot of knowledge available on the subject of boards of directors and their role in corporate governance, but very little focusses on ‘cracking the black-box’ by observing real behavior and what influences that behavior when it comes to decision-making processes.
This need within literature also plays its part within the financial industry, resulting from the need to ‘clean up their act’ and being able to develop suitable governance systems. Regulators seem to pay more attention to culture in firms and boards and behavior of board member instead of solely on solvency and liquidity of the firm. For instance, “De Nederlandsche Bank” (DNB)1. focusses more on behavior, culture and governance, because DNB perceive these factors as ‘risk drivers’ of other prudential risks. The question is, how can governance systems be designed in order to prevent another crisis from happening? And how does the behavior of company directors contribute in this?
This study contributes to the request to open the black-box of corporate boards through an in-depth case study on actual board behavior using a.o. “fly on the wall” techniques (Huse, 2005). The study examines and further explorers specific parts of the research agenda of Huse (2005) by researching how board decision making is influenced by reputational and contractual factors, factors which are currently strongly at stake within the financial industry as they stem from the financial crisis. The following research question was set out:
“How are events following from the financial crisis, as 1) intensified liability risk out of regulatory supervision and a raise in law suits against directors and 2) intensified reputational risk arising out of multiple ‘scandals’ regarding mismanagement by directors, changing the perceived level of managerial responsibility among directors within the Dutch financial industry and thereby influencing their behavior in decision making?”
Outcomes suggest that decision making among directors indeed is influenced by the events following from the financial crisis. The higher litigation risk and reputational risk resulted in more awareness of managerial responsibility. It was recognized that there is a higher level of formalization of processes by handling audit trails, strictly following company protocols and maintaining high transparency within processes, since the crisis started. It was also recognized that there is more consultation of others at stake within decision making processes with experts, colleagues or countervailing powers. Those developments have a positive impact on decision making as it generates more defined and balanced decisions regarding all stakeholders. However these developments could also have implications on more negative developments. Most important implication is that it could hinder operational effectiveness. For instance, the deliberation of decisions will require longer processing time or people are not willing to (fully) take responsibility for decisions and therefore decisions could be delayed or not made at all. Another implication that could hinder operational effectiveness is that employees in operational layers of an organization could have a tendency to misrepresenting situations due to the higher level of transparency and the risk of being held responsible for poor performance outcomes. This causes the risk that decision makers base their decisions on wrong information. What the exact implications of those changes in decision making processes are, should be explored in further research.
All together the results emphasize the extensive and elusive nature of behavioral processes. This research seeks to provide a little insight on the many edges of board behavior. It contributes to literature in three ways:
1) Contributing to the insight in actual board behavior (e.g. Daily, et al. (2003), Gabrielsson and Huse, (2004), van Ees et al. (2009)). According to Huse (2005) as the researcher had access to real boardrooms and was able to observe and question how actual behavior is influenced by external factors and influencing.
2) By contributing to the research framework on board behavior by Huse (2005) by selecting variables that touch up on four of the factors that are in need for further research.
3) By expanding the geographical scope of current literature, from solely Northern America to Europe. As the phenomena was researched within the Dutch financial industry. Which appears to show important differences relative to the underlying governance systems and cultures (de Graaf & Williams, 2009).
The research report is organized as follows: Chapter 2 starts with an extensive literature review starting with the principles of the age old neoclassical agency theory, followed by alternative theories, carefully shifting towards behavior theories and ultimately narrowing the subject down to the researched factors: liability risk and reputational risk. Chapter 3 describes the extensive and accurate research setting of the performed case study, including the methodology and data analysis. Chapter 4 presents the evidence regarding the influence of reputational and liability risk on the awareness of managerial responsibility structured along the research model. Followed by the discussion of the results in chapter 5, answering the research question, the contribution to literature and the significance of the findings. Chapter 6 concludes by summarizing all findings.
2.
Literature review
This literature study starts with an organizational economic view on governance, the agency perspective, followed by challenging theories from other research streams: the resource dependence theory, the social network theory and the stewardship theory. Those theories together form an important basis on which corporate governance studies are built until recent years and on what is lacking in this field of research.
The shift towards a more behavioral view on corporate governance and especially on the behavior of boards of directors, which is seen as very important corporate governance institution (van Ees et al., 2009), is one of great debate nowadays. This literature study sets out the difficulties that exist in this area of research and will lead towards a needed research objective to further explorer the phenomenon of board behavior.
2.1 Agency theory
In 1932, Berle and Means wrote about the separation of ownership in their book ‘The Modern Corporation and Private Property’ which is seen as a foundational text in the theories of corporate governance. With the separation of ownership two parties are involved: the principal (owner) who delegates the work to the agent (controller) who performs the work (Eisenhardt, 1989). Because both principal and agent have their own interests within the performance of the firm (principal strives for profit maximization and agent for a sustainable position), the assumption of self-interest is at stake (Eisenhardt, 1989). This implicates that agency costs do appear by this separation of control out of (1) monitoring costs in order to monitor the agent, (2) entrenchment costs due to non-profitable actions of the agent in order to maintain its position and (3) the residual loss, which is explained as the “the dollar equivalent of the reduction in welfare experienced by the principal” (Jensen & Meckling, 1976, p.308), due to the divergence between the agent’s decision and the decision that would
maximize shareholders welfare (Jensen & Meckling, 1976). These consequences of separation implicate as stated by Jensen and Meckling (1976) that outside equity raises the costs of the firm: the agency costs, because if the manager (agent) would own 100 percent of the residual claim it would make decisions which maximize their utility and therefore the welfare of the firm. When a portion of the firm’s shares is sold, the manager will change its behavior in decision making. The incentive of the manager shifts from profit maximization towards a need to entrench itself, which is most likely not the decision maximizing profitability.
