Fraud and the Road to Abilene

Over the weekend, an (anonymized) interview was published in a Dutch national newspaper with the three “whistle blowers” who exposed the enormous fraud of Professor Diederik Stapel. Stapel had gained stardom status in the field of social psychology but, simply speaking, had been making up all his data all the time. There are two things that struck me:

First, in a previous post I wrote about the fraud, based on a flurry of newspaper articles and the interim report that a committee examining the fraud has put together, I wrote that it eventually was his clumsiness faking the data that got him caught. Although that general picture certainly remained – he wasn’t very good at faking data; I think I could have easily done a better job (although I have never even tried anything like that, honest!) – but it wasn’t as clumsy as the newspapers sometimes made it out to be.

Specifically, I wrote “eventually, he did not even bother anymore to really make up newly faked data. He used the same (fake) numbers for different experiments, gave those to his various PhD students to analyze, who then in disbelief slaving away in their adjacent cubicles discovered that their very different experiments led to exactly the same statistical values (a near impossibility). When they compared their databases, there was substantial overlap”. Now, it now seems the “substantial overlap” was merely a part of one column of data. Plus, there were various other things that got him caught.

I don’t beat myself too hard over the head with my keyboard about repeating this misrepresentation by the newspapers (although I have given myself a small slap on the wrist – after having received a verbal one from one of the whistlers) because my piece focused on the “why did he do it?” rather than the “how did he get caught”, but it does show that we have to give the three whistle blowers (quite) a bit more credit than I – and others – originally thought.

The second point that caught my attention is that, since the fraught was exposed, various people have come out admitting that they had “had suspicions all the time”. You could say “yeah right” but there do appear to be quite a few signs that various people indeed had been having their doubts for a longer time. For instance, I have read an interview with a former colleague of Stapel at Tilburg University credibly admitting to this, I have directly spoken to people who said there had been rumors for longer, and the article with the whistle blowers suggests even Stapel’s faculty dean might not have been entirely dumbfounded that it had all been too good to be true after all... All the people who admit to having doubts in private state that they did not feel comfortable raising the issue while everyone just seemed to applaud Stapel and his Science publications.

This reminded me of the Abilene Paradox, first described by Professor Jerry Harvey, from the George Washington University. He described a leisure trip which he and his wife and parents made in Texas in July, in his parents’ un-airconditioned old Buick to a town called Abilene. It was a trip they had all agreed to – or at least not disagreed with – but, as it later turned out, none of them had wanted to go on. “Here we were, four reasonably sensible people who, of our own volition, had just taken a 106-mile trip across a godforsaken desert in a furnace-like temperature through a cloud-like dust storm to eat unpalatable food at a hole-in-the-wall cafeteria in Abilene, when none of us had really wanted to go”

The Abilene Paradox describes the situation where everyone goes along with something, mistakenly assuming that others’ people’s silence implies that they agree. And the (erroneous) feeling to be the only one who disagrees makes a person shut up as well, all the way to Abilene.

People had suspicions about Stapel’s “too good to be true” research record and findings but did not dare to speak up while no-one else did.

It seems there are two things that eventually made the three whistle blowers speak up and expose Stapel: Friendship and alcohol.

They had struck up a friendship and one night, fuelled by alcohol, raised their suspicions to one another. And, crucially, decided to do something about it. Perhaps there are some lessons in this for the world of business. For example, Jim Westphal, who has done extensive, thorough research on boards of directors, showed that boards often suffer from the Abilene Paradox, for instance when confronted with their company’s new strategy. Yet, Jim and colleagues also showed that friendship ties within top management teams might not be such a bad thing. We are often suspicious of social ties between boards and top managers, fearful that it might cloud their judgment and make them reluctant to discipline a CEO. But it may be that such friendship ties – whether fuelled by alcohol or not – might also help to lower the barriers to resolving the Abilene Paradox. So perhaps we should make friendships and alcohol mandatory – religion permitting – both during board meetings and academic gatherings. It would undoubtedly help making them more tolerable as well.

