What directors should know about keeping the top dog's cockiness in check
According to myriad commentators, the culprit responsible for an array of problems in today’s capital markets is “short-termism”—the idea that companies and boards are increasingly sacrificing long-term value creation in exchange for short-term profits, largely prodded by pressure from activist investors.
A variety of institutional practices such as quarterly reporting and earnings guidance, the story goes, serve mainly to exacerbate these pressures. Much ink has been spilled on strategies for how board members (possibly with an assist from government regulators) can resist these influences and focus on the long term.
But could the pendulum to swing too far the other way?
In a recent study, Eric Talley of Columbia Law School and Michal Barzuza of the University of Virginia School of Law School draw on the field of behavioral finance to find evidence that there may be a widespread and countervailing force to short-termism also at work: what they call “long-term bias.”
CEOs and other corporate leaders appear to be especially susceptible to overconfidence and excessive optimism, and those biases appear to be sharpest when it comes to their long-term projects, according to the findings. Managers’ sanguine faith in the success of these projects might, in turn, cause them to forego or deprioritize superior short-term investments.
How Optimism Bias is Amplified for Long-Term Investments:
Barzuza and Talley flag several cognitive phenomena that could cause managers to be overconfident. Most generally, each of us tends to suffer from some level of overconfidence in our own abilities and likelihood of success. But several studies show that corporate managers suffer from an especially pronounced “better than average effect” and are exceptionally optimistic about their projects’ chances of success. In some ways, this makes sense — we expect CEOs and other business leaders to act decisively, persuade, inspire investor confidence, and counterbalance others’ risk aversion.
For long-term projects moreover, there are additional factors that can amplify managerial overconfidence. For example, long-term projects are often volatile, with a much higher potential upside (and downside) compared to shorter-term projects. Just a little overconfidence on a manager’s part can telescope into a large distortive effect on the project’s perceived expected value. A lengthy time horizon also makes managers feel confident that a huge amount of progress can be made, giving them an illusion of control over the project’s underlying risk and chances of success.
Given their often-innovative nature, these projects generally lack objective feedback mechanisms, data, and reference class projects that would allow managers to benchmark success on the road to completion, causing them to rely even more heavily on their subjective views and perceived skills.
To illustrate these effects in action, Talley and Barzuza present several case studies, one of which highlights Dan Ustian, Navistar, and the use of a novel technology for engine design.
Ustian was the up-and-coming CEO of Navistar, an international manufacturer of trucks, busses, and diesel engines, who had quickly developed a reputation for his focus on innovation and long-term growth. When the EPA introduced a regulation in 2001 requiring the industry to meet a new, stricter standard for nitrogen dioxide pollutant by 2010, Ustian was not interested in simply defaulting to the industry-standard technology (Selective Catalytic Reduction, or “SCR”).
Instead, despite lacking engineering background himself, Ustian insisted that Navistar’s engineers develop a new, groundbreaking technology called Exhaust Gas Recirculation (“EGR”) that would give the company a sizeable competitive advantage if successful. The CEO was so confident in his plan, he refused to acknowledge technical problems raised by his engineers as the process continued, or to develop a backup plan in the event the EGR technology failed. There was no reference class of projects to which Ustian could compare the project’s progress, which only served to strengthen his resolve that EGR was achievable at scale.
Consequently, it was natural for him to attribute a 40% decline in Navistar’s share price in 2008 to short-termism, rather than the market’s awakening to warning signs that the project was headed for failure. And fail it did: After investing 10 years and $700 million in expenses (not to mention regulatory penalties), Ustian finally gave up on the failed EGR experiment in 2012 and was ousted from the company.
Ustian’s case illustrates the damage that an exuberant and overconfident manager with a long-term bias can cause.
At a recent roundtable hosted by the Millstein Center for Global Markets and Corporate Ownership at Columbia Law School and Gibson Dunn, Talley and Barzuza presented these findings to a group of academics, business leaders and lawyers. Members of the group pointed out that the risks of long-term bias are compounded in today’s environment, where shareholder primacy reigns supreme and directors are encouraged to prioritize long-term share price above all else.
If Ustian and the board would have taken a more stakeholder-centric view and considered the risk to employees and other affected parties, one commentator noted, perhaps Navistar would never have gone down the path of attempting to develop the EGR technology. While the potential upside for shareholders was sizeable, the potential downside for these other stakeholders was extreme.
The threat of long-term bias points to a few considerations. First, we might consider altering shareholder primacy as a guiding principle for directors. It also complicates the narrative around short-term pressures and how directors should respond to them.
While Talley and Barzuza’s findings concede that problems with short-termism are real and often significant, they also maintain that some of the most oft-criticized causes of “short-termism” (like shareholder activism and quarterly reporting) may in practice serve to counterbalance long-term bias in an imperfect sort of equilibrium. Both implications highlight the dangers of focusing too narrowly on the interests of a single constituency over a specific time horizon, which directors should keep in mind as they balance these competing considerations.