University of Groningen Nose In, Fingers Out Mostert, Irene

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University of Groningen

Nose In, Fingers Out

Mostert, Irene

DOI:

10.33612/diss.132018621

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Publication date:

2020

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Mostert, I. (2020). Nose In, Fingers Out: Essays on Board-Governance Effectiveness. University of

Groningen, SOM research school. https://doi.org/10.33612/diss.132018621

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CHAPTER 1

Directors who truly want to build an effective board need to look far beyond any externally imposed rules and procedures. The starting point is taking an honest look at how – and how well – they work

with one another (Carter & Lorsch, 2004: 164).

INTRODUCTION

Corporate governance – the system by which companies are directed and controlled – is of paramount importance to an organization and its stakeholders (Boivie, Bednar, Aguilera & Andrus, 2016; Aguilera, Florackis & Kim, 2016). Good corporate governance not only decreases the risk of corporate scandals and fraud but also enhances an organization’s image in the public eye (Dalton & Dalton, 2011). Companies such as Enron, WorldCom and Ahold as well as – more recently – ING, Volkswagen and Tesla have all faced, or are facing, heated discussion about what exactly constitutes good corporate governance (e.g., Boivie et al., 2016; Nordberg & McNulty, 2013; Withers, Hillman & Cannella, 2012). It is therefore rather surprising that the question how corporations should be effectively governed has not been fully answered yet, especially given that the corporate form has existed for centuries (see also Hermalin, 2005). In his book The History of Corporate Governance, Fentrop (2013), for instance, highlights that corporate governance issues such as protecting shareholders’ interests and curbing managerial self-interests already emerged in 1602 when the East India Company was founded (see also Smith, 1776). So, why – after 400 years of corporate governance – is it still difficult to answer the question what constitutes good corporate governance?

In finding an answer to the question what constitutes good corporate governance, much of the governance literature has been dominated by principal-agent theoretic reasoning (Boivie et al., 2016; Dalton & Dalton, 2011; Westphal & Graebner, 2010). A central assumption in this stream of research is that because managers are likely to act self-interestedly and because they do not bear the full weight of their decisions—they are not residual claimants—goal conflict is likely to ensue between

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12 the top management team (hereafter TMT) and shareholders (i.e., the residual claimants, cf. Jensen & Meckling, 1976; Berle & Means, 1932; Fama, 1980; Fama & Jensen, 1983). To help align the conflicting interests of the TMT and the organization’s stakeholders, several governance and control mechanisms, both internal and external to the organization, have been put to the fore, such as compensation contracts, concentrated ownership holdings and the market for corporate control (Daily, Dalton & Cannella Jr., 2003; Dalton, Hitt, Certo & Dalton, 2007; Westphal, 1999).

Perhaps the most important governance mechanism in curbing managerial opportunism is the board of directors1_{(e.g., Lorsch, 1989; Daily et al., 2003). Agency-theorists generally view the board of} directors as the “ultimate internal monitor . . . whose most important role is to scrutinize the highest decision makers within the firm” (Fama, 1980: 294). In line with this perspective, governance researchers and practitioners alike have persistently asserted that boards must be comprised of independent directors because they are more likely to scrutinize and critically assess managerial decision making and performance (e.g., Dalton & Dalton, 2011; Dalton et al., 2007; Daily et al., 2003). Consequently, an extensive body of research has examined how board composition and board leadership structure – the two most commonly employed measures of board independence – impact the effectiveness of boards in monitoring management (Dalton & Dalton, 2005; Adams, Hermalin & Weisbach, 2010).

Notwithstanding its intuitive appeal, a wide array of empirical research on board independence has yielded conflicting and ambiguous results on the prescriptions derived from agency theoretic reasoning (Dalton & Dalton, 2011; Roberts, McNulty & Stiles, 2005; Acharya & Pollock, 2013). Fifteen years ago, Dalton and Dalton (2005: s93) noted that “when considering the structural independence argument […], we would appear to have hit the proverbial ‘it’s one, two, three strikes you’re out’”. Daily et al. (2003: 371) even concluded that “an intriguing element of the extensive body

1_{I refer to non-executive or outside directors as the board of directors or the board. The CEO and the other} executives are referred to as top management or the top management team (TMT). This is in line with the literature in which the board of directors is referred to as the controlling body of top management (e.g., Adams, Hermalin, & Weisbach, 2010).

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13 of corporate governance research is that we now know where not to look”. These views are echoed by more recent review studies and meta-analyses demonstrating that there is no clear evidence of a systematic relationship between the structural characteristics of boards, such as board independence, board outcomes and firm performance (see also Boivie et al., 2016; Aguilera et al., 2016; Dalton and Dalton, 2011).