In addition, another assumption in principal-agent theory, is that agents are risk averse and principals are risk neutral (Eisenhardt, 1989), which has important implication on decision making and agency costs in order to maintain a good decision making process.
In order to overcome the challenges between principal and agent, arising from the principal-agent problem, corporate governance systems are getting in place. As Vishny and Shleifer (1997, p.737) define: “Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment”. According to Vishney and Scheifer (1997) and several other researchers that followed (e.g. Tirole, 2001), such corporate governance systems should be designed as (efficient) monitor structures in the dynamics of the organization. Those systems are practically always designed on the assumption of managerial self-interest, following from agency theory (Daily et al., 2003). They reason that agency theory has such a major position in such constructs because 1) agency theory is a very simple theory. It reduces organizational settings to only two participants involved (the principal and agent) with clear and consistent interests. And 2) the assumption of self-interested people is “both age old and wide spread” (Daily et al., 2003, p.372). This approach of designing corporate governance systems causes a focus on monitoring the actions of agents within governance systems. Translated into a business
environment this focus lies a major role with the board of directions as the monitor of the organization. There are multiple concerns recognized in this context by researchers in the field of corporate governance.
The most important one was already explained by Simon in 1979 when he concluded firmly that there can be no doubts that the assumptions of agency theory about perfect rationality is contrary to fact: “they do not even remotely describe the processes that human beings use for making decisions in complex situations.” (Simon, 1979, p. 366). Simon explains that human decision making is not rational but influenced by heuristics and ‘rules of thumbs’. Schwenck (1984) deepens this view by explaining the cognitive simplifying processes in human decision making which is identified in psychological and behavioral theories. And by explaining the effects of simplifying situations in order to decide on the outcomes and quality of decisions. These papers and multiple other great theorists (e.g. Kahnemann, 2003, with his Nobel price speech about Bounded Rationality) show that the highly theoretical neoclassical models contain important flaws in approaching real life reasoning.
A second heard critic on agency theory is that it only assumes two parties: the agent and the principal. Where the principal is the shareholder (owner). Thereby the theory focusses only on meeting the interests of the shareholder. However, recent studies shine their light on a broader scope of parties of interest: the stakeholders. ‘Stakeholder’ implies all parties involved in an organization, for instance shareholders, employees, clients, suppliers, government, local community and environment. Kochan and Rubinstein (2000) explain the differences between a shareholder firm and a stakeholder firm. The most important difference is that the objectives of a stakeholder firm consider all interests of stakeholders instead of solely pursuing shareholder value, if needed at all costs.
Furthermore the agency theory assumes that corporate boards only have a role to monitor firm’s management in order to safeguard the interest of the shareholders, to maximize firm value. Consequently other possible roles of boards of directors are neglected. Therefore one could not unadulterated guarantee that maximum firm value is secured (e.g. Daily et al.; 2003, Pettigrew 1992).
The following paragraphs will outline some important insights from other perspectives as well as a missing topic in this area of research.
2.2 Alternative theories
In 1992, Adrew Pettigrew mentioned in his paper ‘on studying managerial elites’ that until then, sociological, organizational and managerial literature “have not talked to one another” (p.163). Something Pettigrew mentioned as an important step towards a more behavioral based theory on how corporate governance systems and boards of directors in particular function. In this study, several board functions are summarized. Besides the monitor role, other roles as defining the company’s purpose, providing business contracts, creating corporate identity, maintaining the code of ethics and strengthening the link between the company and its environment, are mentioned as well. Daily et al. (2003) mentions the resource role, the service role and the strategy role of boards besides the role of monitor and control. Additionally, Huse (2005) addresses roles of behavioral control, strategic control, advice/council, networking/legitimacy and strategic participation. These papers endorses the fact that the assumptions of the agency theory are not sufficient to conceptualize other roles besides the monitor function. By overseeing other roles and actual board behavior (opposed to the assumptions agency theory holds) no assurance can be given that maximum firm value is
reached. Additional theories are needed to explain these other roles and to provide deepened insight in behavior in order to grow towards a more complete measure of the quality of boards of directors.
2.2.1. Resource dependence theory
One perspective often mentioned is the resource dependence theory (e.g. Huse, 2005; Daily et al., 2003). This theory addresses one of the other roles of directors as pointed out in the previous paragraph. It prescribes that directors can be seen as boundary spanners of an organization. Because each director will have its own experience and expertise it is able to gain resources externally (Huse, 2005). The possession of experience, reputation but also expertise and networks by board members is called “board capital” (Hillman & Dalziel, 2003). Directors can function as mechanisms managing external dependencies through their board capital (Hillman, Canella & Paetzold, 2000, in reference to: Pfeffer and Salancik, 1978). With external dependencies uncertainty raises and it is in the role of board members to reduce these uncertainties by obtaining the right resources. This level of environmental uncertainty will therefore determine board size and the internal/external ratio of board member (Hillman et al., 2000). The more uncertain the environment is, the more external board members are needed in order to gain resources from their experience and knowledge.
