Employment capital, board control, and the problem of misleading disclosures *.

Recent years have witnessed unprecedented levels of accounting irregularities and scandals, leading to a thorough re-examination of governance practices and the institutionalization of mandated governance and accounting standards such as those incorporated in the Sarbanes-Oxley Act. Left unanswered by all of the publicity and legislation is the question whether the phenomenon has been fully and properly understood. Although agency theory (Fama and Jensen, 1983; Jensen and Meckling, 1976) speaks to the issue of monitoring and control of executive discretion, do we know enough about how governance structures operate in different contexts to be confident that we can reduce the incidence of problems such as misleading disclosures?

We seek to contribute to our understanding of the dynamics of the disclosure process and effective governance design by examining the response of CEOs to threats to their employment capital and the relationship between the board and the CEO. To date, the majority of published research on misleading disclosures has appeared in the accounting literature and focuses rather narrowly on audit and litigation issues (e.g., St. Pierre and Anderson, 1984; Stice, 1991). More recently, work investigating misleading disclosures has started appearing in the management literature (e.g., Dunn, 2004; Latham and Jacobs, 2000; Reed et al., 2004). Like this emergent research, our work is grounded in management thought rather than accounting theory and practice. We draw primarily on agency theory (e.g., Fama, 1980; Jensen and Meckling, 1976) to focus on the tension between managerial motivations and the ability to control managerial decision making. In short, this research adopts more of a governance perspective than a broad behavioral approach. Although we apply prospect theory (e.g., Kahneman and Tversky, 1979)--a behavioral framework--we do so within the context of the agency relationship.

Understanding the framework presented here also necessitates a brief recapitulation of agency theory, particularly as it relates to the problem of misleading disclosures. In the modern corporation, the separation of ownership from management results in an efficient division of labor and differential risk-bearing in which shareholders, as risk-bearing specialists, can reduce their exposure by diversifying their portfolio of securities, while managers, who have skills in formulating and implementing strategy, seek to maximize returns within individual companies (Berle and Means, 1932). This separation of roles implies that the interests and motives of owners and managers can diverge, thereby giving rise to an agency problem (Fama and Jensen, 1983; Jensen and Meckling, 1976). Because they cannot diversify their employment capital (Fama, 1980), managers may have positive incentives to pursue strategies and make decisions that are suboptimal for shareholders (Eisenhardt, 1989; Lee and O'Neill, 2003).

The inability of managers to diversify employment capital leads to two critical considerations relevant to the disclosure process. First, any impairment of employment capital necessarily will be borne directly by the managers concerned. Thus, the value of their employment capital will fluctuate with reported results, and disappointing or below-target outcomes will decrease its value. Second, given this relationship between performance and employment capital value, board oversight of the disclosure process is crucial. Indeed, theorists generally advocate strengthening the role and power of the board of directors in order to mitigate the agency problem (e.g., Deutsch, 2005; Fama and Jensen, 1983; Walsh and Seward, 1990; Zahra et al., 2005). In the context of misleading disclosures, the board's proximity to management, and its ability to review strategy and performance on an ongoing basis, gives the board the greatest likelihood of discovering and correcting any misbehavior. (Shareholders, even large ones, are external to the disclosure process and may not be able to uncover problems.) However, the board's success in doing so often depends upon the balance of power between the board and the CEO. Hence, we focus here on managerial employment capital concerns and the board's ability to monitor and control the disclosure process.

The article begins by developing the theoretical framework for our investigation of these issues. We review the linkage between firm performance and the CEO's employment capital, and continue by examining both the power of the CEO relative to that of the board and the board characteristics likely to contribute to effective control. Thereafter, we present the methodology and results of the study, and conclude by discussing the implications of our findings and offering suggestions for future research.

THEORETICAL DEVELOPMENT AND HYPOTHESES

Firm Performance and Threats to Employment Capital

Because managers cannot diversify their employment capital, the value of that employment capital necessarily becomes intertwined with the performance or value of the firm (Fama, 1980). Fama used the term "employment capital" to incorporate not only the CEO's current earnings but also the potential future earnings that would reflect the CEO's tenure in office--and ultimately the record of performance the executive is able to sustain. Thus, executives will encounter a certain amount of pressure to perform because of its effect on their employment capital, and may perceive or react to that pressure in different ways under different circumstances.

Research has identified the existence of performance pressure among a wide variety of work environments and groups (see, for example, Barnes et al., 1983; Clancy and Krieg, 2001; Rossier, 2002). That research also shows that pressure increases stress (Barnes et al., 1983; Ho, 1997), and may affect intellectual performance and result in aberrant behavior such as over-forecasting of company performance (Sochocki, 2000), creative accounting (Shah, 1997), and fraud (Thompson, 1999).

A theoretical explanation for the relationship between performance pressure and deviant behavior can be found in prospect theory, which makes the case that an individual's risk propensity changes according to achieved performance relative to target performance (Kahneman and Tversky, 1979; March and Shapira, 1987). When individuals are near or above target performance they tend to be risk-averse, but when they are below target they tend to become risk-seeking. Managers who can consistently deliver required (target) performance can continue implementing their proven strategies, while managers who produce losses or below industry-average performance will be tempted to adopt riskier strategies in order to meet expectations. In short, desperation can be expected to increase as the targeted performance level moves ever higher relative to current performance (Reed et al., 2004).

In practice, this scenario is likely to play out in two different sets of contextual circumstances: situations in which the risk of firm failure is high, and situations in which the firm performs well and is expected to do even better. In the case of sustained poor performance, the likelihood of eventual firm failure directly imperils managerial employment capital (Gilson, 1989, 1990), and may lead to displacement of the incumbent management team even prior to a declaration of bankruptcy (Daily and Dalton, 1995). Consistent with prospect theory, the need to preserve employment capital as performance declines and the risk of failure increases may lead managers to various acts of desperation, including the dissemination of misleading financials designed to mask the extent of the firm's decline.

However, it is not only the managers of firms experiencing high levels of distress who are likely to perceive threats to their employment capital and to act accordingly. Based on observations of past high performance, expectations for future growth may simply project historical growth rates into the future (Lakonishok et al., 1994; La Porta, 1996), such that the performance target for high-growth firms continually increases to higher and higher levels. In this variation of the "no good deed goes unpunished" syndrome, managers are faced with a loss-oriented framing context (Kahneman and Tversky, 1979) in which a mere reproduction of current period performance, however good in absolute terms, automatically translates into less-than-expected future performance. Therefore, managers in this situation are likely to perceive a threat to their employment capital, and are likely to adopt a risk orientation favoring any strategies and other decisions necessary to produce increasingly higher results (Kahneman and Tversky, 1979; March and Shapira, 1987). The issuance of misleading disclosures would be one such action that would both boost reported performance and protect employment capital.

Hypothesis 1: The incidence of misleading disclosures will increase as either the risk of firm failure or firm performance increases.

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