The paucity of consistent empirical findings has prompted calls for a richer and more nuanced behaviorally oriented understanding of boards (Johnson, Schnatterly & Hill, 2013; van Ees, Gabrielsson & Huse, 2009; Roberts et al., 2005). Fortunately, a growing body of governance research, rooted in the behavioral sciences, acknowledges that to more fully understand what drives board functioning, there is a need for researchers to pay more attention to management-board interactions and behavioral dynamics within the confines of the boardroom itself (He & Huang, 2011; Roberts et al., 2005; Zhu & Westphal, 2014). In this dissertation, I respond to these calls for such a more nuanced understanding of board functioning by providing a more socialized, socio-psychological interpretation of what drives board and non-executive director (hereafter: director) functioning behind the closed doors of the boardroom. Specifically, whereas most governance research to date builds on agency-theoretic reasoning and focuses on structural elements of board independence, the social embeddedness perspective I propose emphasizes the behaviors and psychological processes operating among directors and between directors and top managers. By combining agency-theoretic insights with a more socialized perspective on board functioning, this dissertation aims to provide a more in-depth understanding of board functioning. In so doing, I offer insights that prompt a rethink of several aspects of the current (under-socialized) perspective on what drives board-governance effectiveness.

LITERATURE REVIEW Corporate Governance: An Agency-Theoretic Perspective

The last few decades have witnessed high levels of research interest in board functioning, spanning several disciplinary areas, including management, accounting, economics and sociology (e.g., Veltrop,

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14 Molleman, Hooghiemstra & van Ees, 2018; Srinivasan, 2005; Gupta, Otley & Young, 2008; Cardinaels & Soderstrom, 2013; Bruynseels & Cardinaels, 2014; Hooghiemstra, Hermes, Oxelheim & Randøy, 2019; de Haan & Vlahu, 2016; Mizruchi, Stearns & Marquis, 2006). As noted above, the majority of corporate governance research has been conducted under the theoretical umbrella of agency theory (see also Dalton & Dalton, 2011; Aguilera et al., 2016). According to agency theory, agency problems occur when a principal (i.e., corporate owners) delegates work to an agent (i.e., TMT) but (a) the interests and goals of the principal and the agent do not (fully) align – commonly referred to as moral hazard – and (b) when it is difficult or costly for the principal to verify what the agent is doing – commonly referred to as information asymmetry (cf. Fama & Jensen, 1983; Eisenhardt, 1989). Consequently, to keep managerial opportunism in check, the board is charged with setting top management pay to reduce the potential for moral hazard as well as critically scrutinizing and monitoring managerial decision making to reduce the information asymmetry vis-à-vis top management (Daily et al., 2003; Roberts et al., 2005; Dalton et al., 2007; Abernethy, Kuang & Qin, 2015). That is, the board is expected to ratify managerial proposals that promote shareholder interests while challenging those proposals which do not serve shareholders (Westphal & Stern, 2007; Hillman & Dalziel, 2003; Daily et al., 2003).

Building on agency theory, a consistent prescription in discussions of board-governance effectiveness is the reliance on independent directors (i.e., directors who are not current or former employees or otherwise linked to the organization and its managers, see also Gordon, 2007) to reduce agency costs (i.e., managers not acting in the best interest of the organization). The underlying rationale of this prescription is that independent directors – being detached from the managers and daily operations – are more objective about managerial strategic proposals and, therefore, more capable of engaging in proactive inquiry, prompting discussions of concerns and pursuing information until satisfactory answers are given (Hambrick, Misangyi & Park, 2015; McDonald & Westphal, 2010; Hillman & Dalziel, 2003; Fama & Jensen, 1983). As such, independent directors are theorized to add

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15 value to the firm to the extent that they critically assess top management decision making (Boivie et al., 2016; Hambrick et al., 2015).

As noted, scholarly research on director independence has, however, generally failed to materialize in unequivocal findings (e.g., Daily et al., 2003; Dalton et al., 2007). In this respect, Boivie et al. (2016: 348) note that given that over the past 20 years there has been a tremendous amount of research on corporate governance and yet it is still difficult to find solid prescriptions for effective boards, governance researchers may need another lens through which to consider board effectiveness. In line with this premise, several researchers have in fact started questioning whether the very act of critically challenging and scrutinizing managerial decision making – precisely the behaviors deemed appropriate from an agency-theoretic reasoning – may have harmful implications for directors and may actually undermine board-governance effectiveness rather than increase it (cf. Hambrick et al., 2015; Westphal & Khanna, 2003; Westphal & Stern, 2007). As such, to further our understanding of board-governance effectiveness, a reconsideration of several aspects of current agency-theoretic prescriptions pertaining to board composition and board functioning is highly warranted.

