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THE AMERICAN UNIVERSITY KOGOD SCHOOL OF BUSINESS | SPRING 2012

BONDS OF PARTNERSHIP

Do We Prepare Partners

Adequately For Challenges?

CRASH LANDING

Congress Attempts to

Deate Golden Parachutes

WOMENS WORTH

Why a Token Female Board

Member Cannot Add Value

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FROMTHE DEAN

LETTER BY

MICHAEL J. GINZBERG

DEAN, KOGOD SCHOOL

OF BUSINESS

Nowhere is this more true than in the case o

amily frms. By exploring this nuance, Proessor

Ronald Anderson zeroes in on the unique orces

at play in amily frms that impact corporate gover-

nance decisions. His groundbreaking research has

opened up entirely new avenues o thought on what

amily ties do to, and or, businesses. His collabora-

tions with Associate Proessors Parthiban David and

Augustine Duru have revealed that the closely held

frms with the most market value are also the mosttransparent; he has also uncovered that G reat-Aunt

Tilly just might be trading a little too early on that

undisclosed quarterly earnings report.

Barry Dewberr y, MS 82, provides a captivating

frst-person perspective on the tough choices amily

members who double as managers must make when

planning or the uture o the frm.

CEO compensation decisions create an intriguing

quandary or the boards o amily and publicly held

frms alike. Assistant Proessor Yijiang Zhao joins

his colleagues David and Duru to consider why a

handsomely rewarded chie executive, hired to steer

a company into new seas o opportunity, may be

taking major risks that yield little return.

Ready to raid the external audit team or fnan-

cially savvy leadership? Take heed, warns As sistant

Proessor Yinqi Zhang: negative investor percep-

tion, along with regulationincluding the Sarbanes-

Oxley Actencourages greater distance between

ormer auditors, auditing frms extraneous business

services, and their clients.

Across the board, our aculty are pushing past

the accepted thinking in fnance, accounting, taxa-

tion, management, and more. Through their collabo-

rations with private- and public-sector businesses,

government agencies, and a bevy o nonproft orga-

nizations, new knowledge is being created to shape

the markets o today and tomorrow.

Creating sustainable value or shareholders, now

and in the uture, is a complicated endeavor and a

key concern o Kogod School o Business aculty.The carnage wrought by short-term thinking peppers

daily headlines and flls congressional committee

dockets. Market perceptions ormed around green-

ing core business unctions, like supply chain

management, are being reconsidered by Proessor

Bruce Hartman and Assistant Proessor Ayman

Omar. And DuPonts chie sustainability ofcer,

Linda Fisher, weighs in on how the global science

giant helps its clients consider sustainability as a

business priority.

Viliying corporations, and their leaders who

make too much and think too little, has become

a national pastimeone that will certainly remain

an undercurrent in the unolding presidential race.

Yet the long-term value that business gener-

ates cannot be distilled into a single number. For

our part, well keep digging deeper into the multi-

aceted concept o value creation, and examine

how a little perspective may help bridge the seem-

ingly insurmountable divide between K Street and

Main Street.

Few would argue that good corporate governance is not important to the long-term success o businesses and our entire fnancial system. There is, however,much less agreement on exactly what constitutes good governance.

IN THIS ISSUE

1 FROM THE DEAN

2 THE RISK-RETURN PARADOX

4 O PARTNER, WHERE ART THOU?

COVER STORY

8 Blood in Business13 Relative Leaders

KOGOD TAX CENTER

18 Golden Parachutes Get a Lit From Congress

22 RUSSIAS CORRUPT FREE MARKET

24 DUX FEMINA FACTIWomen and Board Leadership

32 KOGOD STANDOUT Adventures in Silicon Valley

34 THE FRAGILE NATURE OF SUPPLY CHAINS

39 SUSTAINABILITYS SPLINTER EFFECTS

40 FINDING FEDERAL SAVINGS IN THE STRATOSPHERE

PRACTITIONER PERSPECTIVE42 When Succession Planning Goes Beyond the Family

Barry Dewberry, Chairman, Dewberry, Inc.

44 The Business Case or SustainabilityLinda Fisher, Chie Sustainability Ofcer, DuPont

47 REGULATING INDEPENDENCE

48 WEB EXCLUSIVES Beyond the Page

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market discipline. In almost every case, the market

measures tempered the paradox.

In the presence o weak market mechanisms,

the risk-return relationship was negative, as the

paradox predicts. However, as the market mecha-

nisms gained inuence, the relationship between

risk and return became less negative. This relation-ship even became positive as the market mecha-

nisms, such as monitoring by dedicated institutional

owners, grew stronger.

The returns to risk taking are increasingly

positive as the frm aces stronger market orces,

Zhao said.

This was what they had hoped. And in the

context o manager incentives, its clear what led

to these results.

A vigilant board o directors, or example, oers

a powerul deense against brash business plans.

Board members hold many trump cards; they sign

o on executives compensation plans, and they also

approveor disapproveproposals. The presence

o more outsiders on a board, requent board meet-

ings, and the separation o duties on the board have

all proved to take the edge o excessive risk taking.

IT STOPS AT THE TOP

There was one notable exception to the markets

inuence, in the realm o CEO compensation.

As a corporate governance measure, compensa-

tion should help to ensure that managers take risks

only when they are sure to be ollowed by a return.

When motivated correctly, executives should swingor the ences with shareholders returns in mind,

rather than their own payos. But the researchers

point out that this does not hold true when the

compensation structure isnt working.

Certainly, CEO compensation has been heavily

scrutinized and hotly debated. But the risk-return

paradox has never beore been considered in terms

o the inuence o market mechanisms, compensa-

tion being one.

CEOs are compensated in a myriad o ways,

but oten the majority percentage o their salary is

dependent on perormance. A typical compensation

package includes a mix o total cash compensation

(salary, bonuses), long-term incentives (restricted

stock, stock options), benefts, and perks.

Two compensation methods that the proessors

ocused on were CEO ownership and stock options.

They ound that these two components behaved

quite dierently when analyzed.

Fundamentally, an owner ship stake exposes

CEOs to both the upside and downside o a risk.

Their regression showed that CEO ownership, like

the other market mechanisms they studied, helped

alleviate the risk-return paradox.

Not so with CEO stock options. Thats not too

surprising; i stock options are never exercised, the

CEO is not any worse or the wear (even though the

shareholders suer).Lets say that CEO Barney Johnson is given the

rights to buy 10,000 shares o Cheap N Quick

Restaurant Chain or $100 a share in January

2013. I the companys stock is trading at $120 a

share at that point in time, Barneys made a cool

$200,000without investing a personal cent. And

i the companys stock is only trading at $75 a

share at the time, well, he simply wont exercise

his options. At that point the options are called

out o the money.

The stock options shield the manager rom the

downside, so there is a tendency to take excessive

risks; that is what we are seeing, Duru said. All

were trying to point out is that stock options could

lead to distorted incentives.

NO MAGIC SOLUTION

The proessors research clearly indicates that

strong market mechanisms provide some relie or

the risk-return relationship. But the larger ques-

tion remains to be answered: Can the market truly

mitigate managers actions as they seek to climb

mythical beanstalks? Without the ability to isolate

the markets individual inuences, the remedy to

the problem could remain as elusive as Jack himsel.David, Duru, and Zhao expect to submit their

paper to journals this year.

THE RISK-RETURN PARADOX

Ever since young Jack traded his cow or some magic beans, society has boughtinto the concept that greater risk promises greater reward. The relationship istaken or granted as act; empirically, researchers have shown it is fction.

There is a negative relationship: frms that take

bigger risks get lower returns. This ies in the ace

o what we would expect to fnd, said Associate

Proessor Parthiban David, who holds the Collins

Chair in Strategic Management. His expertise is in

corporate governance.

The risk-return contradiction, known as

Bowmans paradox, has beuddled management

scholars or years. Its unavoidable that frms must

undertake riskeach time they enter a new market,

launch a new product, or look or creative ways to

cut costs. But they should do so only when rational

decision making is at work.

Heres the conict: managers, not shareholders,

are the ones making the decisions. And their biases

and behaviors can cause excessive risk taking in

two common ways, agree like-minded researchers.