2.2.2. Social network theory
Later work in the field of resource dependency theory expands the view by adding the ability of board members to use its network to gain these resources: the social network theory. This theory explains that board members use their ties to other boards not only on social motives but rather to gain strategic knowledge from these networks. The theory addresses the importance of the level of competence of directors because if directors are not familiar with a
certain strategic subject, it appears that they would withhold their contribution regarding the subject. In such cases they would be remiss towards their control function on management. This social network theory thus addresses the importance of networking as a board role in order to complement the strategic knowledge and therefore the right control of the firm (Carpenter & Westphal, 2001). With those activities the resource role and the strategy role as mentioned by Daily et al. (2003) are explained.
Hillman and Dalziel (2003) bring the two theories, the agency theory and the resource dependence theory, together. They state that the two are no substitutes but are supplementing each other. They provide a model in which board capital is seen as a source to monitor (agency perspective) and to the provision of resources needed to mitigate uncertainty from the environment (resource dependence theory). Both taken together will determine the performance of the firm. In addition, they state that board incentives impact the effect of board capital on both monitoring performance and the performance on the provision of resources.
2.2.3. Stewardship theory
This creates a link to another often mentioned theory: Stewardship theory. This theory describes executives as them often having aligned interests with shareholders (or translated in terms of the agency theory, the interests of agent and principal are often aligned instead of non-aligned). This is contradicting to the agency theory (Daily et al., 2003). However, stewardship follows a new approach in how interests get aligned which agency theory does not include because of the limiting nature of the assumptions made. The theory claims that interest of executives are often pointing at the same direction of shareholders’ interests because executives’ reputations are often interwoven with the financial performance of the
firm. This is because if the performance of the firm is disappointing or even alarming, the directors will be held responsible for bad management of the firm by public and law (Daily et al., 2003). Such situations will damage a directors reputation and therefore, Stewardship theory states that board members will act as ‘good stewards’ and fulfill roles as collaboration and mentoring, but will also claim an active role in strategy formation and implementation and will act upon this in their best possible way to meet the interest of shareholders.
This theory both contrasts and complements the agency view by predicting that directors will often act in shareholders’ interests (contrast) but that this situation is created by an intrinsic incentive (complement): reputation.
2.3 Behavioral theories
Theorists in the field of corporate governance and specifically on the subject of the board of directors as a governance institution, address the agency theory, resource dependence theory and stewardship theory as important views on which roles board members act in an organizational setting (e.g. Pettigrew, 1992; Daily et al., 2003; Gabrielsson & Huse, 2004; Huse, 2005; Roberts et al., 2005; van Ees et al., 2009). This shows that a much wider range of board activities should be included than solely the monitor function of the board. As this was indeed the initial reasons to further explorer other theories besides the ‘age old’ agency theory, these current theories do not fulfill the existing literature gap. What stays underexposed in current literature is how board members actually behave regarding the operationalization of their duty. The discussed previous studies again relied on behavioral assumptions, just as the agency theory does, which may not reflect the reality of board behavior (Pettigrew, 1992). To quote Pettigrew (1992, p.169): “Trickers 1978 observation that ‘the work of the director, in and out of the boardroom, is rated as the most
under-researched management topic’ is still ringingly true in 1992”. Pettigrew continues by stating that there is still a need for research on board member characteristics and board structure, culture and process linked to theoretical frameworks like the agency theory. Argote and Greve (2007) provide an overview about the impact of the book “the behavioral theory of the firm” after it was written 40 years ago by Cyert and March in 1963. They find that within the last forty years, the book of Cyert and March did not procreate one theory of the firm, instead a very wide amount of research on behavioral theories of the firm with divergent methods and implications are conducted. Argote and Greve (2007) set out what has been researched and explain the key concepts of what a behavior theory of the firm should include: bounded rationality, problemistic search, the dominant coalition, standard operating procedures, and slack search. Opposing the assumptions of agency theory. Van Ees et al. (2009) continues on the work of Argote and Greve (2007) by examining the gaps in behavioral theories of today. They focus on behavior of board of directors as this is an important institution of corporate governance. Van Ees, et al. (2009) starts with providing an overview of the research streams in the field of board and corporate governance and continues with an overview of what is still uncertain in literature based on the key aspects of Argote and Greve (2007). One important implication of van Ees et al. (2009) is the lack of contextual aspects which need to be taken into account when measuring board behavior. Huse (2005) addresses such factors in a framework for exploring behavioral perspectives of bards and corporate governance. Their framework consists four areas through which Huse tries to enfold the whole agenda for black box research on boards (figure 2.1). Contextual factors are mentioned as an influence on final decision making. Huse (2005) designates mainly the context of the firm and boards but also the industry and the industrial environment of the corporation which contain contextual factors. The provided list of factors included in this paper is however not exhaustive.
Figure 2.1: research agenda for the black box research of boards (Huse, 2005).
2.3.1 Behavior in different countries
Earlier in this chapter it was already addressed that this study focusses on the Dutch financial industry. As previous research on board behavior solely focused on Northern American countries (Gabrielsson & Huse, 2004) it lacks insight in how directors behave in other countries. Although this might seem as a minor limitation, other cultures within organizations in different countries are actually expected to yield major implications on behavior.
