External controls help mitigate risks from overconfident CEOs: study

Photo courtesy of Roger Braunstein on Flickr

Photo courtesy of Roger Braunstein on Flickr

Rob Swystun, Pristine Advisers

Although you’ve no doubt heard that everyone loves confidence (it’s the basis of most sex appeal, after all), there is such a thing as overconfidence, which can be a turn off … er, a bad thing.

Even CEOs — who need to ooze confidence in order to effectively run a company — can get a little too overconfident. Overconfidence can lead to overestimating returns and underestimating risks, a new research paper says. Fortunately, CEOs who are overbrimming with confidence can be brought back down a peg or two with improved governance, including measures passed in the Sarbanes-Oxley Act (SOX).

That’s the subject of the paper Restraining overconfident CEOs through improved governance: Evidence from the Sarbanes-Oxley Act by Senior Lecturer at the UNSW Business School Mark Humphery-Jenner, along with fellow researchers Suman Banerjee, Associate Professor in the Department of Economics and Finance at the University of Wyoming, and Vikram Nanda, Professor of Finance at Rutgers University.

The researchers used the joint passage of the Sarbanes-Oxley Act, which mandated more board and auditor independence and more robust oversight, coupled with changes to the NYSE/NASDAQ listing rules, to analyze the impact of improved governance on moderating the behavior of overconfident CEOs.

While a little CEO overconfidence can be a benefit to shareholders, the researchers say, sometimes it can distort reality and cause a skewed view of risk-return profiles and therefore destroy shareholder value.

The team set out to see if there are ways to channel that drive and optimism while at the same time curbing the extremes of the risk-taking and over-investing that typically comes with an overconfident CEO.

Specifically, they wanted to see if appropriate restraints on CEO discretion and the introduction of diverse viewpoints on the board sufficiently moderated the actions of overconfident CEOs and benefited shareholders.

Defining Overconfidence

Using both options-based and press-based measures of overconfidence, the team came up with a formula for gauging whether a CEO was overconfident.

“The premise behind the option-based measures is that a CEO’s human capital and personal wealth is tied to his/her company,” the team wrote. “Since CEOs are relatively undiversified, they should rationally exercise deep-in-the-money options and cash-out the shares as and when they vest. Hence, holding deep in-the-money vested options represents a degree of overconfidence.”

In robustness tests, the researchers also examined other measures of overconfidence, including press-based measures of overconfidence.

The Findings

The research team found that prior to the passing of SOX, overconfident CEOs invested more heavily than their counterparts. After the passage of the act, though, overconfident CEOs were found to have moderated their capital spending; selling, general and administrative expenses; property, plant and equipment growth; and asset growth. This served to bring them in line with CEOs of comparable firms in their industries.

Other effects of the passing of SOX included:

  • Post-SOX, overconfident CEOs’ investment-sensitivity-to-cash-flow decreased.
  • Post-SOX, firms with overconfident CEOs exhibited a significant drop in corporate risk.
  • SOX is also associated in an increase in the market value, earnings, and takeover performance of overconfident CEOs’ firms.

With CEO overconfidence leading to excessive risk-taking and expenditures, this study provides at least some support for the benefit of having externally mandated governance practices in place to curb that overconfidence.

“These benefits go beyond limiting expropriation and perquisite consumption by powerful CEOs and are important in terms of moderating the excesses of highly overconfident CEOs,” the research team said.

In an area where confidence is coveted, it can easily become too much of a good thing. But with the right corporate governance measures — even if those measures are from an outside body — an overconfident CEO can be reigned in for everyone’s benefit.

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