In Framing, managers categorize perormance

as either a gain or a loss. When they see a clear

point or the Win column, risk taking seems like

a threat. But when a project is seen as a loss,

then risks are suddenly viewed in a new light: as

potential salvation. Simply classiying a project as

a loss prompts the manager to take an excessive

risk to get it back on track.

Overconfdence is easier to relate to. By overes-

timating their own competence or the frms uture

prospects (or by underestimating their competition),

prideul managers are led astray. They buoy their

own belie in the likelihood o a positive return.

Aligning risk and return is a riddle worth

solving, because there are deep consequences

or the company when a risk doesnt pay o.

Beyond the direct fnancial hit to the frm, risks

can lead a frm to grow its personnel or reallocate

its resources gratuitously. They can also negatively

aect consumers confdence in the frms products.

No one is arguing that risks should never be

taken. On the contrary, managers must be induced

to take risks, the authors write, but only those

that are likely to produce gains.

CHECKS AND BALANCES

For the frst time, the Kogod proessors looked at the

perplexing risk-return relationship in the context o

market mechanisms. They wanted to unearth whether

the markets role could help explain the paradox.

Is the market, let to its own devices, capable o

correcting managers mistakes? Market mechanisms

might be the reason that the risk-return relationship is

not working well, said Associate Proessor Augustine

Duru, who had previously studied CEO compensation

in the context o accounting.

In theory, these mechanisms should constrain

the managers rom taking excessive risks. For

example, the labor market could act as a constraint

to an overzealous CEO; i he takes unwise risks and

is fred, he may not be able to fnd another job.

David, Duru, and their colleague, Assistant

Proessor Yijiang Zhao, undertook the project.

Zhaos research background in corporate gover-

nance (in particular, takeover markets) and fnancial

reporting primed him or the eort.

The researchers studied how two broad types

o mechanismscorporate governance measures

and product market competitionwould aect

the risk-return relationship. With a sample o more

than 2,100 frms rom the S&P 1500, the authors

studied perormance over a 12-year period and

tested the interaction between the relationship and

each o these market mechanisms:

Institutional ownership

Blockholder ownership (concentrated owners)

External corporate governance (measured

through frms antitakeover provisions)

Board o directors monitoring

CEO ownership

CEO stock options

Product market competition

Using regression analysis, the proessors simu-

lated the eect o each mechanism on the risk-

return relationship. They controlled or other actors

that might aect perormance, such as frm size,

leverage, and diversifcation, as well as the possi-

bility that risk taking can arise rom withinsay,

in frms operating in high-perormance industries

(like the high-tech sector).

They ound that Bowmans paradox is direr

or companies that are not subject to efcient

ARTICLE BY

JACKIE SAUTER

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O PARTNER,WHERE ART THOU?

Contrary to the romantic notion o a passionate dreamer going it alone, moststart-ups are ounded by partners, not solo entrepreneurs. Think o some othe high-tech companies that have risen to ame and stunning capitalization inalmost no time: Google, Facebook, LivingSocial. All started by partners.

DAVID GAGE, PHD,

IS A CLINICAL

PSYCHOLOGIST AND

MEDIATOR, CO-

FOUNDER OF BMC

ASSOCIATES, AND

ADJUNCT PROFESSOR

AT THE KOGOD SCHOOL

OF BUSINESS. HIS

BOOK ON EFFECTIVE

PARTNERSHIPS,

THE PARTNERSHIP

CHARTER: HOW TO

START OUT RIGHT WITH

YOUR NEW BUSINESS

PARTNERSHIP (OR FIX

THE ONE YOURE IN),

WAS PUBLISHED

IN 2004.

The trend isnt limited to cutting-edge tech frms.

Partners also ounded some o the best-known

companies o the 20th century: Black & Decker,

Warner Bros., Hewlett-Packard. And then there are

3M, Costco, Microsot, Intel, and Apple. Partners,

too, ounded them.

PARTNER ADVANTAGES

Partnerswhether they are amily members or

notare extremely important because their pres-

ence boosts the chance o success. It seems

like common sense; ater all, there is strength in

numbers. Generally speaking, partners mean greater

resources: more skills, energy, capital, psychological

support, networking capabilities.

Need urther proo? A study published last year

by the National Bureau o Economic Research tried

to determine whether having partners is really an

advantageous strategy or entrepreneurs trying tocommercialize inventions. The results were impres-

sive. Projects run by partners were fve times more

likely to reach commercialization, and their average

revenues were approximately 10 times greater than

projects run by solo entrepreneurs.

Research rom Marquette University backs that

up. The researchers investigated a sample o nearly

2,000 companies, categorizing the top perormers

as hypergrowth companies. Solo entrepreneurs

ounded only 6 percent o the hypergrowth compa-

nies. Partners ounded an amazing 94 percent.

One or all and all or one! Even Alexandre

Dumas knew there needed to be three Muske-

teersnot one.

UNDENIABLE RISKS

So why wouldnt all start-ups begin with co-owners

at the helm? Because there is also a dark side to

the partner story.

There are no hard numbers that spell out how

many companies die premature deaths as a result

o partner difculties. Private companies are not

obliged to undergo a postmortem, but estimates

oten run to more than 50 percent ailure within

a ew years.

We know that many business advisers regu-

larly warn entrepreneurs not to start businesses

with partners, oering horror stories rom past

clients. There are too many risks involved, and

its extremely difcult to extract yoursel rom par t-

ners, they warn.

The risks arenumerous. Many would-be business

owners are under the dangerous misconception that

completing certain legal documents ully prepares

them or partnership. I anything, these legalities

give partners a alse sense o security that they

have done all they need to do to protect themselves.

I we accept that partner problems are a leading

cause o start-up ailure, we have to ask: Why arent

we doing more to educate and train entrepreneursto maximize the benefts and minimize the risks o

co-ownership? Why arent organizations that und

entrepreneurial research helping start-ups prepare

better or the challenges o having partners? Why

arent VCs asking start-ups to do more to ensure

their survival?

As advisers to entrepreneurs and business

students, we are not guiding them out o harms way.

We are not teaching them sufciently about either

the risks o having partnerstur battles, person-

ality clashes, values conicts, money disputes,

distrustor how to minimize them.

The box ofce hit The Social Network helped

bring this issue to light in 2010, when moviegoers

turned out en masse to watch the story o Mark

Zuckerberg and his ill-ated Facebook co-ounder

Eduardo Saverin unold on the big screen. A high-

profle multimillion-dollar lawsuit between the two

was eventually settled out o court.

And Saverin wasnt the only one to haul the

Facebook co-ounder to court. How do we prepare

entrepreneurs or the Winklevoss twins o the

worldthose who publicly allege they hold partner

status, even though they may not?But helping uture Mark Zuckerbergs mitigate their

risks is not sufcient either. We need to also teach

them how to proactively create healthy partnerships.

PREPARATION FOR SUCCESS

Reviewing the curricula o our peer business schools

reveals that very ew oer courses or entrepre-

neurs who want to learn how to set up healthy

business-partner relationships. Courses on lead-

ership, managing teams, choosing among legal

entities, and identiying unding are valuable to

entrepreneurs, but miss the mark when it comes

to having partners.

Developing and maintaining good relationships

with partners is not the same as leading an execu-

tive team or managing a company o a thousand

employees. The intimate dynamics among part-

ners are quite dierent rom the dynamics o any

employer-employee relationship.

True co-owners tie their utures and ortunes

together in a unique way. Partners have a fduciary

duty, and a loyalty, to one another that employers do

not have to their employees, even i they give them

honorifc partner or associate titles.

Business schools arent the only ones behindthe partner curve. Incubation labs, economic devel-

opment centers, the Small Business Association,

venture unds, and even other private organizations

ocused on helping entrepreneurs seem to miss the

importanceand the challengeso having partners.

To address some o these defciencies, I devel-

oped and have taught a graduate course at Kogod

or the past 10 years on managing private and

amily businesses. It covers the range o partner

issues described above, delves into the value o

co-ownership, and gives students concrete strate-

gies to minimize the risks. In my view, more schools

need to experiment with courses to help students

understand partnerships.