Relating this to governance systems, de Graaf and Williams (2009) wrote about the different market systems of the United States and the United Kingdom versus Northern European countries. The market systems of the US and to a lesser extent the UK are aligned with the neoclassical assumptions which yields a high level of deregulation. This high level of deregulation resulted among others in a rapid expansion of the financial industry which is
seen by many others as well as by de Graaf and Williams (2009) as an instigator of the financial crisis. They proceed their research by shedding a light on alternative market systems as in Northern Europe. They explain the governance systems within Dutch organizations as being network-based systems instead of market-based systems, which contain interesting interaction mechanisms. They explain that the Dutch governance systems are more focused on balancing the interests of stakeholders which is embedded in the law system by making people accountable for all stakeholders instead of solely shareholders. It is describled as a delicate interaction model which takes perspectives of others into account in formulating policies. The system is characterized by the consultation of others, which appears to be an important aspect of managerial responsibility (Bertelly & Lynn, 2003). This is further explained in chapter 2.7.4. As the network-based system strongly differs from the market-based system, it is expected that behavior and decision making will be influenced differently as well. This advocates that it is important to research board behavior in a multiple countries, just as Gabrielsson and Huse (2004) suggested.
2.4 Propositions
Within research themes as corporate governance, the financial industry represents an interesting field to research as the financial crisis of 2007 started within this industry and it appears to contain major issues according to corporate governance systems. This need for better structured corporate governance mechanisms makes the industry an interesting one to study regarding the subject of board behavior. Therefore this industry is selected to research within this study (for a further description see chapter 3, methodology).
The research field on board behavior and board decision making lacks major insight in actual board behavior, despite the fact that Simon addresses this issue already in 1979, in his paper on rational decision making in business organizations. However, several theorists did already
that the context of board decision making is very important to be taken into consideration within behavioral studies (Huse, 2005), part of the research agenda of Huse (2005) will be used in order to further funnel the subject, select specific variables which are of interests within the financial industry and to design the propositions of this research.
2.4.1 Liability Risk
Due to the financial crises since 2007, the resulting bankruptcies and several recent accountancy scandals, legislation within the financial industry got tightened. For instance through the use of liability legislation and through the sharpened regulatory supervision.
To start with liability laws, Holderness (1990) wrote about the growing number of lawsuits against directors on behalf of personal liability. The paper explains that the number of suits made against directors fourfold in one year between 1984 and 1985. In recent cases of accounting fraud, like in the case of Enron and WorldCom, it has proven that courts can sentence the directors to jail and/or recoup the losses by fining on behalf of personal liability. These court decisions in which directors where held personally responsible have made the subject of directors and officers personal liability one of recent discussion. Laws are addressed which prescribe that officers are responsible to act in good faith when leading a firm and can be held responsible if it appears they did not. By this, law tries to create an incentive for directors to properly and honestly direct the organization and weigh the risks their taking with the possible consequences. Aiming to ensure that directors lead the firm into good currency in their best possible way and by this align the interests of the shareholder and the directors of the firm.
In the US, Sarbanes-Oxley was introduced in the US constitutional law. It targets at corporate governance and at the actors involved in a firm’s governance and prescribes rules on the
formation of boards and internal controls (McDonnell, 2004). This law strengthens the monitor role of boards in an organization as deriving from the agency theory by prescribing the following fiduciary duties of directors: duty of care, duty of loyalty, business judgment rule and oversight and monitoring responsibility (Skinner, 2006). Skinner (2006) concludes that there has been no actual raise in liability risk concerning directors resulting from Sarbanes-Oxley. However, McDonnell (2004) argues that the effects of the law are in line with the intended decrease of moral hazards in board behavior. According to McDonnell (2004), directors are performing their duty more diligently partly out of greater fear of liability.
As this research focusses on the Dutch financial sector (the selection of the Dutch financial industry is explained later on in this chapter) this is further, other legislation is at stake. In the Netherlands liability litigations knows a very small and specific definition, one which is hard to actually assign in the case of a suit. In the eighties and nineties, the law on personal liability of directors and officers was defined as (translated from Dutch): ‘personal reproach’, more informally explained as to ‘blame’ one on personal behalf. This actually is a very broad definition as it can hold directors liable for practically all mistakes made by their decisions even if they acted in good faith. Therefore, the definition became into disrepute because it would create a very vulnerable position of directors, the definition was too broad and directors could get sued too easily. Other than in the united states the laws where adjusted in order to narrow the definition by which litigation risk was lowered. Article 6:162 of the Dutch Civil Code, prescribes personal liability when ‘substantial serious personal reproach’ which was approved by “De Hoge Raad” (translated: the Supreme Court) on the third of June 2003 (van Maanen, 2004). As van Maanen claims, the Supreme Court has adjusted the law on personal liability in favor of the director.
Due to this adjustment it could be expected that liability risk does not have a great influence on how directors of Dutch institution would behave. However, as explained by Weterings (2011), there is still a higher fear of litigation among Dutch directors and officers. This can be explained through the fact that the amount of claims from shareholders against directors has raised either way. In 2009 a 30% raise of claims reported to insurers was seen relative to the previous year (Weterings, 2010). And regardless the fact that actual liability is not proven very often because of the narrowed description of the law (with exception of actual fraud cases), directors still are burdened by defense trials and defense costs. Therefore it could make directors more aware of the litigation risk they are facing and possibly influence their behavior as is expected by international scholars (e.g. McDonnell, 2004).
