Title: Bottom-Up Corporate Governance
Author: Augustin Landier (Toulouse School of Economics), Julien Sauvagnat (Toulouse School of Economics), David Sraer (Princeton University), and
David Thesmar (HEC Paris)
Publisher: Review of Finance, vol. 17, no. 1
Date Published: January 2013
Need new evidence on the value of speaking truth to power? According to a recent study, firms with more “independent” top executives—those appointed before the current CEO took over—exhibit superior decision making, see better returns following large acquisitions, and post higher profits. The study’s authors say the implication is clear: These leaders can act as a powerful counterbalance to and disciplining force on their CEO, irrespective of organization hierarchy.
Previous research has shown that in the absence of effective monitoring, CEOs often engage in self-interested strategies that prove damaging to shareholders. The consensus recommendation has been to install strong boards of directors. But evidence that independent boards boost performance is lacking. Not so with independence in the executive suite, which this paper finds is a “strong predictor” of positive performance.
The authors looked at five data sets collected between 1992 and 2009 that covered some 1,850 of the largest U.S. corporations each year. They calculated how many high-ranking subordinates came aboard after the then current CEO’s appointment, reasoning that these executives would be more disposed to share their leader’s outlook, and less likely to challenge him or her, than those who worked under a predecessor. Controlling for a variety of factors, they found that even the smallest uptick in the nonindependence of executives caused a decrease in the firm’s annual return on assets of between 0.5 and 0.8 percentage points.
The authors also examined all acquisitions above US$300 million. Although acquisitions, on average, led to decreases in shareholder value for the companies in the study, firms with fewer independent top subordinates fared much worse, losing about 45 percent four years after they made an acquisition, almost triple the 16 percent loss posted by firms with more of those executives.
The authors explain that CEOs typically interact with members of the executive suite daily, in contrast to their dealings with board members, who meet infrequently—meaning that CEOs must continually weigh their subordinates’ opinions. Through that steady connection, independent subordinates can subtly affect their firm’s strategic direction.
Because of the value of such “bottom-up governance,” the authors write, “the human resource role of the board should not be limited to the usually emphasized CEO succession problem, but should also be concerned with the choice of key executives.”
Bottom Line: Having a high number of independent senior leaders is an effective way to keep the CEO on a tighter leash and produce better returns.