Behavioral Corporate Finance Chapter 9 GROUP PROCESS Behavioral Corporate Finance by Hersh Shefrin

Traditional Approach to Group Process Group Process is critical to the effectiveness of corporate financial decisions. The major decision about corporate governance take place in board meetings. The major decisions made by managers take place in managerial meeting. Effective groups exploit potential synergies form bringing together people with different skills, perspectives, and values.

Cont.. Effective groups are said to experience process gains. In theory, the key to process gains is the constructive use of individual differences among group members.

Process Loss Despite the potential for process gain, many groups are unable to exploit potential synergies and instead experience process loss. The source of this loss is typically psychological, in that group psychology often leads people to make different decisions when they operate as part of a group than when they act as individual.

Three Features About Group Behavior Accuracy: Groups outperform individuals in intellectual tasks, but not judgmental tasks. Polarization: Groups become polarized in respect to risk tolerance. Unwarranted Acceptance: Group discussion leads members of a group to accept a decision readily. illusion of effectiveness

General Reasons for Group Errors Three main factors that underlie group inaccuracy and unwarranted acceptance. groupthink poor information sharing inadequate motivation

Group Think The derive for achieving group consensus overrides the realistic appraisal of alternative courses of action. The following conditions are especially conducive to the emergence of group think: The group dynamics feature amiability and esprit de corps. A powerful , opinionated leader leads the group. Group members operate under stress. Group members are strongly influenced by a desire for social conformity. There is no explicit decision making procedure.

Poor Information Sharing Group members fail to share enough information with other group members.

Inadequate Motivation Inadequate motivation leads to a free rider agency conflict known as social loafing. Social loafing: Group members reduce their contributions, instead relying on others to exert the requisite effort.

Enron's Board and Special Purpose Entities CFO Fastow and aide Michael Kopper used special purpose entities to enrich themselves at the expense of Enron’s shareholders. Enron’s board approved use of special purpose entities to obscure failure of its investments through off-balance sheet items. Board waived Enron’s code of ethics for CFO Fastow, allowing him to gain financially from leading the partnership.

Enron:Board Looked Good on Paper Were there not enough independent directors on Enron's board? Enron’s board complied with conventional corporate governance standards. The majority of its board was indeed made up of independent directors. Board had an independent nominating committee. Audit committee chaired by financial expert.

Groupthink at Enron Enron's directors asked few questions, readily accepted answers they received, and cast no dissenting votes. Established no mechanisms to monitor for conflicts of interest on the part of Enron’s CFO. Did not ask to see the partnership prospectus material that identified the conflict.

Contrasting Enron's ROE and Free Cash Flows

WorldCom CEO Bernard Ebbers borrowed $253 million to acquire land, yachts, and boatyards. Collateral was WorldCom stock. When the stock price fell and bank required more collateral, WorldCom's board approved a loan to Ebbers instead of asking him to sell some his personal assets.

PSINet Both WorldCom and PSINet grew quickly by using debt-financed acquisitions. Between 1997 and 2000, PSINet made 76 acquisitions. However, on May 1, 2001, PSINet began to default on its $400 billion debt, and its stock was delisted.

Poor Information Sharing at PSINet CEO Bill Schrader and CFO Pete Wills separately pursued acquisitions, from Lebanese Internet service providers to Chicago-based consultancies. At times without telling the board, or each other. Through it all, no one on the board, in the executive suite, or on Wall Street stopped to caution that PSINet’s addiction to debt threatened its existence.

Polarization And the Reluctance to Terminate Losing Projects Project termination illustrates polarization, the accentuation of attitude toward risk. Managers tend to become risk seeking when having to decide on whether or not to terminate losing projects. The derive for consensus associated with group think also accentuates the risk seeking tendencies of the individual group members when faced with a sure loss.

Debiasing Illustrative Example SRC’s processes are built around five components: Standards Planning Compensation Information sharing Employee stock

Standards Having clear goals and well defined roles and responsibilities. Standards refers to the use of financial statements in order to set realistic business goals which is called as ‘critical numbers’ by Stack.

Planning Business plan has to be a tool, not a club, as many people as possible have to be involved in putting it together. Planning becomes the vehicle through which forecasts are developed, goals are set, incentives are put in place, and commitments are made.

Compensation Motivation requires an effective compensation system featuring pay for performance. A good incentive system serves multiple functions. It provides an opportunity for education about the company’s financial condition. People are implicitly developing a forecast of their future compensation. Encourages special attention on areas of vulnerability. Brings organization together as one team. Induces people to identify critical problems quickly.

Incentives “What a bonus plan does is communicate goals in the most effective way possible—by putting a bounty on them… When you do that you’ll get people’s attention very fast. You’ll send them a strong message. You provide them with a focus.” Jack Stack, CEO

Information Sharing SRC calls their information sharing process “huddling” and it is the heart of their communication system. SRC’s huddle is a weekly meeting. Selected representatives from across the company meet to exchange forecasts. How the actual financial statements will turn out at the end of the current month. These forecasts feature accountability.

Stock Ownership By its nature, the compensation plan, and attendant communication focuses on performance for the current fiscal year. However, value creation is a multi-year proposition. Employee stock ownership serves to discourage the tendency to take decisions that improve short-term performance, but destroy value.

The End