ABSENCE OF ATTENTION

I we are going to improve our perormance in

teaching about partnership, it will be important

to create a sound base o research or the lessons

we convey. To date, there is very little scholarship

available on this subject.

One reason or this is the complexity o the feld.

How many times have you heard the amous line, Its

not personal, its just business rom The Goda-

ther? For partners, amily business owners, and even

mafosi, it couldnt be urther rom the truth. Almost

everything that occurs among partners in closely held

companies is both personal andbusiness. Co-owners

constantly describe their partner relationship as a

marriage, but hasten to add, Except I spend more

time with my business partner!

Recognizing the duality is advantageous.

Researchers need to develop a realistic conceptu-

alization o the challenges that partners ace, one

that ully appreciates the interpersonal-business

pairing o partnerships.

Anything less will be too simplistic to be helpul.

The ocus has to be on the individuals who do busi-

ness together, not on the business itsel.

Unortunately, researchers who want to study

partners oten eel slightly out o their element. Theyare typically experts in one disciplinepsychology

or businessbut not both. Researchers rom

dierent disciplines may need to collaborateas

partners!to study this topic eectively.

Another hurdle is the act that closely held

businesses are truly closely held. They are private,

which is an advantage or co-owners but a barrier

or researchers. Researchers will need to provide

partners with an incentive to share private inor-

mation. Without a reason to open up, partners will

likely remain something o a mystery.

MEDIATION AS AN ACADEMIC RESOURCE

As the ounder o a irm that specializes in

preventing and resolving co-owner disputes, I have

learned that mediation is not only a process that

partners usually agree on when they have serious

dierences. It is also a process that opens the door

to the private, inner workings o partners.

I discovered that the confdentiality o media-

tion helps partners open up and discuss things

THE INTIMATE DYNAMICS

AMONG PARTNERS AREQUITE DIFFERENT FROM THEDYNAMICS OF ANY EMPLOYER-EMPLOYEE RELATIONSHIP.

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they would otherwise never reveal to a stranger,

rom plans to sell the company to creative and

sometimes ill-conceived methods or taking moneyrom the business.

Behind this shield o confdentiality, partners in

mediation quickly realize that they only hurt them-

selves i they play their cards too close to the chest.

Mediators, like mysel, strive to convince the parties

that to be eective, we must know everything that

has transpired. We need to understand how their

partnership works.

Part o the conict resolution process involves

separate, individual caucus sessions in which

each partner has a chance to lay his or her story

completely on the table. They are oten quick to

seize this opportunity, because they believe that

i they dont disclose something, another partner

almost certainly willand no one wants to be seen

as withholding key inormation, or appear to have

something to hide. Partner mediations have thus

been ertile ground or learning about what makes

partners tickand stop ticking.

CASE IN POINT

Heres one example, rom more than two decades

o mediating business partnerships, that illustrates

one o the common challenges partners ace and

or which they are ill prepared: determining owner-

ship percentages.

These partners, who ran a company in an

emerging medical device industry, were not

neophytes by any stretch o the imagination.

Numbering fve in total, they included a successul

CEO rom a regional consulting frm, an attorney,

a seasoned marketer, a physician-investor, and an

established medical researcher.

As all partners must do, they had to determine

their respective percentages o ownership. From

the starting gate, each began jockeying or as large

an interest as possible. Like orty-niners staking

their gold rush claims, each o the fve ought or

his share o equity. Eventually they ollowed the

conventional advice o their advisers and flled in

the blanks o an operating agreement. The stormappeared to pass.

Exactly one year later, the consulting irm

CEO (now the CEO o the new company) and the

researcher claimed that they had all agreed to review

everyones perormance ater a years operation,

and then adjust their percentages accordingly.

The lawyer and the marketing director disagreed

vehemently, claiming that the idea o revising the

percentages had been raised but then dismissed.

The physician-investor, a riend o both the

marketing director and the CEO, demurred, saying

he was unable to remember the decision.

The resulting deadlock took a toll on their rela-

tionships, their motivation, and their productivity.

Worse, their employees were becoming aware o

the disagreement. With threats o lawsuits hanging

in the air, the partners agreed to try mediation.

The convoluted dynamics among the partners

quickly became apparent in individual discussions

with mediators. The mediation was an in-depth

study o the complexity o determining ownership

percentages, and it revealed how tightly the part-

ners egos were wrapped around these percentages.

Since they were united around the goal o growing

and selling the company in a ew years, they wereacutely aware o the value o every percentage point.

With the help o the mediators, the owners even-

tually resolved the equity battle. In brie, some o

the partners agreed to reduce their percentages to

ree up equity or certain key employees, and they

shited certain management responsibilities to resolve

underperormance issues. The details can be ound in

my book on having partners, The Partnership Charter:

How to Start Out Right With Your New Business

Partnership (or Fix the One Youre In).

Four things are important about this case study.

First, mediation provided an opening to better

understand how partners operate. Second, the

plot line is very common: some variation o this

true story occurs in most partnerships.

Third, despite it being a common problem,

there is almost nothing written to help entrepre-

neurs with a more rational process or determining

equity percentages. And fnally, this story describes

but one o the many challenges partners may ace.

THE BOOKAND BEYOND

The lessons I learned rom scores o mediation

clients became the blueprint or The PartnershipCharter. The book talks on the interpersonal side

about personalities, values, expectations, and air-

ness. On the business side are roles and responsi-

bilities, decision making, governance, money, and

ownership. Partners also have to decide how they

will handle dierences.

A scenario-planning process orces partners to

prepare or the uncharted waters that lie in ront o

them. Some o the what-is they need to prepare

or are unique to having partners:

What happens i a partner hires a key

employee whom the other partner(s)

dislike(s)?

How will you decide how to respond to an

unsolicited buyout oer rom a competitor?

What i the partners decide to close the busi-

ness and the company has nothing but debt?

Though mediation has taught us a great deal,

we need to investigate the inner world o partners

with more typical research paradigms and tech-

niques. The research topics are many, but could

include the importance o fnancial transparency,

whether establishing a governing board mitigates

conict, and whether a partnership with a best

riend improves, or lessens, the chance o success.

Despite the gap in partnership know-how, we

have learned a signiicant amount about what

causes partners to all out with one another.

While there are numerous topics partners must

address, the most important step they can take is

to engage in a comprehensive planning process.

To get the ball rolling, my business partner

and I have also set up a website or The Busi-

ness Partner Institute, an organization that can

help people to share research ideas and explore

interdisciplinary collaboration.

By joining eortsas partners doI have no

doubt that we can dramatically improve the short-

and long-term success rate o start-ups.

PARTNER MEDIATIONS HAVEBEEN FERTILE GROUND FORLEARNING ABOUT WHAT

MAKES PARTNERS TICK ANDSTOP TICKING.

WHAT IF?

WHAT IF THE PARTNERSDECIDE TO CLOSE THEBUSINESS AND THECOMPANY HAS NOTHINGBUT DEBT?

HOW WILL YOU DECIDEHOW TO RESPONDTO AN UNSOLICITEDBUYOUT OFFER FROMA COMPETITOR?

WHAT HAPPENS IF APARTNER HIRES A KEYEMPLOYEE WHOM THEOTHER PARTNER(S)DISLIKE(S)?

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CLOSED

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ARTICLE BY JACKIE SAUTER

I "The Godather" truly provided the answer to any business question, there wouldbe a lot less angst about how to motivate employees. Its not a stretch to contend

that business was simpler under the Mobs thumb. Processes and procedureswere understood: amily came frst. The appearance o propriety was

paramount. No Sicilian could reuse a request on his daughterswedding day. And i gambling debts arent paying the bills,

its time to diversiy the business. Why not tryan emerging market?

JOHNDOE

JR.

JOHNDOEIII

RACHELROEJACOBDO

ESR.

RICHARD

ROESR.

JOHNDOEIV

REGINAROEJACOB DOEJR.

JACKIEDOE

RICHARDROEJR.

JANEDOE

JOHNDOESR.

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But imagine how turbulent the markets would be i

a violation o respect resulted in literal bloodshed.

It would make 2008 look like a banner year.

