Saturday, April 08, 2006

Don't humor them! Overconfident CEOs and corporate governance

At a time when a lot of finance research examines overconfidence and other irrational behavior on the part of investors in their stock purchase decisions, it seems natural to examine the corporate implications of irrationality. Specifically, CEOs making suboptimal decisions because of overconfidence in their own abilities for example.

I came across this interesting article by a law professor at Washington University entitled: "Too much pay, too much deference: Behavioral Corporate Finance, CEOs, and corporate governance" that examines CEO overconfidence.

" executives, particularly CEOs, suffer from overconfidence—often referred to more pejoratively as executive “ego,” “hubris,” or “arrogance.” In fact, it is reasonable to believe that people in powerful and influential positions with track records of success—qualities that typify CEOs, especially of large public companies—might particularly be overconfident and prone to believe that they are in control. Such self-serving tendencies might be amplified still further for so-called “celebrity” CEOs, who are regarded more for their charisma than their managerial skills."

Sounds reasonable. But the paper goes further in ascribing the largest part of this CEO overconfidence to - hold your breath - corporate governance!

"I theorize that CEO overconfidence is in important ways a product of corporate governance. Corporate governance structure and practice in the United States is likely to lead to CEO overconfidence in two key ways.
..(First,) a large executive compensation package gives positive feedback to a CEO and signals that the chief executive is a success. Studies show that positive feedback and recent success build confidence.
..(Second,) my theory is that CEOs are emboldened and more confident as a result of the great deal of corporate control that is concentrated in their hands, as well as the fact that their business judgment is deferred to and their exercise of control is for the most part unchallenged.In sum, my hypothesis is that deference to the
CEO can bolster CEO confidence."

I beg to differ. While blaming CEO overconfidence on corporate governance makes for an attention-getting headline, this accusation is quite unfounded.
The simplest and clearest objection I can think of to this is that a)overpaying CEOs and b)being deferential to the CEO and concentrating power in the CEO's hands are NOT corporate governance!
In fact, the opposite is true. The aim of good corporate governance is to maintain a good system of checks and balances so that the CEO is accountable to his/her shareholders and acts in their interest, always. Part of creating this alignment of interests is ensuring an optimum compensation structure.

So perhaps this thought gives us yet another definition of corporate governance: keeping a rein on CEO overconfidence.
Which brings us back to the previous post: CEO overconfidence is yet another reason why takeover defenses should be decided by shareholder vote! Not a unilateral decision by the CEO.

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