Corporate Governance: A Social Embeddedness Perspective

Corporate governance researchers increasingly acknowledge that to further our understanding of board-governance effectiveness, governance researchers need to be more cognizant that directors operate amidst a set of social relationships (cf. Huse, 2005; Westphal & Zajac, 2013). Roberts and colleagues (2005), for instance, note that the web of interpersonal and group relationships between TMTs and boards strongly shapes board effectiveness. Similarly, some authors stress that top managers and directors are part of a social system and that board effectiveness therefore is strongly influenced by management-board interactions and behavioral dynamics (i.e., how directors engage with and work with top management; see also Petrovic, 2008; Forbes & Milliken, 1999; Zattoni & Cuomo, 2010). While it may seem straightforward that management-board interactions are likely to

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16 impact board effectiveness, to date, the implications of these interactions and the related behavioral dynamics – between managers and directors – are left relatively unexplored (Boyd, Haynes & Zona, 2011). A more socialized perspective on board functioning contributes to governance research by providing unique insights into actual board functioning (see also Westphal & Zajac, 2013). That is, examining the nature of social interactions between directors and top managers may yield important insights on what makes boards work effectively (Finkelstein & Mooney, 2003).

Furthermore, whereas the prevailing perspective on board-governance effectiveness holds that challenging managerial decision making helps to ensure that the TMT continues to act in the best interest of the organization (e.g., McDonald & Westphal, 2010; Kroll, Walters & Wright, 2008), it is important to be aware that directors are socially situated when challenging top managers (Westphal & Zajac, 2013; Boivie et al., 2016; Tasheva & Hillman, 2018). The simple fact is that directors who challenge managers do so as members of a board and the prevailing board climate may therefore have important implications for how a director’s challenge is received. Indeed, some studies acknowledge that, at least within some boards, fellow directors might very well interpret these behaviors as “headache inducing” (Hambrick et al., 2015: 333) and that directors may actually experience social costs from challenging their managers (e.g., Westphal & Khanna, 2003; Hambrick et al., 2015). In this respect, Khurana and Pick (2004: 1260) argue that a board is not a simple aggregation of individuals but is, in fact, a complex social system and must be understood as such.

By integrating an agency-theoretic perspective with a more socialized perspective emphasizing social processes and behavioral dynamics, this dissertation calls into question the basic logic of viewing boards that critically challenge and scrutinize top managers – precisely the behaviors deemed appropriate from an agency theoretic perspective – as a panacea for board-governance effectiveness in and of itself. Specifically, by acknowledging that boards are social entities and that directors are individuals operating within these social entities, the overarching research question of this dissertation is, “what shapes director functioning within boards in carrying out their fiduciary duties (i.e., evaluating, advising and monitoring management)”.

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17 OUTLINE

This dissertation presents three empirical studies designed to provide a richer and more in-depth understanding of director and board functioning. Chapter 2 responds to calls for a more behaviorally oriented examination of board functioning that acknowledges that prescriptions and reforms aimed to increase the board’s critical stance towards the TMT may have unintended consequences that could actually reduce rather than increase board effectiveness. Specifically, in this chapter, I examine how TMT tenure, TMT-board cognitive conflict and board tenure jointly shape the two key tasks of the board, namely board monitoring and board advice giving. Drawing from research on team dynamics and cognitive conflict, I propose that TMT-board cognitive conflict may affect monitoring and advising high-tenured executives differently. In this vein, while governance scholars have long argued that cognitive conflict within boards impacts how boards function (Forbes & Milliken, 1999; Minichilli, Zattoni, Nielsen, & Huse, 2012), I argue that cognitive conflict between the TMT and the board may impact board effectiveness. Furthermore, in keeping with the literature on board capital and in line with the notion that performance is a function of motivation and ability, I propose that the extent to which TMT-board cognitive conflict affects board functioning may crucially depend on the board’s ability to assess managerial decision making.

In Chapter 3, I examine the affective consequences of boards evaluating TMT’s performance. I propose that if the board’s critical evaluation of TMT’s performance and TMT’s own performance evaluation are incongruent (i.e., when the board is more negative about TMT performance than the TMT itself is), this may result in emotional conflict between the TMT and the board. Then, drawing on expectancy violation theory, I extend this baseline proposition by arguing that the gender makeup of both the TMT and the board influence how incongruent performance evaluations lead to different levels of emotional conflict. Specifically, according to expectancy violation theory, people implicitly expect an alignment of task-related views with same gender others (Graham, Dust & Ziegert, 2018; Rink & Ellemers, 2006). This can be damaging to relationships because people show negative emotional reactions when the expectancy of having similar views is violated (Rink & Ellemers, 2007a; Phillips,