The key was that in the gangster-ridden world o

Old New York, everyone in the organization had

aligned goals: preserve pride, proft, and a pulse.

The same cant be said or modern-day frms.

This indisputable act has given rise to the feld o

corporate governance, which endeavors to mitigate the

myriad conicts between managers and shareholders.

It all boils down to a matter o diverging interests.

Shareholders frst priority is to maximize their

own wealth: stock prices should go up, dividends

should be paid.

Shareholders are oten thousands o miles

away; they generally dont want to know about

the day-to-day operationsthere is a separa-

tion between management and ownership, said

Proessor Ronald Anderson, who has spent the last

decade researching corporate governance, particu-

larly in amily frms. Anderson holds the Gary D.

Cohn Proessorship in Finance.

On the other hand, no one is entirely sure whatcompany managers hold sacred. They should be

ocused on maximizing shareholder wealth, but they

have a natural tendency to protect themselves and

maximize their own utility, Anderson said, citing

examples like the implosion o Enron and scandal

at Tyco. Its a problem that has reared its head a

lot over the last 10 to 12 years.

ITS NOT PERSONAL

A companys ownership structure should be a super-

uous ingredient in its success, but Anderson and

his colleagues have proved that amily owners are o

a unique avor. Firms with controlling amily owners

(those who wield sufcient power to enorce deci-

sions) are singularly motivated. Though the amily

members may not be as hands-on as Vito Corleone,

their frms make distinctive investment choices, and

ourishor ounderin certain circumstances.

Spurred by the lack o research on amily frms,

Anderson and colleague David M. Reeb, now at the

National University o Singapore, began in the late

1990s to evaluate amily ownership and its connec-

tion to frm perormance. Their fndings changed the

way academics and practitioners view this previously

underrated demographic.

Further research at Kogod has investigated

amily frms transparency, proclivity or insider

trading, investment choices, and the impact o

amily-style debt. The surprising fndings serve

as indicators o how this inimitable slice o the

business world stands apart.

FAMILY FIRSTIn hindsight, amilies should have gotten acclaim

beyond the box ofce or their business skills. Ater

all, amily owners are highly incentivized to pay

attention: on average, amily owners have held their

shares or more than 78 years, and have 69 percent

o their personal wealth invested in the frm. They

have a vested interest in ensuring that the managers

running their companies are protecting their assets.

Anderson and Reeb proved that despite their

bumbling portrayal in the media (see: the Bluths o

HBOs Arrested Development), amily frms are more

valuable than diusely owned frms, which are held

by a large number o shareholders and investors.

Family businesses are also highly prevalent.

Thirty-fve percent o Fortune 500 companies and

60 percent o publicly held companies in the US

are amily-controlled, according to the advocacy

group Family Enterprise USA.

It turns out amily presence cannot be ignored.

Just as overbearing amilies tend to weigh in on deci-

sions or our own good, frms with actively engaged

amily owners generally outperormed frms without

an active amily member. Decades ater public frms

initial oerings, many amily members continue to

hold hands-on positions in day-to-day operations.

The fndings ignited a urry o attention rom

academic and mainstream media, including aBusinessweekcover story. For Anderson, the next

questions quickly took shape: Why are these frms

more valuableand under what circumstances?

NOW YOU SEE ME

In their recent article in the Journal o Financial

Economics, the pair invited Associate Proessor

Augustine Duru to study the eects o corporate

transparency on amily frms. Thanks to his prior

research on the use o accounting inormation in

CEO compensation, Duru had expertise in measuring

transparency through an accounting lens.

Like many others, Duru had initially assumed

that amily irms would be less valuable than

diusely owned frms. But my colleagues empirical

work showed that, certainly, amily frms were more

valuable. It seemed counterintuitive, Duru said.Past research has demonstrated that corporate

transparency is crucial in order to protect share-

holders and mitigate conict between large and

small investors. But no one had studied transpar-

ency specifcally within the context o amily frms .

When they decided to bring in the accounting

perspective, Duru noted, the question became: I

we believe that accounting inormation is important

to frm perormance, what would happen i there

was a lack o inormation?

While all publicly traded frms must comply

with mandatory accounting disclosures, the authors

acknowledge that there is still substantial variation

in what frms choose to revealas well as in the

amount o outside scrutiny they receive. Firms can

also elect to engage in voluntary disclosures.

Transparency is clearly a choice; there are

public companies that are not as transparent as

they could be, Anderson said. But some o it

is market-driven, and some o it is shareholder-

driven as well.

To test their theories, the researchers built an

index that ranked the opacity o the largest 2,000

US frms. Family involvement was defned as frms

in which the ounders or heirs maintain inuence,

usually through an equity stake. About 22 percent

o the frms in the sample were ounder-controlled,

and another 25 percent heir-controlled.

Opacity was categorized using our actors

that indicated the levels o both internal and

external opacity:

Trading volume and bid-ask spread,

which lend insight into the amount o

inormation uncertainty

Analyst ollowing and analyst orecast

errors, which help explain the availability

o frms inormation

The researchers determined that both types o

amily frms are signifcantly more opaque (by about

fve percent) than diuse shareholder frms. Their

shares trade less than those in diuse shareholder

frms and exhibit signifcantly less analyst ollowing,

they wrote.

Analysts are important because they play a

monitoring role. Large, publicly traded multina-

tional frms are subjected to scrutiny; multiple

monitoring keeps controlling amilies on their best

behavior, just as the looming threat o the Five

Families did in the Godathers world.

How does opacity impact other shareholders

wealth, beyond the amily? Since amily frms are

more valuableand tend to be more opaquethen

was opacity more valuable?

The opposite was true.

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THERE APPEARS TO BE A LOT MOREINFORMED TRADING GOING ON INFAMILY FIRMS; GIVEN THE MAGNITUDEOF IT, SOME OF IT IS LIKELY ILLEGAL.

RONALD ANDERSON, PROFESSOR

JUST AS OVERBEARINGFAMILIES TEND TO WEIGH INON DECISIONS FOR OUR OWNGOOD, FIRMS WITH ACTIVELYENGAGED FAMILY OWNERSGENERALLY OUTPERFORMEDFIRMS WITHOUT AN ACTIVEFAMILY MEMBER.

WMT1.95M@62

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0.50...DELL6.21M@17.93 0.31...CCL3.09M@30.58 0.16...CPB455

K@31.73 0.35...COLM135K@49.30 0.04

COVER STORY BLOOD IN BUSINESS

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Where a positive relationship existed between

amily ownership and perormance, it was limited

to frms with a high level o corporate transparency.

When the corporate inormation environment was

opaque, however, amily frms ceased to be as valu-

able as frms without amily owners.

When its harder to see whats going on inside

the company, it is much harder or the market to

monitor the amily, and as a consequence maybe

the amily can misbehave, Anderson said. Opacity

reduces the ability o outsiders to police opportunism

by amily frms. Simply put, the top-perorming amily

frms are also the most transparent.

Think Walmart. The Walton amilys massive

multinational is currently ollowed by 36 analysts,

all o whom are listed on the Walmart website, along

with extensive stock inormation, historical pricing,

and governance documents. The worlds largest

retailer is also covered widely in the news media.

For Walmart, there is no escape rom scrutiny.

The researchers also looked at CEO types in

these transparent top perormers. In their sample

the original ounders held the top spot

37.7 percent o the time;

outsiders, like Campbell Soup Co.s

Denise Morrison, 34.2 percent; and

heirs, such as Nordstrom Inc.s

Blake Nordstrom, 28.1 percent.

Transparent amily frms led by an outsider

perormed best, ollowed by those led by ounders

and then heirs. Yet all three types o these trans-

parent amily frms still outperormed transparent,

diusely owned frms.

In the absence o a highly transparent environ-

ment, there was no evidence o a beneft attributableto amily ownership. In act, in more opaque amily

frms, there was a negative relationship: as opacity

increased, perormance ell. Opaque amily frms

perormed worse than any other type o frm. In those

muddy waters, amilies can exploit control to extract

private benefts at the expense o smaller investors.

Its clear that shareholdersand thus the

S&Pvalue ounder or heir involvement only when

those amily values include fnancial transparency.

