They graduate from the same universities, support the same charities and are members of the same clubs, but does the fact that company directors and CEOs share the same social networks damage corporate governance? Innovative research from Cambridge suggests it might.
When Dr Bang Dang Nguyen – a lecturer in finance at Cambridge Judge Business School – decided to study corporate elites and their social networks, the Enron scandal was still fresh in the minds of the business community.
And it was the US government’s response to the scandal – the Sarbanes-Oxley Act (SOX) of 2002 – that made him question whether social networks have an impact on boardroom performance.
According to Dr Nguyen:
When I started this research in 2006, the SOX had been in force for four years. It obliged the majority of directors in all publicly listed companies in the US to be independent and competent in accounting and finance.”
The SOX, however, defines independence narrowly in terms of financial and family ties between board members and CEOs. “The underlying assumption is that by making the board more independent and competent, you can prevent huge scandals such as Enron. I wanted to see if the argument behind SOX was true: whether independent, more competent boards are better than other boards,” he explains.
The second reason the question intrigued him was that it had not been asked before.
Finance research rarely examines human relationships. We assume the market is efficient and that market forces oblige all firms to behave well,” says Dr Nguyen. “Social networks are important sociological phenomena, but in finance we have no evidence, no studies, on their impact.
All the top directors in the US, for example, know each other. They play golf together, share the same charities, sit in the same banquets. And I wanted to find out what impact that might have on company performance.”
While his aims were relatively straightforward, finding appropriate data proved more challenging. “The most important pieces of data we needed were on social networks – on the connections between directors and CEOs,” explains Dr Nguyen, but in the absence of any ready-made data set, he opted instead to build his own using France’s Le guide des états majors.
As well as containing the biographical information he needed on the boards and CEOs of major French firms, focusing on France also meant Dr Nguyen would be able to generalise his results to the US and UK. Like the Ivy League and Oxbridge, the French businesses elite is produced by a small number of high-calibre colleges known as Grandes écoles, where close networks of long-term friendships are formed and find their way into the boardroom.
His final sample of 2,536 semi-annual firm observations from the largest publicly traded French firms between 1994 and 2001 was hard-won, necessitating hundreds of hours of coding.
Le Guide tells us which director graduated in which year from which school and what he did after graduating. And it tells us how he’s connected to others in the same board – whether they did the same undergraduate degree, whether they crossed paths at work. But the data isn’t ready to use, it’s just a huge inventory, so we had to code it to quantify these relationships, which was a horrendous job!” he admits.
The study’s findings – which are three-fold – suggest the effort was worthwhile. First – and arguably most importantly – Dr Nguyen found that close ties within a board adversely affects company performance.
There is no indication in our study that when the board is very connected, the firm outperforms others,” he says. “In fact, they are more likely to underperform than outperform other firms.”
While his study is not designed to explain why this is the case, Dr Nguyen believes opposing forces are at play: the positive effects of connectedness on information asymmetry as well as the board’s advisory role versus its willingness to be tough on a CEO when circumstances demand.
A key challenge facing boards is information asymmetry between the CEO and the board. Most of the time the CEO will have more and better information on the firm than the board, so good connections between board and CEO can help reduce that asymmetry, which is good for the firm.”
Social networks could also boost board performance by improving its advisory role, he explains: “To a certain extent close relationships can be good because they promote the advisory role of the board of directors. The board is not just a policeman; it’s supposed to provide the right strategic advice.”
The study, however, shows these positives are outweighed by the negative effects of social networks, in particular the willingness of a connected board to be lenient on a poorly performing CEO.
The second result is that social networks seem to impact board effectiveness in that connected CEOs are less likely to be ousted for poor performance than non-connected CEOs. For the same poor performance, the connected CEO is almost three times less likely to be fired,” he says. “One of the most important powers of the board is hiring and firing a CEO to protect shareholder value but it seems they are very bad at this policing role.”
The third key finding is that a connected CEO ousted for poor performance is much more likely to find a better job, more quickly, than an unconnected CEO.
“It’s shocking, a huge failure,” he says. “Theories in finance and economics tell you that directors and CEOs have to perform for their reputation in the labour market. If you’re a bad CEO, you are fired and less likely to find a job. That’s the theory.”
Dr Nguyen believes his findings have clear policy implications, and thinks shareholders and politicians as well as regulators would do well to read his paper.
It might be useful for shareholders – increasingly taking a view on remuneration issues – to scrutinise recruitment decisions. “Shareholders should know about these problems and should not allow a board to be dominated by one social network,” he says. “Shareholders should know these connections could affect a firm’s performance – negatively.”
“Now shareholders can tell directors that they should refrain from nominating their friends onto boards, you have to refrain from pretending that because you know this guy it’s good to hire him. There is no such evidence. We looked at hundreds of companies over 10 years and didn’t find any evidence, any obvious advantage of connection in improving firm value.”
For regulators, the paper’s message is also clear: that legislation of the ilk of SOX may fail to prevent future corporate scandals. “The regulations are naïve,” says Dr Nguyen. “SOX imposed a ratio on companies that the number of independent directors on a board must be greater than the number of insiders, but we shouldn’t expect that imposing this ratio will make the board more effective and more likely to fire a poorly performing CEO.”
My paper shows that imposing this ratio may not change anything, because the fact is that although they are not financially connected, board members and the CEO are socially well-connected, and this social connection will prevent the board from working properly. We have to broaden our definition of board independence; it’s not like if you have no financial connection that you’re independent.”
Faced with widespread and resilient social networks, regulators should focus more time and effort on making the market more competitive, he says: “[Corporate] governance requirements will not change anything. Social networks are very stable. Regulators should instead increase transparency and market competition, instead of imposing stupid ratios. That’s the lesson for SOX.”
Last but not least, Dr Nguyen hopes his research will stimulate other studies of social networks which – thanks to Facebook and LinkedIn – have been transformed from a backwater of sociology research into a ubiquitous social currency.
I’d like to encourage others to investigate the impact of social networks in other areas. My paper doesn’t have all the answers, and other researchers may find positive impacts of social networks. We need more studies.”
For himself, thankfully using data collected and collated by Boardex, Dr Nguyen is currently investigating the impact of social networks on the US boardroom. The results will be intriguing, so watch this space!