From another angle, the increased supervision of regulators in the industry on ‘good governance’ became a very important. De Nederlandsche Bank (DNB)2 is monitoring culture in decision making. DNB focusses in recent years on behavior, culture and governance, because DNB perceive these factors as ‘risk drivers’ of other prudential risks. In order to control the level of board members, they measure board members on education, working experience and competencies as loyalty, independence, responsibility and their ability to create overview and judgment3. To design this new risk driver in order to monitor the behavior of boards, DNB is researching board behavior and culture from inside the boardroom as well (B&E, 2011; DNB Research programme, 2013). This research creates at the same time the awareness of good governance among directors. Although this has no direct impact on the degree of the liability of a director, regulators are in the position to put pressure organization under pressure as they do not agree with the behavior of directors. DNB has the
2 The mission statement of ‘De Nederlandse Bank’ recalls [translate from Dutch]: “DNB commits itself to financial stability and contributes therefore to sustainable welfare in the Netherlands” Found on the website of DNB: http://www.dnb.nl/over-dnb/onze-missie/index.jsp
3 Presentation of mr. R.W. Wijnands MSc, regulator at DNB, of January 28, 2014 at the ‘Hoge School van Amsterdam’.
mandate to disallow the appointment of a director in a new position according to the Dutch law on financial supervision4. Such mandates could have impact in terms of growing ‘fear’ as claimed by Weterings (2011), which is one of the desired effects of liability legislation (McDonnell, 2004).
It is expected, given what is seen by theorists in current literature (e.g. Holderness, 1990; Weterings, 2011; and McDonnel, 2013) and given the events deriving from the financial crisis, that these developments will have an impact on the awareness of manager’s responsibility as they do not want to be prosecuted on personal behalf.
Proposition 1a: Higher litigation risk, as one of the effects originating from the financial crisis, will lead to greater awareness about managerial responsibility.
Proposition 1b: Higher regulatory supervision on directors’ suitability and trustworthiness, as one of the effects originating from the financial crisis, will lead to greater awareness about managerial responsibility.
Proposition 1a and 1b match with the item of ‘external actors’ on the agenda of Huse (2005)5. Huse expects that external factors eventually have an influence on board behavior. As Pettigrew (1992) points out, it is important to recognize that boards act in open and interacting systems, and are therefore exposed to influences from both internal and external actors. Liability risk stems from external actors, the law, regulators and stakeholders clinging to legislation.
4 For an overview: file:///C:/Users/Annelinde/Downloads/STB-2012-7.pdf .
5 Given the extensive scope of the research agenda and all its individual factors, it is not argued that these propositions cover the full scope of ‘external actors’ of the research agenda. It will only contribute by providing
2.4.2 Liability insurance
To answer the litigation risk that stems from liability legislation, insurance companies developed an insurance product to cover this litigation risk: the directors’ and officers’ liability (D&O) insurance. In the insurance literature it is known that insurances create moral hazards because the risk of an individual is moved towards the insurance company upon a premium payment (e.g. McDonnell, 2004; Visscher, 2006; Weterings, 2011). Regarding the subject of director’s behavior, the D&O insurance provides security for the risk of liability of directors. A D&O policy covers the liability costs arising out of a claim made against a director personally, and also the defense costs, even if the claim is not grounded. The D&O insurance provides a proper defense against claims brought upon directors of the firm.
The typical D&O insurance policy knows two covers: A) costs that the insured (directors and officers) make themselves arising from claims against them personally and B) costs that the company makes as it indemnifies the liability of its directors and officers. The insurance covers actual payment as well as defense costs, even when the claim is rejected.
Such an insurance has a mitigating influence on the intended effects of liability legislation, which was designed in order to encourage directors to act in good faith. This is because insurance products shift the litigation risks of the directors towards the insurance companies (Baker & Griffith, 2007, 2010). This situation raises the question about what the consequences are of insuring director’s liability, while these legislations were developed from a law perspective as an incentive to lead the firm in good intent.
Different theorist, internationally, found that the effects of shifting liability risk from a director towards insurance company evoke unintended moral hazard with directors (e.g. Lin, Officer & Zou, 2011; Weterings, 2011). This is, the directors have less incentive to perform in shareholders’ best interest because they become less vulnerable to shareholders litigation, which on its turn will lower shareholder value. Chung and Wynn (2008) complement this
insight. They explain that managers have an incentive to report earnings aggressively because it will increase their compensation. As they explain, litigation that is developed in order to lower this aggressive reporting is negated by D&O insurance because managers are not personal held responsible anymore.
Given this shift of liability risk towards insurance companies, it is expected, that this will have a lowering impact on the awareness of manager’s responsibility as directors have to worry less about their personal wealth when they make decisions.
Proposition 2: Directors’ and Officers’ liability insurances moderate the meant effects of liability legislation – lowering non-aligned behavior in decision making - by shifting litigation risk towards insurance companies, which will lead to less managerial responsibility.
Proposition 2 matches with the item of ‘external actors’ on the agenda of Huse (2005) just as proposition 1 does. However, in an opposite direction. Whereas proposition one predicts a decrease in risk taking behavior in decision making, this proposition claims to raise the risk taking behavior of directors. By that, the contextual factor ‘liability insurance’ from proposition 2 presents a moderating variable on ‘litigation risk’. As it expect to lower the meant effects of liability legislation on risk taking behavior.