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18 Kim-Jun & Shim, 2011). In line with this premise, I propose that TMT-board performance evaluation incongruence is more likely to spiral into emotional conflict when TMTs and boards both have a high male representation. I also argue that emotional conflict subsequently increases the chances of directors leaving the board early. In line with Chapter 2, this chapter therefore further underlines the importance of considering how management-board behavioral dynamics and relationships play a critical role in board-governance effectiveness

Chapter 4 focuses on the negative personal consequences for directors disagreeing with the CEO. In line with agency-theoretic insights, the prevailing perspective on board-governance effectiveness holds that directors should take critical stances towards their CEO to ensure that the CEO acts in the best interest of the organization. Although theoretically appealing, I propose in this chapter that, in reality, there is more than meets the eye from outside the boardroom. Specifically, extant research increasingly acknowledges the social costs affiliated with CEO-director disagreement (Westphal & Khanna, 2003; Hambrick et al., 2015). Accordingly, the acknowledgement that CEO-director disagreement does not occur in a social vacuum allows me to add to this stream of research. Specifically, I introduce board psychological safety climate as a crucial board-level factor that explains when and why directors are most likely to experience negative personal consequences from disagreeing with their CEO. I argue in this chapter that in a psychologically unsafe board climate – a climate that is unconducive to speaking up and discussing issues openly –, a director challenging the CEO may very well see his or her social status undermined (i.e., the prominence and respect he or she enjoys in the eyes of fellow directors) and with it, his or her satisfaction with that board position.

In sum, these three chapters all call for new directions and alternative theorizing in research on board-governance effectiveness. However, by more closely examining management-board interactions as well garnering insight into behavioral dynamics within the confines of the boardroom, this dissertation requires data that are not easily available. That is, whereas research into board-governance effectiveness has long been dominated by the use of archival data, research on management-board behavioral dynamics and interactions requires the use of first-hand empirical data

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19 collection methods (Van Ees, 2009; Huse, 2005; Daily et al., 2003). Chapter 2 builds on a unique multi-source dataset that incorporates survey data from 285 directors of 102 Dutch banks and insurance companies. To conduct the study, endorsement was obtained from De Nederlandsche Bank (The Dutch Central Bank) – i.e. the micro-prudential supervisor of banks and insurance companies – as well as from two key interest groups (the Dutch Banking Association and the Dutch Association of Insurers). Chapter 3 relies on both archival sources of information and survey data gathered from a Dutch cooperative comprised of independent financial institutions. In total, 828 top managers and directors from 118 institutions participated in the study. Access to these financial institutions was endorsed by senior managers of the cooperative. Finally, Chapter 4 incorporates individual-level data on 206 directors and 40 CEOs from 40 organizations. In return for full cooperation from the CEO and the directors within every organization, tailored reports were offered providing insights into decision making processes and behavioral dynamics. For an overview of the different chapters in this dissertation, see Table 1.

Table 1

Overview of the Empirical Chapters

Chapter 2 Chapter 3 Chapter 4

Agency-Theoretic Perspective

A key role of the board is to actively monitor managerial decision making and performance

Critically evaluating managerial performance represents a key task of boards

Directors have to challenge CEO decision making

Social Embeddedness Perspective

The behavioral dynamics between TMTs and boards may oppositely shape board monitoring and advice giving

It is important to consider the affective consequences (i.e., TMT-board emotional conflict) of such critical performance evaluation

Challenging CEO decision making can be personally risky for t directors

Boundary Condition

Board tenure: vigilance without

experience is unlikely to result in increased board monitoring and advice giving

Male-similarity: the gender makeup

of both the TMT and the board lead to different levels of emotional conflict

Board Psychological Safety Climate:

the board’s psychologically safety climate fundamentally alters the way CEO-director challenge is received within the board

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20

It Takes Two to Tango: How Board Functioning is Jointly Shaped by TMT Tenure, TMT-Board Cognitive Conflict and TMT-Board Tenure2

ABSTRACT

By explicitly acknowledging that boards carry out their duties towards the top management team (TMT), this paper is well-positioned to investigate to what extent board functioning is impacted not only by TMT and board structural characteristics, but also by the behavioral dynamics operating between TMTs and boards. Rather than examining the effects of these structural characteristics in isolation, we study how board functioning is jointly shaped by structural characteristics, captured by TMT tenure and board tenure, and the extent to which boards take a critical stance towards the TMT, captured by TMT-board cognitive conflict. Specifically, building on a unique dataset comprised of survey data from board members of Dutch financial firms, we first argue and demonstrate that TMT tenure is negatively associated with board functioning. Then, extending our reasoning, we also show that the impact of TMT tenure is contingent on both the level of cognitive conflict between the TMT and the board and the tenure of the board itself. All in all, our findings highlight that studying the behavioral dynamics between TMTs and boards together with structural characteristics can increase our understanding of what drives board functioning.

Keywords: Board of Directors, TMT Tenure, Board Tenure, Cognitive Conflict