Guts before glory may well be the mantra for some overconfident, risk-taking chief executives. The approach can bring with it innovation and drive, but it is an attitude that could also have negative consequences for their organizations.
In an international study – “Executive Overconfidence and Securities Class Actions” – UNSW Business School senior lecturer Mark Humphery-Jenner, along with Suman Banerjee, Vikram Nanda and Mandy Tham, analyzes how CEO overconfidence can have an impact on the likelihood of a securities class action (SCA) being taken against a company.
“[During the research], executive overconfidence was routinely remarked on as being an issue of concern in relation to financial misconduct and poor financial performance,” Humphery-Jenner says. “That appears to date back to corporate scandals such as Enron [in 2001] which were, at least in part, attributed to overconfidence in addition to fraud.”
Humphery-Jenner notes that more recently, in the global financial crisis of the late 2000s, there was also a degree of audacity about the types of assets in which companies invested, leading to poor corporate performance. “Certainly when companies are failing there’s increased risk of litigation – the real issue is that to get litigation going you would have to be able to show some form of misconduct that warrants litigation and you would want the companies to have enough financing so that if you sued you could actually get the money,” he says.
Clearly, however, the repercussions for companies and executives in the face of an SCA can be serious. As the paper states: “Firms that are sued often suffer in the product market and have worse access to capital. Given the large potential cost of SCAs, it follows that executives will tend to risk SCAs only if they believe the benefits to be large or believe that their actions are unlikely to be detected and punished.”
“Results of the research show that overconfident CEOs’ firms are about 25% more likely to be subject to a securities class action than are other firms.” –Mark Humphrey-Jenner
Opportunities to Pounce
Jenny Campbell, a partner at international law firm Allens, specializes in managing commercial disputes, with a particular focus on class actions and financial services litigation. She played a key role in the defense of the Aristocrat SCA – the first such action in Australia to proceed to trial – and has acted for other corporate clients.
While SCAs often grab media headlines, Campbell says her firm’s research suggests there has not been a class actions spike in Australia of late. “We’re talking about 40 having been filed across a 15-year period – six last year, six the year before, seven in 2010,” she says. “There hasn’t been the so-called explosion that people were anticipating back in the mid-2000s.”
Campbell believes corporate Australia has responded to the risks of being exposed to a class action, meaning most boards and executives are very careful to ensure compliance with continuous disclosure obligations.
She notes that during the Aristocrat case, which started in 2003 and ran until 2008, there was a focus around potential risks associated with SCAs, with the Australian Securities and Investments Commission stating it considered such class actions to be an important facet in the regulation of corporate behavior.
“From that point, boards all around the country really did start to stand up and pay attention,” Campbell says.
She advises clients to be alert that class actions can occur – “but not alarmed” – and know that there are people and law firms “looking for opportunities to pounce.”
“[Firms are] very conscious of the risk. They’re also conscious of the fact there are adverse consequences potentially in terms of their share price if a claim is launched – even if there’s no substance behind it.”
Misplaced Optimism
With SCAs arising when a company or its employee “makes a materially falsely positive statement (or erroneously omits negative information) and shareholders subsequently suffer loss or damage by reason of relying on this misstatement,” Humphery-Jenner and his team have explored some hypotheses empirically to enable data analysis.
They propose that overconfident executives are more likely to make such falsely positive statements because they tend to overestimate projects’ returns and underestimate projects’ risks.
They can also over-invest; have miscalibrated perceptions of the risks and returns associated with investments; and are more likely to omit negative information.
“These overconfident executives believed their company’s prospects would remain stronger than they actually are and would do so for a longer period of time,” Humphery-Jenner says.
Results of the research show that “overconfident CEOs’ firms are about 25% more likely to be subject to a SCA than are other firms,” and that such bravado among non-CEO executives further increases the likelihood of an SCA.
“I’d like to create a lot more awareness around the types of managerial attributes that can lead to value destruction and perhaps how companies can mitigate those through improved governance.” –Mark Humphrey-Jenner
Humphery-Jenner notes that more class actions occur in the U.S. than in Australia, and some industries appear more prone to potential danger. “IT and high-tech industries might be more prone to getting these overconfident CEOs,” he says. “There’s evidence that overconfident CEOs tend to invest in and take more risk, and that could be the thing you want as a high-tech company.”
Risk versus Return
Would it simply make sense for organizations to avoid the overconfident CEO – and, as a result, potential SCAs?
Not necessarily, according to Humphery-Jenner. “Having an overconfident CEO could be very beneficial in some contexts,” he says. “It’s not that they’re always harmful all the time – it’s just that they may not be suitable for all types of companies.”
For example, if your business requires risk-taking or innovation, it could be a good move to hire a confident, yet competent CEO who will engage in taking some risks.
The research team suggests ways to ameliorate the risks. “Improved governance is certainly important, and what constitutes this requires definition,” Humphery-Jenner says. “So increased independence of the board is generally beneficial, but one doesn’t want to take it to extremes. You don’t want a fully independent board.”
He advises companies to be wary of options-based compensation for executives, noting that some CEOs may be more likely to take additional risks if bonuses are on the agenda. “Excessive risk-taking needs to be balanced with the incentive alignment to determine the best way to compensate these individuals,” Humphery-Jenner says.
Greater Oversight
The research also reveals that the Sarbanes-Oxley Act of 2002 (in the U.S.) and the changes to the NYSE/NASDAQ listing rules have reduced the impact of overconfident CEOs and the prospect of SCAs. This has led to greater oversight of executives, and forced CEOs to sign off financial reports and “to consider the alternative viewpoints when making decisions.”
Additionally, if an SCA does occur it can lead to culture change and see overconfident CEOs more likely to lose their jobs than other CEOs.
According to the research: “Overconfident CEOs also learn from prior SCAs, with an SCA attenuating the impact of CEO overconfidence on future litigation risk.” Overall, “this highlights the need for shareholders to be cautious when interpreting statements given by overconfident CEOs.”
The research team plan further research in this space, including the impact of executive overconfidence on capital raising and other corporate behaviors.
“I’d like to create a lot more awareness around the types of managerial attributes that can lead to value destruction and perhaps how companies can mitigate those through improved governance,” Humphery-Jenner says.