What's wrong with senior executive pay – lots in my view

There are three things I do not like about top management pay: 1) they usually get paid too much, 2) way too large a part is flexible, performance-related pay, 3) often, a very sizeable chunk of it is paid through stock options.

I used to think - naively - that high top management pay was high simply due to supply and demand: these smart people with lots of business acumen and experience are hard to come by; therefore you have to pay them lots. These grumpy anti-corporates claiming their pay is too high are just envious and naive. Turns out I was (maybe not envious, but certainly naive).

Pay level
Because digging into the rigorous research on the topic - and there is quite a bit of it - I learned that there is really not much of a relationship between firm performance and top management pay. These guys (mostly guys) get paid a lot whether or not their company's performance is any good. Moreover, I learned what sort of factors push up top managers' remuneration - and it ain't supply and demand. It has much more to do with selecting the right company directors (to serve on your remumeration committee) and making sure you are well networked and socialized into the business elite.* Now I have to conclude: top management pay is generally too high, and quite a bit too high.

Flexible pay
Secondly: where does this absurd idea come from that 80+ percent of these guys' remuneration has to be performance related?! "To reward them for good performance and stimulate them to act in the best interest of the company and its shareholders" you might say? To which I would reply "oh, come on!?" If your CEO is the type of guy who needs 90 percent performance-related pay or otherwise he won't act in the best interest of the company, I would say the perfect time to get rid of him is yesterday. You and I do not need 90 percent performance related pay to do our best, do we? So why would it be allowed to hold for top managers? As Henry Mintzberg put it: "Real leaders don't take bonuses".

Moreover, one should only pay performance-related remuneration if you can actually measure the person's performance. And that is - especially for top managers - actually pretty darn hard to do. The strategic decisions one takes this year will often only be felt 5 or 10 years from now, if not longer. Moreover, the performance of the company - which we always take to proxy the CEO's performance - is influenced by a whole bunch of other things; many not under a CEO's control. Hence, short term financial performance figures are a terrible indicator of a top manager's performance in the job and long-term performance contracts all but impossible to specify. If you can't reliably measure performance, don't have performance-related pay, and certainly not 80+ percent of it. We know from ample research that humans start manipulating their performance when you tie their remuneration to some strange metric and, guess what, CEOs are pretty human (at least in that respect); they do too.

Options
Finally: stock options... Once again, I have to say "oh, come on...". We pretty much take for granted that we pay top managers by awarding them options, but don't quite realize any more why. When I ask this question to my students or the executives in my lecture room ("why do we actually pay them in options...?") usually a stunned silence follows after which someone mumbles "because they are cheap to hand out...?". I usually try to remain polite after such an answer but why would they be cheap; cheaper than cash, or shares for that matter? True, it does not cost you anything out of pocket if you give them an option to buy shares for say 100 one year from now, while your present share price is 90, but if the share price by that time is 150 it does cost you 50. Moreover, you could have sold that stock option to someone who would have happily paid you good money for it, so in terms of opportunity costs it is realy money too. No, stock options are not cheaper than cash, shares, or whatever.

We give them options to stimulate them to take more risk. "Risk?! We want them to take more risk?!" thou might think. Yes, that's what you are doing if you give them options. If the share price is 150 at the time the option expires, the CEO can buy the shares at 100 and thus make 50. However, if the share price is 90 the option is worthless, and the CEO does not make anything. However, the trick is that the CEO then does not care whether the share price is 90 or, say, 50 - in either case he does not make any money; worthless is worthless. As a consequence, when his options (i.e. the right to buy shares at 100) are about to expire and the company's share price is still 90, he has a great incentive to quickly take a massive amount of risk. Going to a roulette table would already be a rational to do.