TAKE THE CANNOLI

As it turns out, inormed trading may also be a

amily aair. And when there are short sales, theres

gonna be trouble.

Andersons latest project, with coauthors Reeb

and Wanli Zhao o Worcester Polytechnic Institute,

fnds that amily frms boast substantially higher

volume o abnormal short sales, where traders bet

on a companys poor perormance.

There appears to be a lot more inormed

trading going on in amily frms; given the magnitude

o it, some o it is likely illegal, Anderson explained.

Prior studies have ound that amily owners are

among the best inormed o shareholders. Anderson

postulates that this is attributable to a ew actors.

For instance, they are likely to know about skeletons

in the amily closet. Also, amily members who do

not serve in senior management at the frm can y

under regulators radar more easily, and potentially

avoid detection.

O course, outside investors could play a role

in these antics by gleaning inormation rom a

amily member and using it or personal beneft.

Or perhaps the short sales are a product o disgrun-

tled employees who perceive amily domination as

hurting the frm.

Take the case o Robert Chestman, a stock-

broker convicted on insider trading charges ollowing

the 1986 takeover o Waldbaum Inc., a New York-

based grocery chain now owned by the Great

Atlantic and Pacifc Tea Company. The Securities

and Exchange Commission (SEC) asserted that Mr.

Chestman had received nonpublic inormation rom

a member o the Waldbaum amily, which he used

to trade 11,000 shares o company stock.

But Chestman was by no means the only one

selling. In the days beore the companys announce-

ment, the trading volume in Waldbaum stock skyrock-

eted. In two days, trading climbed rom 2,300 shares

to more than 77,000 shares traded daily, according

to The New York Timesand the SEC.

Insider trading hardly capped in the 1980s.

In 2005, ormer senator Bill Frist, heir to the or-

proft hospital chain HCA, raised the SECs ire. The

commission conducted an 18-month investigation

into Frists sale o his blind trust o HCA shares,

but ultimately did not press charges. Frist ordered

the sale during a peak in the stocks trading; weeks

later, a less than stellar earnings report drove the

share price down by nine percent, according to

USA Today.

THE VALUE OF DISCRETION

Inormation leakage was at the center o Andersons

study. At the root o short sales is the spread o

nonpublic inormation. By identiying and homing

in on the times when short sales preceded negative

earnings surprises, the researchers made the issue

empirical. The question: Does amily presence aid

or impede inormed trading?

They analyzed short sales that occurred prior

to earnings surprises, merging the SECs short-

sales database with their own inormation on amily

ownership in the largest US frms. The resulting

sample was 1,571 strong, with amily frms making

up more than one-third o the sample.

Rather than ocusing on the motivation o the

sellers, the researchers simply sought to uncover

whether insider trading was more prevalent in

amily frms.

It was. Family frms experienced almost 17

times more abnormal short s elling preceding nega-

COVER STORY BLOOD IN BUSINESS

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Compiled by Nicole Federica and Jackie Sauter

Founder CEO

Michael Dell, Dell Inc.

NASDAQ: DELL

Mark Zuckerberg wasnt the frst

tech entrepreneur to start a

billion-dollar enterprise rom a dorm

room. Dell began his computer

business at the University o Texas in

1984. By 1992, the then-27-year-old had become the youngest CEO

o a Fortune 500 company.

Dell has since racked up accolades,

written a book on his success, and

served on the US Presidents

Council o Advisors on Science and

Technology. Though he stepped

down as CEO in 2004, he returned

to the position in 2007 at the

request o the board o directors.

The Texan has our teenage

children; perhaps a successor is in

their midst? In the meantime, Dell

Inc. announced plans to launch its

frst consumer tablet late this year.

Proessional Manager CEO

Denise Morrison,

Campbell Soup Company

NYSE: CPB

Denise Morrison, president and CEO o

Campbell Soup Company, hails rom a

amily o successul businesswomen.

Perhaps, then, its appropriate that

she took over leadership o the

amily-rooted company in August2011. Morrison is only the 12th CEO

in Campbells 140-year history, and its

frst emale leader; she joined the

company in 2003.

With 35 years experience in the

packaged goods industry, Morrison

started in the sales department o

Procter & Gamble, and previously

served at Pepsi-Cola, Nestl USA,

Nabisco Inc., and Krat Foods.

Campbells has projected net sales

growth between 0 and 2 percent

in 2012.

Heir CEO

Micky Arison, Carnival Cruises

NYSE: CCL

Micky Arison is the CEO o Carnival

Cruises CCL, the cruise operator

that owns brands such as AIDA,

Seabourn, Carnival, Ibero, and a

series o others. His ather, Ted,

ounded the business in 1972.Micky joined in 1974 and worked

his way up to the chairman role in

1990; he became known or

acquisitions, including the purchase

o Holland America Line in 1989

and P&O Princess Cruises in 2002.

The Israeli American also owns the

NBAs Miami Heat.

Hes no stranger to controversy;

early this year, the partial sinking o

cruise ship Costa Concordiain Italy

claimed at least 17 lives, with many

more injured or missing. The

company said it expected a $175

million hit against net income in

fscal 2012 as a result o the

disaster, according to Reuters.

ESTABLIS

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D1990

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tive earnings shocks than nonamily frms, the

authors wrote. These frms also had marginally ewer

abnormal short sales beore positive surprises

indicating that more sellers were hanging on to their

stock in anticipation o good news.

This was no coincidence. The presence o amily

members as managers or board members increased

the likelihood o short sales. The researchers

contrasted amily ownership with that o hedge

unds, private equity unds, and other large-block

shareholders, but did not fnd the same results.

There are regulatory implications. Despite

the researchers fndings, the SECs enorcement

actions o late have ocused on hedge unds, with

22 enorcements between 2006 and 2008 against

the unds, and zero fled against amily owners.

Further investigation reveals zero enorcements fled

against amily owners through early 2012.

Certainly, the SEC takes abuse o short sales

seriously. The commission has held numerous

public hearings, enacted new rules on naked

short sales, and required more transparency about

the short-selling process. The ocus on short sales is

warranted: the SEC says that short selling comprised

almost hal o US equities volume, based on data

provided by exchanges or June 2010.

Our analysis suggests that regulations to reduce

inormed trading, while potentially limiting such

activity in nonamily frms, appear substantially

less eective in amily frms, Anderson concluded.

DO ME THIS FAVOR

O course, in order or earnings surprises to occur,

frms have to play a role in the action. That could

mean an acquisition or investing in a new business

venture. And the latter oten requires frms, and

their managers, to borrow money.

Debt can be a tricky business, and all debt is

not equalnow that debt is no longer traded inMafa-style personal avors, that is.

No one knows this better than Associate Proessor

Parthiban David, whose expertise ocuses on the

impact o corporate governance on frm perormance.

David holds the Collins Chair in Strategic Management.

David, along with coauthor Jonathan OBrien

o Rensselaer Polytechnic Institute, examined how

the type o frm debt is related to growth. The pair

chose Japanese frms to make up the sample, due

to their predilection or growth.

On its ace, growth is a noble goalbut

there can be too much o a good thing. Excessive

growth can harm profts i managers dont share

the resulting wealth with investors, and instead

unnel it back into the frm.

Debt helps to keep managers in check: they

have to make interest payments, repay the balance

at the end o a contract, and ace the threat o

deault. Just as amily-owned frms are inherently

anchored in relationships, orms o debt can also

have a relational quality. And debt plays an impor-

tant, pseudo-parental role in corporate governance.

Exhibit A: Bank loans are built on relationships.

Business owners have a rapport with the bankers

who invest in the growth o their businesses. Loans

are not merely dollars and cents to the bank (or so

they would have us believe); rather, banks assess

the complete picture o the borrower and company.

They also consider the possibility o ancillary

business relationships that might orm down the

line; loans could be a oot in the door to a more

robust, potentially lucrative relationship. Oten

bank representatives will hold seats on the frms

board o directors, provide other business services

beyond lending, and have relationships with the

frms customers and suppliers.

Bank loans are long term, David said,

explaining that both sides build trust and may act

as partners. Banks have business relationships;

growth is important to them, because more growth

means more business.

