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

Hypothesis 1 proposed that as employment capital was put at risk in the presence of significant pressure to perform, executives would be more likely to issue misleading disclosures in order to meet performance expectations and thereby protect their current employment status and future prospects. Our results confirmed these expectations, at least with respect to high market returns, and are therefore consistent with the tenets of prospect theory (Kahneman and Tversky, 1979). Return on assets and bankruptcy risk were not statistically significant, although their signs were in the anticipated direction. This pattern, with significant results for market returns but not the other aspects of performance, suggests that the principal source of pressure, or at least the one to which managers are most sensitive, comes from the market. Investors use already realized, and therefore objectively verifiable, returns to set future performance targets that increase pressure on managers. Alternatively, or perhaps additionally, executives themselves may not view the internal return figures as sources of performance pressure--perhaps because they know better than to place too much emphasis upon such performance indices.

Hypotheses 2 and 3 examined the effects of CEO power, measured respectively in terms of tenure and equity ownership, on the incidence of misleading disclosures. CEO tenure did not emerge as a significant predictor of misleading disclosures. However, our findings suggest that the incidence of misleading disclosures is related to CEO ownership in the form of a U-shaped curve, a pattern similar to that disclosed by previous research investigating the effects of CEO equity (Finkelstein and Hambrick, 1989; McConnell and Servaes, 1990). This result also is broadly consistent with agency theory (Jensen and Meckling, 1976), although with an important contingency for power effects. There is indeed an incentive-alignment process in the present context, given that misleading disclosures decrease as ownership increases from low levels. But, the fact that the incidence of misleading disclosures increases again after ownership reaches a certain level implies that we must be sensitive to the entrenchment potential associated with ownership power. Indeed, the positive relationship between the contingent compensation control variable and misleading disclosures hints at the same problem: ownership translates to power, which can lead to abuse. Collectively, then, our findings suggest that the question of incentives must be approached carefully, and must be tailored to maximize incentive effects without also maximizing power.

Finally, Hypothesis 4 proposed that board control would decrease the likelihood of misleading disclosures otherwise occurring as a result of employment capital risk or CEO power. Board tenure was found to interact significantly with performance, specifically the firm's market return, but in a manner somewhat at variance with expectations. High-return restating firms indeed had lower levels of board tenure than their match counterparts, but at lower return levels board tenure actually was higher among restating companies than among non-restating firms. The implication here is that board tenure reduces the influence of performance pressure when performance is high but may accentuate pressure when performance is low.

To some extent, this may reflect appropriate board activity: boards should, as part of their oversight role, seek to stimulate improved performance and to hold executives accountable. The problem arises, however, in the present context when executives resort to unethical means to achieve the results desired, and when boards do not inquire too closely into how those results were achieved. Gilson (1989, 1990) documented that boards also are concerned about their reputations and employment capital, just as we describe here in relation to CEOs, and that directors of failing firms suffer significant and sustained losses to future employability. It may not be surprising, then, if, in firms with lower returns, boards push executives to deliver improved results, and if the executives sometimes rely on misleading disclosures to accomplish that result. Nevertheless, this result also is troubling from a governance perspective; ideally, boards always would both hold CEOs accountable for performance standards and also investigate the means by which that performance is attained.

Managerial Implications

In this section, we use a broad definition of "managerial" implications to provide direction for firms looking to strengthen their defenses against misbehavior. In short, we are concerned here with the problem of managing the managers.

To begin, our results clearly support the general need to strengthen boards and improve oversight (e.g., Deutsch, 2005; Zahra et al., 2005). In particular, our work shows the importance of board tenure as a means of increasing independence for this purpose. Long-serving boards have the opportunity to learn the business at a substantive level, which can help them identify questionable decisions and activities as well as gain authority within the organization (Fiske and Taylor, 1991; Golden and Zajac, 2001).

A second aspect of the board-CEO relationship is the role of the board in moderating performance pressure. This study shows that board tenure facilitated the process of reducing pressure in high-return firms that seemed to lead to misleading disclosures in firms without the same level of board authority. Our results also are cautionary, however: board tenure appeared to increase the likelihood of misleading disclosures among low-return firms. Less successful firms thus appear to need help in striking a balance between demanding performance and yet not, at the same time, inducing the kinds of desperation that lead to unethical or illegal actions. Obviously, this is a difficult balance to strike, and precisely how to achieve this must remain a matter for future research, to which we now turn.

Limitations and Future Research

As is true of any study, limitations in design and orientation limit the generalizability of the results obtained and leave room for additional work to extend understanding and answer remaining questions. Most obvious in this regard is our study's limited behavioral inquiry. The problem at issue here has a significant behavioral component, leaving many areas of inquiry open beyond the question of governance and control. Aspects of personality and motivation, along with many other similar constructs, could be investigated.

Somewhat related to this issue is the question of proper compensation design. Our study did not directly investigate the relationship between CEO pay and the issuance of misleading disclosures beyond including a gross measure of contingent compensation as a control variable. Finer grained measures might be important subjects of study. For example, as our results suggest, it would be important to understand the trade-offs inherent between incentive structures and power accumulation. Compensation patterns also might provide some insight into the problem of moderating performance pressure. Coupled with effective boards, the proper incentive design could address many remaining concerns surrounding this phenomenon.

In addition to compensation, the question of employment capital effects can and should be investigated further. Our results showed that executives of poorly performing firms did not respond by increasing the issuance of misleading disclosures, yet high levels of board tenure in those same firms appeared to contribute to such an increase. However, absent consideration of board control high performers were associated with a greater likelihood of misleading disclosures. Greater understanding of these relationships would be an important contribution.

Finally, we should note that the sample for this work was drawn from the latter part of the 1990s, which was characterized by a strong bull market. That single condition allowed us to examine the effects of a uniform set of market expectations on the drivers and moderators of misleading financial disclosures. While it provided us with the opportunity for a simpler analysis and, consequently, a cleaner interpretation of results, it clearly limited the generalizability of our work. Therefore, future research needs to extend this study by examining the antecedents of misleading financial disclosures in a broader context that includes both bull- and bear-market conditions and, thus, a full range of investor expectations and managerial motives.

* The authors wish to thank Barbara Chatburn and Janet Heter for their diligent efforts in data collection. A previous version of this research was presented at the 2003 Academy of Management Annual Meeting in Seattle, Washington.

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