Because if you placed the company's capital on red, and the ball hits red, share price may jump from 90 to 130, and suddenly your options are worth a lot of money (130-100 to be precise). However, if your bet fails, the ball hits black and you lose a ton of money, who cares; the share price may fall from 90 to 50, but your options were worthless anyway. Hence, options give a top manager the upside risk, as we say, but do not give them the downside risk. Therefore, we incentivize them to take risk. You might think "I seldom see herds of CEOs in a casino by the time options expire, so this grumpy Vermeulen guy must be exaggerating" but I'd reply we have seen quite a lot of casino-type strategy in various businesses lately (e.g. banks). More importantly, we know from research that CEOs do take excessive risk due to stock options (see for instance Sanders and Hambrick, 2007; Zhang e.a. 2008). I think it would be naive to think that we give CEOs 90 percent performance related pay and most of it in stock options, and then think that they will not start acting in the way the remuneration system stimulates them to do. Of course it influences their decisions, and if it didn't, there would be no reason left to make their pay flexible and based on options, now would there?

Therefore, I would say, out with the performance-related pay for top managers (a good bottle of wine at Christmas and, if you insist, a small cheque like the rest of us would do). And while we're at it, let's try to reduce the level as well.

Steve Jobs’ deification serves a very basic and fundamental human need

“I am not that surprised that an academic of entrepreneurship (are you kidding me?) would lead a story about one of the world's best innovators and CEO's about that he actually and in fact ! OMG had body odour as a teenager because of his diet, not to mention the rest of your embarrassing piece. Forbes would be best sticking with writers that are inspired by such great entrepreneurs as Steve Jobs, and not with writers such as this, who are unhappy they have not had the courage to 'live the life they love and not settle' and so sit in front of their computer with not much else to do but trying to bring others down. Shame on you Mr Vermeulen”.
This is just one of the comments I received on my earlier piece “Steve Jobs – the man was fallible” (also published on my Forbes blog). Of course, this was not unanticipated; having the audacity to suggest that, in fact, the great man did not possess the ability to walk on water was the closest thing to business blasphemy. And indeed a written stoning duly followed.

But why is suggesting that a human being like Steve Jobs was in fact fallible – who, in the same piece, I also called “a management phenomenon”, “fantastically able”, “a legend”, and “a great leader” – by some considered to be such an act of blasphemy? All I did was claim that he was “fallible”, “not omnipotent”, and “not always right”, which as far as I can see comes with the definition of being human?

And I guess that’s exactly it; in life and certainly in death Steve Jobs transcended the status of being human and reached the status of deity. A journalist of the Guardian compared the reaction (especially in the US) to the death of Steve Jobs with the reaction in England to the death of Princess Diana; a collective outpour of almost aggressive emotion by people who only ever saw the person they are grieving about briefly on television or at best in a distance. Suggesting Princess Diana was fallible was not a healthy idea immediately following her death (and still isn’t); nor was suggesting Steve Jobs was human.

We are inclined to deify successful people in the public eye, and in our time that certainly includes CEOs. In the past, in various cultures, it may have been ancient warriors, Olympians, or saints. They became mythical and transcended humanity, quite literally reaching God-like status.

Historians and geneticists argue that this inclination for deification is actually deeply embedded in the human psyche, and we have evolved to be prone to worship. There is increasing consensus that man came to dominate the earth – and for instance drive out Neanderthalers, who were in fact stronger, likely more intelligent, and had more sophisticated tools – because of our superior ability to organize into larger social systems. And a crucial role in this, fostering social cohesion, was religion, which centers on myths and deities. This inclination for worship very likely became embedded into our genetic system, and it is yearning to come out and be satisfied, and great people such as Jack Welch, Steve Jobs, and Lady Di serve to fulfill this need.

But that of course does not mean that they were infallible and could in fact walk on water. We just don’t want to hear it. Great CEOs realize that their near deification is a gross exaggeration, and sometimes even get annoyed by its suggestion – Amex’s Ken Chenault told me that he did not like it at all, and I have seen that same reaction in Southwest’s Herb Kelleher. Slightly less-great CEOs do start to believe their own status, and people like Enron’s Jeff Skilling or Ahold’s Cees van der Hoeven come to mind; not coincidentally they are often associated with spectacular business downfalls. I have never spoken to Steve Jobs, but I am guessing he might not have disagreed with the qualifications “not omnipotent”, “not always right” and, most of all, “human”.