In contrast, bonds are transactional, impersonal

orms o debt. Bonds allow lenders to keep their

borrowers at arms length. These securities are

diusely held, and lenders are ocused solely on

the returns they earn.

Consider the case o Columbia Sportswear Co.,

a amily-owned business that began selling hats

in 1938.

Ater the 1970 death o the amily patriarch,

the near-insolvent company struggled to stay aoat;

it had already taken a $150,000 loan rom the

Small Business Administration. Within two years

the company racked up a negative net worth o

$300,000, according to Funding Universe.

Yet the Boyle amily was able to draw more

credit rom its bank; bank ofcers even suggested

the amily consult an adviser, which was the frst

step on a path toward stability and then growth,

the owners told Family Businessmagazine. Theinusion o credit happened to pay o; Columbia

has come a long way since then, projecting revenues

o $1.7 billion in 2011.

SO WHATS THE RUB?

There is no question that relational debts are benef-

cial to frms that invest substantially in R&D. The

long-term relationship between lender and borrower

allows continuity o investment; the bank can step

in more easily i the frm were to deault.

Transactional debt was more eective in

preventing overinvestment in irm growth than

relational debt. While relational debt may lead to

more growth, the growth may hurt profts, David

and OBrien concluded.

This may be best understood with an example

one thats all too amiliar.

In 1980s Japan, stock and real estate markets

peaked, and real estate was all the rage. Many frms

that previously had never invested in real estate

were tempted to get in on the action.

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COVER STORY BLOOD IN BUSINESS

ON ITS FACE, GROWTHIS A NOBLE GOALBUT THERE CAN BETOO MUCH OF A GOODTHING. EXCESSIVEGROWTH CAN HARMPROFITS IF MANAGERSDONT SHARE THERESULTING WEALTHWITH INVESTORS...DEBT HELPS TO KEEPMANAGERS IN CHECK.

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COVER STORY BLOOD IN BUSINESS

As Northwesterns I. Serdar Dinc discovered,

frms that had relational debt were more likely than

those with transactional debt to make real estate

investments. When the bubble burst less than 10

years later, they were hurt badly. Parthiban Davids

work implies that the leniency o those relational

lenders led to that overinvestment, which ultimately

weakened the frms.

I debt is to be used eectively or corporate

governance, then managersand shareholders,

amily or otherwiseneed to understand the vast

dierences provided by these two diverging orms

o debt.

GO TO THE MATTRESSES

Debt was something that J. Willard Marriott

detested. When the ounder o Marriott Interna-

tional wanted to ocus on growing Hot Shoppes, the

amilys modest restaurant chain, his heir saw the

promise o hotels. Getting into bed with the hospi-

tality industry meant going into debt, something

the elder Marriott avoided at all costs.

Debt was something that [my ather] didnt

understand, and he hated ithe didnt want

anything to do with it, Bill Marriott once told The

Washington Post. Luckily or travelers, J. Willards

son went to the mattresses or the company, now

valued at around $10 billion.

In the frst six years ater Bill took over the presi-dency, the company quadrupled in size, surpassing

Howard Johnson and Hilton Hotels in both revenue

and profts. The younger Marriott acquired Big

Boy and Roy Rogers restaurant chains, and made

the company international with an acquisition in

Venezuela. He also invested heavily in research,

which inormed the decision in 1983 to target the

mid-priced hotel market with Courtyard by Marriott.

Still, J. Willards conservative business strategies

are consistent with Anderson, Duru, and Reebs

fndings rom a recent study o the ties that bind

amily ownership and investment decisions.

The authors examined dueling potential motiva-

tions behind investment decisions: an aversion to

risk was one possibility, or an extended invest-

ment horizon. With Durus help, the team ocused

on accounting disclosures required by regulators,

including R&D and capital expenditures.

What was the amilys biggest inuence?

The researchers discovered that amily frms

preerred to construct their uture in physical assets,

like new restaurants, as opposed to riskier ventures

such as expanding into a new industry segment.

We ound that amily irms invested less

in R&D; they are more risk averse, Duru said,

explaining that amily frms devote less capital to

long-term investments than do diusely owned

frms. Compared to their peers, amily frms also

receive ewer patents per dollar o R&D investment.

Rather, they seem to preer doubling down on

reinorcements that strengthen their core business.

Take Carnival Corporation, which has 101 ships

among its brands and 10 new ships on order, ocusing

on expansion into Europe, Australia, and Asia. The

Arison amily retains 35 percent o company stock

in the worlds largest cruise ship operator.

The reluctance to pony up or long-term invest-

ments may be counterintuitive. Tales o amily

business owners oten hinge on the notion o their

ar-reaching view o the uture and their fnancial

sacrifces, made to prop up the business. It is

possible that there is less spending on R&D in

amily frms simply because amily oversight makes

frms more efcient.

TIMES HAVE CHANGED

Efciency is something that Richard Lenny, the

frst outsider to serve as CEO o Hershey Foods

Company, understood. Lenny increased company

profts by closing six underperorming plants in the

US and Canada in 2007, cutting 3,000 workers,

and outsourcing the production o cocoa.

It was a ar cry rom the utopian community

that Milton Hershey envisioned or his employees

and their amilies. When the Great Depression hit

and sales plummeted 50 percent, Hershey did not

lay o a single worker, but instead used employees

to pursue growth opportunities. His ideals were

as popular as his companys sweets; more than

a century later, the towns identity is still tightlywrapped in silver oil with a tidy bow.

Milton Hersheys ocus on protecting employees

was not the norm or corporate America, but it is

representative o many Japanese frms, which oten

increase their investments in growth when demand

or their products alls.

Given a choice between cutting dividends or

workers, CEOs there generally say their employees

and suppliers are the most important stakeholders,

David said. Its almost a amily situation.

The reason behind frms diversifcationand

whether the motivation diered by the identity o

its ownerswas the ocus o Davids recent study.

In the same way that types o debt can be consid-

ered either relational or transactional, domestic and

oreign owners also display these characteristics.

Prior research on corporate diversifcation and

its implications or frm perormance had treated

all owners as i they had the same end goal: proft.

Not so, David and his colleagues ound, in a

paper published by the Academy o Management

in 2010. Diversifcation is also a means to other

ends, such as career advancement opportunities

or employees, higher compensation, and lower

employment risk.

Using data rom our sources, and excluding

small frms and those in highly regulated sectors,

their sample resulted in 1,180 unique frms.

It turns out that relational owners emphasize

growth, while transactional owners emphasize proft

or shareholders. The dierences are considerable:

on a share-per-share basis, transactional owners

are over three times more eective than relational

owners in pressuring managers to improve proft.

What we ound is that when there is more rela-

tional ownership, the frms are less likely to cut their

wages or lay o people, even when perormance

goes down, David said. But with transactional

ownership, they are more likely to do so.

For domestic owners, he believes, it all comes

down to stakeholder relationships. Firm growth

means new business, which keeps frm employees

and their suppliers working. But frms with oreign

ownership are more likely to diversiy the business

in order to collect more profts.

David was quick to point out that domestic

owners are not blindly making poor business deci-

sions. There is a sel-interest here also, he said.

It is not irrational altruism. There is an economic

incentive or domestic owners to support growth;

once again, more growth means more business.

The project helped to rerame a central question

about frm perormance, which previously had been

viewed only through the proft lens.

Like his colleagues work, the fndings rom

Davids team had signifcant implications or gover-

nance literature.

Taken together, the emphasis that Kogods

aculty have placed on researching the value o

amily frms has highlighted the frms critical valueto the US economy.

Beyond their proftability, amily businesses

also employ 63 percent o the US workorce. As

regulators look ahead to a November election in

which the key issue is jobs, they should pay a visit

to these frms or counsel on how policy will impact

expansion and job creation, said Ann Kinkade, CEO

o Family Enterprise USA, in Forbes.

Questions remain. Will the SEC step up its

ocus on short-sale trading in these valuable frms?

Can larger frms in the US gain access to relational

unding to uel frm growth, traditionally a more

popular investment choice or small businesses? How

can amily businesses be encouraged to add jobs?

As Clemenza argued to Michael Corleone, At

least give me the chance to recruit some new men.