2.4.3 Reputational risk
In addition to the previous discussed variables, the earlier discussed stewardship theory implies that the risk of reputational damage is another factor which can influence board behavior (Daily et al., 2003). According to the stewardship theory, the directors of a firm will be held responsible for bad management by public and law. Such situations will damage a directors reputation and therefore stewardship theory states that board members will act as ‘good stewards’ and fulfill roles as collaboration and mentoring, but will also claim an active
way to meet the interest of shareholders.Current literature has not yet examined the possible effects of reputational risk on actual board decision making, according to Chung and Wynn (2008). They conclude with this statement after making their statement that the effect of liability legislation are negated by D&O insurance. They see reputational risk as an interesting variable to moderate the effects of D&O insurance on board behavior. Reputational risk forms an interesting variable to research in order to challenge the assumption of full rationality as the agency theory states. Therefore Chung and Wynn (2008) suggest in their discussion that the risk of reputational damage should be further examined regarding board behavior.
Despite the lack of previous studies on the influence of reputational risk in decision making, it is expected that this variable will have a positive impact on the awareness of manager’s responsibility. Not only because of the principles from the Stewardship theory, also because the current events arising from the financial crisis: multiple law suits against directors, bankruptcy of financial institutions and the enormous media attention regarding the mistakes of management of those firms, are expected to cause anxiety among directors. As they do not want to be exposed in the media in such manner. It is therefore expected that reputational risk plays a (unconscious) role in decision making, which has a lowering effect on excessive risk taking just as the variable litigation risk has.
Proposition 3: Reputational risk, strengthened by the ‘scandals’ about peers from the industry that occurred during the financial crisis, provides an incentive to a higher awareness of managerial responsibility.
Proposition 3 matches with the item of ‘interactions and reactions to pressure’ on the agenda of Huse (2005). The reputation risk descended from the negative events arising from the financial crisis. It touches upon trust, emotions and interactions inside and outside the board
room. These elements are highly related to what reputation is about: how an individual is perceived by its environment.
2.4.4 Managerial Responsibility
The first four propositions together predict an influence on the level of managerial responsibility perceived by managing directors. Managerial responsibility forms the starting point of behavior as it influences behavior and thereby also the decisions directors make. Within the financial industry is seen by regulators, especially since the financial crisis, as a very important aspect influencing board behavior as it refers to the level of integrity and awareness in ones actions among managing directors. It is recognized by different expert opinions6 of Company X that managerial responsibility indeed is understood as an important factor influencing decision making by regulators and that it has an influence on how directors act.
In order to contribute to the research question (chapter 2.8) it is important to identify what is understood by ‘managerial responsibility’ and on what level it could influence decision making. However, the exact definition of managerial responsibility remains elusive in literature. Bertelli and Lynn (2003) try to define managerial responsibility by measuring different perspectives and applying it on institutional reform litigation. Although this involves a much more constitutional issue, they provide relatively concrete definition. It includes four interrelated elements: judgment, accountability, balance, and rationality.
Referring to judgment, it remains somewhat unclear how the appropriateness of judgment can be assessed (Bertelli & Lynn, 2003). Bertelli and Lynn (2003) focus therefore on the question
6 1. Personal assistant CEO company X: call about the thesis, a.o. the subject of managerial responsibility, on Friday , March 7.
how one can minimize the consequences of poor judgment. This is, by separating one’s powers and providing directors with enough power to eventually come to a decision. The second is accountability. It is acknowledged by Bertelly and Lynn (2003) that rules cannot eliminate self-interest in behavior. A higher level of perceived accountability among directors contributes to higher alignment of interests as the director will feel ‘accountable’ for its actions and therefore strive to meet the interests of the stakeholders. The third element: balance, relates to the level of which a director balances the multiple and often competing interests, interpretations and values of all stakeholders. The last element is about rationality. It was already discussed that the assumption of perfect rationality of people (agency theory) does not hold. However, it still is an important aspect in ‘good decision making’. The level of rationality will rise when directors apply the art of ‘audi alteram partem’, which means that no decision will be made without hearing all stakeholders. It is about balancing both argument and counterargument. Again by taking the conflicts of interests into account.
Together, assuming the definition of Bertelly and Lynn (2003), a high level of managerial responsibility is reached by: 1) Separating powers, using this separation in decision making and empowering individuals enough to make decisions, 2) Owning a high level of perceived accountability, 3) endeavoring to balance multiple interests of stakeholders in decision making, and 4) trying to reach a high extent of rational by applying the art of ‘audi alteram partem’. By pursuing these factors in decision making, a higher alignment of interests seems to be reached as directors will take responsibility, balance the decisions by receiving multiple points of view and balancing the different, often contradicting interests of stakeholders and will compensate the fact of never being fully rational.
As explained, the first four propositions are expected to influence managerial responsibility to a certain extent. This managerial responsibility is expected to form the mediating variable
which combines the other variables in influencing more alignment in decision making. Based on the definition of Bertelly and Lynn (2003), a high level of managerial responsibility contributes to aligned decision making with regard to a firms stakeholders. It requires a certain pattern to form decisions. More formal, well balanced and with the right hierarchical decision makers in place.
