The Advisors' Blog

– Broc Romanek, CompensationStandards.com

This column by Gretchen Morgenson in yesterday’s NY Times was disturbing. It reported on a recent study – “Will Disclosure of Friendship Ties between Directors and C.E.O.s Yield Perverse Effects?” – by 4 professors who found that directors who had a personal relationship were more willing to slice into a company R&D in order to pay the CEO a higher bonus. And to make matters worse, disclosing the personal relationship made the directors even more willing to forego R&D to support a higher bonus. Here’s an excerpt:

In the experiment, the directors were asked to role-play as board members of a hypothetical biotech company that was about to report earnings for the year. The company had been expected to earn $805 million, the directors were told, but its actual profits were going to be just $800 million. That shortfall would have an impact on the compensation of the chief executive, who would receive a bonus only if the company earned at least $810 million.

The directors participating in the experiment were divided into two groups. Two-thirds were told to assume that they had a personal or social relationship with the C.E.O. of the biotech company. The remaining third were told they had no such tie. Of those who were friendly with the executive, half were told that they had disclosed their relationship to the board, to company management and to shareholders. The other half were told to assume that they hadn’t made the disclosure.

The only option given to the directors to make up the shortfall — and thus help the C.E.O. get a bonus — was to cut the company’s $40 million budget for research and development. As they weighed this possibility, they were told that for every $1 million cut in that budget, there would be a 1 percent increase in the chance that the company would lose ground to its competitors.

Now for the results: Among the directors who counted the C.E.O. as a friend, 46 percent said they would cut research and development by one-quarter or more to ensure a bonus payout to their pal. By contrast, only 6 percent of directors with no personal ties to the chief executive agreed to reduce research and development to generate a bonus. That’s to be expected.

The results get more interesting when disclosure is added to the mix. Of the directors who said they would cut $10 million or more from the budget — the amount necessary to generate a bonus to the chief executive — an astonishing 62 percent had disclosed a friendship with the C.E.O. Only 28 percent of the directors who had not disclosed their relationship with the executive agreed to make the cuts necessary to generate a bonus.

Only one director with no ties to the executive agreed to cut the budget by $10 million or more.

Mr. Rose, an author of the paper, said he and his colleagues were surprised that so many directors said they’d be willing to put the company at risk to ensure a bonus for their pal, the C.E.O. “If just by mentioning that you’re friends with the C.E.O. it affects their decision-making, we think the effects going on in the real world are much, much larger than what we picked up in the lab,” Mr. Rose said in an interview last week.

Even more disturbing, he said, was that so many directors seemed to think that disclosing their friendships with the C.E.O. gave them license to put the executive’s interests ahead of the company’s. “When you disclose things, it may make you feel you’ve met your obligations,” Mr. Rose said. “They’re not all that worried about doing something to help out the C.E.O. because everyone has had a fair warning.”