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CREATINGTHE COVERSTORY

Academic papers that gave rise to the cover story

Ronald C. Anderson, Augustine Duru, and David M.

Reeb, Investment Policy in Family Controlled Firms,Journal o Banking and Finance(orthcoming).

Ronald C. Anderson, Augustine Duru, and David M.

Reeb, Founders, Heirs, and Corporate Opacity in theUS, Journal o Financial Economics(2009).

Ronald C. Anderson and David M. Reeb, Founding-

Family Ownership and Firm Perormance: Evidence

From the S&P 500, The Journal o Finance(2003).

Ronald C. Anderson, David M. Reeb, and Wanli Zhao,

Family Controlled Firms and Inormed Trading:

Evidence From Short Sales, The Journal o Finance

(orthcoming).

Parthiban David, Andrew Delios, Jonathan Paul

OBrien, and Toru Yoshikawa, Do Shareholders or

Stakeholders Appropriate the Rents From Corporate

Diversifcation? The Inuence o Ownership

Structure, Academy o Management(2010).

Parthiban David and Jonathan Paul OBrien, Firm

Growth and Type o Debt: The Paradox o Discretion,

Industrial and Corporate Change(2010).

WHAT WE FOUND IS THAT WHENTHERE IS MORE RELATIONAL OWNER-SHIP, THE FIRMS WERE LESS LIKELYTO CUT THEIR WAGES OR LAY OFFPEOPLE, EVEN WHEN PERFORMANCEGOES DOWN.

PARTHIBAN DAVID, ASSOCIATE PROFESSOR

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In two very visible situations, Congress used the

Internal Revenue Code to deal with this growing

concern. Both times, these provisions were contro-

versial; ater all, executive compensation has typi-

cally been considered a matter to be resolved by

corporate boards and executives.

As the debate over tax reorm rages on, it is

imperative to consider the eectiveness o this

approach. The question is, has using the ederal

tax law to deal with corporate governance issues

solved the problem Congress was trying to remedy?

We think not.

A BALLOONING PROBLEM

In the late 1970s, high-profle executive sever ance

packages, known as golden parachutes, began to

unold. The so-called parachutes triggered substan-

tial payments in the event o a corporate acquisition.

One o the frst corporations to adopt a para-

chute-type arrangement was Hammermill Paper.

According to a study on the origins o golden para-

chutes by Peer Fiss, Mark Kennedy, and Gerald

Davis, the provisions stated that, upon a change

o control, the executives employment by thecompany shall continue or at least three years,

at an annual rate o compensation equal to his total

compensation or 12 months preceding the change.

In other words, Hammermills senior executives were

guaranteed three ull years o salary in the event

o a company acquisition.

By the early 1980s, high ination rates and a

depressed stock market led to a wave o corporate

acquisitions. Economic conditions simply made it

more attractive or companies to grow through

acquisition rather than organically.

As the acquisition wave grew, the golden para-

chute trend continued to pick up steam. By 1981,

15 percent o the 250 largest US corporations

had such plans in place, according to Organization

Science. Congress became increasingly concerned

over some o these arrangements.

Members o Congress worried that, in some

situations, these arrangementsalthough board-

approvedwere hindering corporate acquisitions by

increasing the cost o acquisitions and dissuading

interested buyers. Other times, these payments

tended to encourage the executives involved to avor

a takeover that might not be in the best interests

o the companys shareholdersthe very group

they were hired to serve. In either event, Congress

was concerned that payments to shareholders were

being reduced.

PLAN DEPLOYED

Congress decided to deal with the problem by

discouraging transactions that would reduce

amounts that might otherwise be paid to company

shareholders, according to a report by the Joint

Committee on Taxation at the time.

How did congressional representatives set about

discouraging these arrangements?

By providing that excess parachute payments

would be nondeductible to the corporation and

imposing a 20 percent excise tax on the executive.

What qualiied as an excess parachute

payment? One that was

1. in the nature o compensation (including a

non-compete agreement);

2. paid to an ofcer, shareholder, or highly

compensated individual; and

3. deployed only with a change in control o a

corporationbut only to the extent that the

payment exceeded three times the average

amount o compensation the individual had

earned in the fve years preceding

the acquisition.

The eect? An almost immediate increasein

parachute arrangements, which until then were still

rareand the introduction o gross up clauses,

under which companies pay the 20 percent excise

tax on behal o the executives.

Executives who did not have parachute arrange-

ments argued that their pay should be consistent

with that o their peers. They sought to have para-

chute payments added to their compensation

arrangements, and many boards agreed.

In our countrys recent history, Congress has tried at times to solve problemson its own, spurred by corporate governance issues that (it elt) were notsufciently addressed by state laws. Nowhere is this more evident than inexecutive compensation.

ARTICLE BY

DAVID J. KAUTTER

& ANDREW R. ZANK

THE KOGOD TAX

CENTER IS A NON-

PARTISAN CENTER

THAT PROMOTES

INDEPENDENT

RESEARCH ON TAX

POLICY, PLANNING,

AND COMPLIANCE

ISSUES IMPACTING

SMALL BUSINESSES,

ENTREPRENEURS,

AND MIDDLE-INCOME

TAXPAYERS.

GOLDEN PARACHUTESGET A LIFT FROMCONGRESS

KOGOD TAX CENTER

Meanwhile, executives who already had golden

parachute arrangements ell into two categories:

First, those with payments that were less

than three times their base amount sought,

and oten received, an increase in the

amount o their payments to 2.99 timestheir base amount. They pointed out that at

that level, the payments would still be ully

deductible by the corporation (and no excise

tax would be imposed on the recipients).

Those who had parachute payment agree-

ments in excess o three times their base

amount sought, and oten received, tax

gross up payments. This means that ater

the gross up payment was received, included

in income, and the 20 percent excise tax

paid on the gross up amount, the executive

received the amount he would otherwise have

been let with had there been no excise tax

on the underlying payment (see Figure 1).

CRASH LANDING

Golden parachute agreements remain to this day a

common part o executive contracts, ensuring about

two to three years o salary and bonus, according

to a recent Wall Street Journalarticle. Despite

Congresss eort, golden parachutes are continu-

ally being deployed.

In 2011, at least our CEOs o target companies

were in line or a payout o more than $50 million,

including $100 million to ormer Nabor IndustriesCEO Eugene Isenberg; our more CEOs were in

line or payouts o more than $30 million; and

many more executives expected payouts in the tens

o millions.

It seems pretty clear that Congresss attempt

to implement a change in corporate governance to

reduce the trend 25 years ago has not discouraged

the practice. I anything, these arrangements are

more widespread todayand more generous in

their termsthan they were when the legislation

was enacted.

POLITICAL AIRS

I at frst Congress didnt succeed, it tried again

this time by limiting the deductibility o compensa-

tion paid to executives.

In the early 1990s, inormation on the lack o

correlation between executive compensation and

economic perormance became increasingly avail-

able, thanks to the introduction o United Share-

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Company Pfzer Inc.Executive Hank A. McKinnell Jr.

Term 2001-2006Payout $188,329,553

There are 21 CEOs who received walk-away

packages greater than $100 million, according to a

recent report rom corporate governance consulting

frm GMI. Collectively, the top dogs total earnings

exceeded almost $4 billion. Too many golden

parachutes and too many retirement packages areo a size that clearly seems only in the interest o

the departing executive, the report postulated.

Below are a sample o fve such payouts in a

variety o industry segments: health care, retail,

digital, oil & gas, and banking.

Company Target Corporation

Executive Robert J. UlrichTerm 1994-2008

Payout $164,162,612

Company eBay Inc.Executive Margaret C. Whitman

Term 1998-2008Payout $120,427,360

Company ExxonMobil Corp.

Executive Lee R. Raymond

Term 1993-2005

Payout $320,599,861

Company Merrill Lynch & Co. Inc.

Executive E. Stanley ONealTerm 2002-2007

Payout $161,500,000

WALK-AWAYPACKAGES

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EXAMPLE OFPARACHUTEPAYMENT WITHGROSS UP

EXCESSPARACHUTE

PAYMENT

holder Association Compensation Surveys and

increasingly active corporate shareholders.