DNB, the Dutch regulator of the financial industry, endorses this effect of managerial responsibility as it claims that a higher level of managerial responsibility ensures more integrity within management and more balance in decision making of directors. Therefore, Managerial responsibility is seen by DNB as one of the seven ‘elements of an integer culture’ (DNB, 2009). Former president of DNB, Nout Wellink, illustrated this ideology in a speech in December, 2010, after several disastrous events within the financial industry had happened as a result from the financial crisis (translated from Dutch): “Whereas the 1987 movie ‘Wall Street’ broke all records with the famous quote of Gordon Gekko ‘greed is good’, appears the sequel anno 2010 to be a poor apology as this one dimensional ideology appears to have had its days.”(Speech Nout Wellink, December 09, 2010.). The quote explains that due to the financial crisis which started in 2007, the ideology of making as much profit as possible, the ‘one dimensional diealogy’, does not hold anymore. People do not accept profit maximization at all costs anymore. Thus, since the crisis started in 2007, the 2010 movie did no longer have the strong appealing influence as the previous one from 1987.
It remains a great challenge to understand what ‘good’ decisions are as ‘good’ remains an elusive concept and the consequences of decisions will only be revealed as the diction is made. However, given the literature and taking the field into account, a higher level of managerial responsibility covering the four discussed elements, is expected to change characteristics of decision making.
The level of managerial responsibility within a company as the definition of Bertelly and Lynn (2003) reads, relate to the ‘formal and informal structures and norms’ on the agenda of Huse (2005). It is aboutchair, codes, and committees. About who is responsible and how does one act given the level of rationality provided by the environment (external actors) and interactions and reactions to pressure within the organizational context.
2.5 Research model & question
The propositions derived from literature and current market developments provide together a deepened understanding of what influences board behavior in which way within the financial industry. They answer the need of Huse (2005) and van Ees et al. (2009) by providing insight into the context of decision making: how decisions are influenced by external factors, interaction and reaction to pressure and formal and informal structures and norms7.
Research agenda Huse (2005) Researched phenomena Propositions 1. External actors: stakes and power 1. Higher litigation risk for
managing directors
2. Liability insurance (moderator)
Proposition 1a,b Proposition 2 2. Interactions & reactions to pressure 3. Reputational risk Proposition 3
3. Formal & informal structures & norms 4. Managerial Responsibility Sum of all propositions 4. Decision making culture 5. Decision making by directors Sum of all propositions Table 2.1: Answering the research agenda from Huse (2005)
The propositions all contribute to the research question of this study. Proposition 1a, b, are related to the first part of the question about how the intensified liability risk out of regulatory supervision (1b) and a raise in law suits (1a) influence the perceived level of managerial responsibility. Proposition 2 researches an expected moderating effect on the relationships of proposition 1a,b: the liability insurance mitigating the meant effects of liability risk. The third
7 Given the extensive scope and non-exhaustive character of the research agenda and all its individual factors, it is not argued that these propositions cover the full scope of ‘external actors’ of the research agenda. It will only contribute by providing insight in several specific factors that could influence decision making as addressed in the literature study.
proposition is about the second part of the research question, to what extend perceived managerial responsibility is influenced by reputational risk following from the financial crisis. Through these propositions and the drawn research question, the mechanisms that influence decision making processes are researched within this study.
Figure 2.2 shows the research model which derives from the five propositions made in this study.
2.6 Contribution to literature
By researching these variables through the designed propositions, this study will contribute to current literature in multiple ways. First, by the deployment of the research agenda on actual board behavior by Huse (2005), as highlighted in the figure 2.3.
Figure 2.3: the deployment of the research agenda of Huse (2005)
In order to contribute to a research stream of behavioral theories which strives to find suitable alternatives on the highly theoretical dominant neoclassical models in which the agency theory is an important factor, to approximate truths. Or to quote Simon (1979, p.366) after 35 years: “‘you can’t beat something with nothing.’ You can’t defeat a measure or a candidate simply by pointing to defects and inadequacies. You must offer an alternative.”
Second, by conducting an in-depth case study on the actual behavior of boards, which has very limited been performed in research yet. Current literature is mostly based on assumptions on board member characteristics and economic theories (e.g. van Ees et al., 2009, Gabrielsson & Huse, 2004). For further explanation of this contribution, see the methodology section in chapter 3.
Third, the study will focus on the Dutch financial industry in order to meet the lacking knowledge of board behavior in other countries than the US and North America, as highlighted by Gabrielsson and Huse (2004) who end their paper by calling for research contributions from Europe with a focus on black box studies on board behavior. The need to research the topic in Europe is supported by the stronger focus on stakeholder value instead of shareholder value in Northern European countries, as it is highlighted by de Graaf and Williams (2009) as they ‘propose for reform’. As the current literature on board behavior only relies on the North American countries, which wield a market-based system (focus on shareholder value), it is expected that the same studies have different implications in Northern European countries who wield a strongly different model based on consultation and stakeholdership.
3.
Research methods
Given the current unfamiliarity in literature about the actual behavior within boards and individual directors, an in-depth explanation is needed. According to the drawn research question, an in-depth case study on board behavior will suit the problem perfectly based on the definition of a case study (Simons, 2009, p.21): “Case study is an in-depth exploration from multiple perspectives of the complexity and uniqueness of a particular project, policy, institution, programme or system in a ‘real life’ context.”.
As explained, the subject of this research meets the conditions of a case study where board behavior is described in current literature as complex and unknown. Huse (2005) calls in his paper for the development of a framework for exploring behavioral perspectives of corporate governance for a case study approach in which he explicitly suggest on including direct observations through a “fly on the wall technique” (p.76). Given the characteristics of a case study as explained by Simons (2009), there appears to be a perfect fit between such an approach and the research question.