Steve Jobs – the man was fallible

As a student, at Reed College, Steve Jobs came to believe that if he ate only fruits he would eliminate all mucus and not need to shower anymore. It didn’t work. He didn’t smell good. When he got a job at Atari, given his odor, he was swiftly moved into the night shift, where he would be less disruptive to the nostrils of his fellow colleagues.

The job at Atari exposed him to the earliest generation of video games. It also exposed him to the world business and what it meant build up and run a company. Some years later, with Steve Wozniak, he founded Apple in Silicon Valley (of course in a garage) and quite quickly, although just in his late twenties, grew to be a management phenomenon, featuring in the legendary business book by Tom Peters and Bob Waterman “In Search of Excellence”.

But, in fact, shortly after the book became a bestseller, by the mid 1980s, Apple was in trouble. Although their computers were far ahead of their time in terms of usability – mostly thanks to the Graphical User Interface (based on an idea he had cunningly copied from Xerox) – they were just bloody expensive. Too expensive for most people. For example, the so-called Lisa retailed for no less than $10,000 (and that is 1982 dollars!). John Sculley – CEO – recalled “We were so insular, that we could not manufacture a product to sell for under $3,000.” Steve Jobs was fantastically able to assemble and motivate a team op people that managed to invent a truly revolutionary product, but he also was unable to turn it into profit.

When Jobs was fired from Apple – in 1985 – CEO John Sculley took control. Sculley is often described as a bit of a failure, because “nothing revolutionary came out of Apple under his watch”, “he could have done so much more with the company” and especially for “being stupid enough to boot out a genius like Steve Jobs”. However, the years after Sculley took over were some of Apple’s most profitable. The man did something right, and that was focus on exploiting the competitive advantage that Apple had built up.

In management research, following terminology cornered by the legendary Stanford professor Jim March, we often say that firms have to balance exploration with exploitation. Exploration refers to developing new sources of competitive advantage and growth. Exploitation refers to making money out of them. Steve Jobs was “insanely great” at exploration, but not – at the time – at exploitation. Sculley was.

Now Steve Jobs is a legend. And rightly so; our world literally would have looked different without him. However, what Steve Jobs’ legendary status also tells me is that we – mere mortals – are inclined to overestimate the omnipotence of CEOs. We overdo it when we ascribe the failure of an entire company to just one man or woman (e.g. Enron’s Jeff Skilling) but also when we ascribe the entire success of a company to one individual.

Steve Jobs wasn’t omnipotent (John Sculley had qualities Jobs didn’t) and he wasn’t always right (eating only fruits does not eliminate the need for an occasional shower). His day-to-day influence on Apple over the last years must have been limited, given his rapidly and severely deteriorating health. If anything, he simply would not have been able to be around enough to control and take care of everything. Nevertheless, the company did well in spite of his absence. And of course that is his laudable achievement too; he managed to build a company that could do well without him. And perhaps that may prove to be his best business lesson after all: how a great leader eventually makes himself superfluous.

Don’t be mistaken, bankers kill (but they give life too)

"In terms of power and influence, you can forget the church, forget politics. There is no more powerful institution in society than business” the equally famous as illustrious CEO and founder of the BodyShop – the late Dame Anita Roddick – said. And of course she was right. The most comprehensive and dominant institution in today’s society is business.

Business is more influential than people often realize, simply because it creates – or destroys – wealth. And wealth impacts pretty much anything we care about. Whether you analyze crime rates in a particular country, malnutrition, happiness, or infant mortality; a huge influence is how wealthy the particular society is. And wealth is created by business.

As a consequence, for example, the 2008 banking crisis undoubtedly killed people. Infant mortality is closely related to wealth and consequently an economic crisis will among others lead to a surge in infant mortality, somewhere, in some country down the road. It also means that the strategic business choices made by CEOs such as Lehman’s Richard Fuld or RBS’s Fred Goodwin indirectly but significantly influence the survival chances of some baby boy or girl born on the outskirts of London, Cairo, or Detroit. And therefore, whether you like it or not, bankers kill.

But let’s not forget that they give life too. The inverse of “bankers kill” is true too. If banks make wise choices, given their pivotal role in our economies, they can trigger a huge boost to the prosperity of many industries. And the profits, employment, and general wealth created through this boost will really improve the health and survival chances of the baby cradled by her mother somewhere on the outskirts of London, Cairo, or Detroit.

Given the research we have on the link between economic prosperity and infant mortality it would not even be too onerous to come up with some estimate of the direct relationship between Royal Bank of Scotland’s balance sheet and the probability of a baby surviving. We could relatively easily calculate the link between profit and the number of lives saved. I could even imagine that the computer terminals that give live updates of a company’s fluctuating share price – which many corporations have dotted across their entrance halls and offices for everyone to see – would be reprogrammed to display the number of children’s lives saved. Traders walking over to their lunch break could have an immediate update of how many baby lives the deal they just closed saved – or destroyed.

A ridiculous thought? Why? Don’t you care (even) more about the life or death of a baby than your company’s fluctuating share price? I am guessing you do. And you know these bankers aren’t so different from (other) human beings. Your company’s performance also creates wealth, and wealth saves lives. Why then only monitor its financial performance? I tell you, the sandwich you’re having for lunch will taste a whole lot better, knowing that this morning you just saved some unknown baby’s life, somewhere on the outskirts of London, Cairo, or Detroit.

Boards and fraud – who gets the sack and who gets to stay?

We have seen lots of corporate scandals over the past decade, and in many of these cases the boards of directors were up for some heavy criticism. Whether it was Enron, Tyco, WorldCom, or one of the toppled investment banks, their boards took some flack, since of course they are ultimately responsible for the corporation’s actions.



But what happens to such directors? What happens to these people in the business elite when their company, for example, is caught being involved in financial fraud? Well, perhaps not surprisingly – and this may come as a relief – they often get the sack (as research by Professor Arthaud-Day from from Kansas State University and colleagues convincingly showed). Directors associated with financial misrepresentations are often dismissed from the board of their fraudulent company but, interestingly, subsequently they also regularly get the boot at another board. As you may know, outside directors often serve on the boards of multiple companies and a study by Professor Srinivasan from the Harvard Business School showed that they lose about 25 percent of these (rather lucrative) jobs if one of the companies in their portfolio is caught up in fraud.



Yet, this also implies that 75 percent of companies retain a particular board member, even though he or she is compromised having served on the board of another company while it was committing fraud. And that begs the question, what firms decide to retain such a tainted board member, and which ones decide give them the sack?



Professors Amanda Cowen and Jeremy Marcel from the University of Virginia decided to examine this. They managed to collect data on 277 directors who served on multiple boards concurrently, one of which was associated with financial fraud. Their statistical analysis showed that companies that were covered by more equity analysts and governance-rating agencies were more likely to dismiss compromised board members; up to twice as likely. These external observers apparently serve as a bit of watchdog. However, surprisingly, when a company had a relatively large number of public pension fund investors amongst its shareholders, they were less likely to dismiss a compromised board member. Cowen and Marcel speculated that this was because these pension fund shareholders do the monitoring themselves, so that they don’t care much about the company’s directors; tainted or not.



You also have to realize who does the firing; and that is the rest of the board. Cowen and Marcel’s research also showed that very prestigious, well-networked boards were less likely to fire their tainted fellow director. It is well known that boards of directors form a rather cliquish corporate elite. It is not easy to find your way into this world, but once your solidly in, not even a little financial fraud is going to convince your corporate buddies to throw you out.