To actually provide a solid overall insight into the ‘black box’, several research methods and sources were used:
- Thorough case descriptions by consulting several employees and directors - 7 observations of management meetings
- 13 interviews with 2 board members, 5 chairing directors and 6 deputy directors - 4 meetings with employees to validate and challenge the results
- Multiple company documents (both public and confidential documents)
All obtained data were very carefully recorded and a detailed case study data base was set up in order to organize all data and keeping track about the research process. This chapter further describes the research setting and explains the used research techniques and method of
3.1 Research setting
The case study will focus on how decision making in the daily management of board members is influenced by the three contextual factors: liability risk, reputational risk and liability insurances as a moderating variable.
The composed research question requires an explanative research approach. Part of the developed research agenda of Huse (2005), figure 1, will be further developed by researching specific contextual factors related to liability risks within boards of directors in the financial industry. The selected factors will furthermore be studied in an in-depth case study in order to create insight and explain ‘actual board behavior’, which remains unknown in current literature (e.g. Pettigrew, 1992; Daily et al., 2003; Gabrielsson & Huse, 2004; Huse, 2005; Roberts et al., 2005; van Ees et al., 2009). The fact that actual board behavior is still lacking in current literature is mainly caused by the fact that there is very little to no access to company boards. Therefore researchers are forced to rely on several assumptions. In earlier research the main assumptions stem from the agency theory (Eisenhardt, 1989) and more recent behavioral theories base their implications mainly on board characteristics as insider/outsider ratio, the number of board members and the share of ownership (Huse, 2005) which are derived from the agency theory as well.
3.1.1. Case selection
Because researchers do not have substantial access to board rooms in order to research ‘actual board behavior’ this study is designed in order to contribute to this insight. In order achieve this, a single embedded case study is designed. First, a single case is chosen because current literature is in need of revelatory insights on board behavior. This is reached by selecting a case from which these insights could be drawn. If there exists an opportunity to create insights
through one case by observing and analyzing a phenomena which has been inaccessible previously, this is the most appropriate approach to follow (Yin, 2002).
This given, the possibility to select such a case has been carefully considered. A few requirements were taken into account when selecting the case. First, the case had to be a company in which there are employed directors who perform decision making roles. Second, the company has to be active in the financial sector since this sector is part of the research question given the current circumstances originating from the financial crisis. Third and most important considering the feasibility of this research, the case should contain ‘local knowledge’8, in order to get access to the strongly requested insight in actual board behavior.
One company meets all three requirements and is therefore selected as the case for this research. Since the participating company requests to remain anonymous, the company will be named by ‘Company X’ in this research to meet this condition.
Company X is a medium large organization from the financial industry. The firm offers financial products to SME’s and consumers and competes nationally in the Netherlands. The company focusses on the development of standardized and clear financial products. Furthermore the company has a very large history and has passed through multiple mergers throughout the past decades.
Table 1: the case study organization Company Nr of employees
(FTE)
Number of directors Number of participants
Company X 3000-4000 80 - 100 13
3.1.2. Embedded units of analysis
There were six embedded units of analysis selected within the case of Company X. Thereby a more complex design with more embedded results is made possible. It is decided to select five management teams, chaired by the director as holding the final responsibility, and the board of directors (CEO and COO) in order to create a broad insight of the behavior of directors within Company X.
Because this research focusses on the influence of contractual and reputational factors in the field of liability and managerial responsibility the different units of analysis where selected varying from: closely related to legislation and more distant from legislation, and from close to actual operations to distant to actual operation. The units of analysis are set out in table 2.
All participants were personally contacted by using the author’s personal network. By using this network an important condition in getting access on observing board dynamics, is “deeply rooted trusts” (van Ees et al., 2009, p. 315). This is why the selected participants where all prepared to participate without questioning the nature of the study. Even when they were not informed very specific about the exact factors that will be researched, in order to avoid participants getting biased towards the factors that are researches, they agreed to participate and to provide access to board meetings and decision making documents (secondary data). As to quote one of the participating directors (translated from Dutch): “It is no problem that you do not explain the specifics of your research, because I know you and I know it will be fine. I like to help you out and it is a very interesting subject you are studying.”
To avoid selection biases, strict division of units of analysis where invented before approaching the diverse potential participants.
Table 2: units of analysis
For an explanation of the characteristics of the embedded units of analysis and each selected issue which was observed during this study, appendix I.
3.2 Research techniques
An often heard critique on case studies as a qualitative research approach is that it fails to provide a sufficient operational set of measures and that the data collection is not objective. (Yin, 2002). Because of this, it is very important to develop a rigorous methodological path in which a clear audit trail is maintained. In this section, the diverse research techniques and research sources will be explained by which triangulation of sources as well as triangulation of data is provided. Following Patton (2002), three kinds of data sources are very well suited for qualitative research: interviews, observations and documents. This study entails all three kinds of sources of data. In total 7 management meetings were observed, 13 interviews with directors were held and four meetings with employees of Company X were set up to validate and challenge the results. Furthermore multiple company documents (both public and confidential documents) were used to triangulate the findings.
* This management team was observed during their decision-making process on a selected topic in order to create insight in actual board behavior.
Unit of analysis # directors interviewed Related to legislation Related to operations
Board of Directors 2 interviews Directly Directly
AOV department 2 interviews Directly Directly
Pensions department *9
2 interviews Directly Directly
Risk Management 3 interviews Directly Distant
IT & Change* 2 interviews Distant Distant
Business Support* 2 interviews Distant Distant