As more data on executive compensation came

to light, public outrage began to sweep the country;

by 1992, CEO compensation had become a key

presidential campaign issue, as then-candidate Bill

Clinton debated incumbent George H. W. Bush orthe countrys attention.

As more citizens voiced concern over the contin-

uously rising compensation or top executives, and

politicians looked to take action, heated debates

began in Washington. Some critics argued that

certain executives were increasing their own salaries

without input rom shareholders, and without ties

to the companys economic perormance. The high

pay, they argued, was unearned.

Others believed that the large disparity in pay

between the executives and lower-level employees,

as well as a similar disparity between US execu-

tives and oreign executives, was inexcusable and

clear evidence o the need or ederal intervention.

CHANGING AIM

In 1993, Congress responded by enacting Section

162(m) o the Internal Revenue Code. Under this

provision, the corporate tax deduction or compensa-

tion paid to the CEO and the our other highest-paid

executives o a publicly held corporation was limited

to $1 million each.

An exception was made or perormance-based

compensation: to the extent that payments in excess

o $1 million in one year meet goals set by the BoardCompensation Committee, and are approved by a

majority o the shareholders in a separate vote, then

the compensation is ully deductible.

The House Ways and Means Committee stated

its belie very clearly that excessive compensation

would be reduced ollowing this action. With the

new restraints on deductions in place, Congress

believed it had taken an important step toward

pushing domestic corporations to adopt more

responsible, perormance-based executive compen-

sation systems.

Section 162(m) also attempted to introduce a

level o accountability that had been missing, by

providing opportunity or more shareholder input.

So what happened? A study o the eects o

Section 162(m) calculated that between 1992 and

1997, the median compensation or covered execu-

tives increased17 percent, and executive bonus

and long-term incentive plans (as well as grants o

restricted stock) nearly doubled.

The study, by Tod Perry and Marc Zenner, also

showed that many executives with compensation

below $1 million saw pay raises; 75 percent to 84

percent o executives earning $900,000 or below

got a salary bump ollowing the implementation o

Section 162(m). Perry and Zenner determined that

many others, with pay already above $1 million,

saw no change at all.

Quite simply, in response to Section 162(m),many corporations locked in fxed compensation

or executives right around the $1 million mark

and created perormance-based bonuses to urther

compensate executives beyond their fxed salaries.

Congress wasnt the only injured party. A 2006

study by the Joint Committee on Taxation ound

that Section 162(m) eliminated millions o dollars

in deductions, reducing profts and, in many cases,

adversely aecting company shareholders.

The study concluded that, by making peror-

mance-based pay an exception to the $1 million cap,

there was a resulting increase in executive compen-

sation, and the provision led to more executives

looking to manipulate earnings to demonstrate a

better earnings pattern and, in turn, earn higher pay.

Although the consequences o the $1 million

cap were ar rom the results Congress had antici-

pated, the legislation has increased executive

accountability to corporate shareholders.

BAG IT?

As these experiences illustrate, trying to implement

corporate governance policies through the Internal

Revenue Code has, at best, a mixed record.

Using the tax law to encourage (or discourage)behavior has worked eectively in some parts o the

economy. For example, enactment o the Research

and Development tax credit has been considered

successul in encouraging greater research.

On the other hand, corporate governance does

not appear to lend itsel to a ederal tax solution.

Yet despite the uneven results with respect to past

eorts, when Congress sees other corporate gover-

nance issues it believes are not being addressed

adequately, it is likely to continue taking matters

into its own hands.

An election year in which taxation is a para-

mount issue, and ormer CEOs are vying or the

countrys top spot, presents the opportunity to

make a choice to stop legislating through changes

to the tax code. It has only made the tax law more

complicated, interposed the IRS between executives

on the one hand and corporate boards and share-

holders on the other, and ailed to solve any o the

problems with which Congress was concerned.

$800,000AVERAGE COMPENSATIONPAID DURING PERIOD(BASE AMOUNT / 5)

$3,000,000PARACHUTE PAYMENT

$4,000,000TOTAL COMPENSATIONPAID DURING PERIOD

$3,000,000PARACHUTE PAYMENT

$120,000EXCISE TAX (20%)

$2,400,0003X BASE AMOUNT

EXCESS PARACHUTEPAYMENT

ASSUMEFederal Tax 35%State Tax 7%Fed Excise Tax 20%Total Tax Rate 62%

GROSS UP PAYMENT:

Excise Tax:20% x $600,000 $120,000

Gross Up Payment Calculation:$120,000 (1 - 62%) $316,000

TAX ON GROSS UP PAYMENT:Fed (35%) (110,600)State (7%) (22,120)Excise (20%) (63,200)Total (196,000)

$316,000 $196,000

$120,000(amount needed to pay excise tax)

KOGOD TAX CENTER

2007

$700,000$750,000

$800,000$850,000

$900,000

2009

0

$1M

$1.2M

FIG 1

$800K

$600K

$400K

$200K

2010 20112008

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O course, the days o overt KGB control

are long gone; in todays Russia, order

seemingly prevails over the repression

o an earlier era. And yet, more than 20

years ater the all o the Soviet Union,

intimidation and corruption against busi-

ness owners is rampant.

Media reports estimate that up to

70,000 cases o corporate raiding

reiderstvo in Russianoccur each

year. The sophisticated orm o white-

collar crime involves the seizure and

rapid resale o a company or its liquid

assets: private frms and businesses are

dismembered, and the parts sold to the

highest bidder.

Valeriy Filatov, a Russian-born US

citizen and BSBA 12, coauthored a

research article analyzing the phenom-enon with Claudio Carpano, a ormer

executive-in-residence. His research

discovered that the annual fnancial gains

made rom Russian raids were estimated

at a whopping $4 billion in 2010.

Raiding is mainly perormed by

bureaucrats and mid-size-business

ownersthose who didnt do it in time

or the frst divvying up o the pie during

the 1990s, Filatov asserted, reerring

to the privatization o state assets ater

the breakup o the Soviet Union.

In countries with well-established

institutions, such as the United States,

corporate raids (also known as hostile

takeovers) are usually carried out in

accordance with strict guidelines. They

are used to restore stability and competi-

tive advantage to edgling companies.

In Russia, the reverse is true: the

most successul businesses, or those

that have valuable assets in the orm

o fxed capital or real estate, are at the

greatest risk o raiding.

Certainly, capital accumulation ater

the all o the Soviet Union was uneven;

some benefted more than others. But

that's not why such great disparity

between the haves and have-nots exists.

Without clear rules o competi-

tion and a mechanism or transerring

property to more efcient owners, the

system never evolved. Instead, a process

o negative selection has emerged, where

the strongest and most proftable busi-

nesses are picked o, stiing growth and

damaging the larger economy.

In Vladimir Putin's Russia, where

the power hungry politician was recently

elected to a third presidential term, theclout o the bureaucratnot the wealth o

the ownerguaranteed ownership o an

asset. Its difcult to change duplicitous

legal and political systems in an environ-

ment that rewards those who exploit it,

said Filatov.

SYSTEMIC RISK

In 2009, Evgeniy Konovalov, the owner

o an agricultural company in southern

Russia, ound himsel in pretrial deten-

tion. Though the charges were abri-

catedit was eventually proved in court

that orged documents were used to

purchase his frmhe spent a year under

arrest. During this time he ought the

raid executed by his long-time business

associate and was eventually named the

rightul owner. His business was returned

to him in 2011.

Despite overwhelming evidence o

violations o Russian law by [Konovalovs

business associate], his accomplices,

and complicit government ofcials, none

o the parties have been punished,

Filatov wrote in his award-winning paper.

Similar stories abound.

It used to be gangsters who ran

rackets, and now its consultants and

lawyers wearing ties, who are civilized on

the surace but carry out the same black-

mail, Andrei Girev, the general director

o a Russian cell phone company, told

Bloomberg Businessweek.

One in six Russian businessmen has

been prosecuted or an alleged economic

crime over the past decade, according

to The Economistmost at the hands o

corrupt police, prosecutors, and courts.

The Russian legal system isextremely complex and ull o contra-

dictions, Filatov said. Almost everyone

in business is breaking the law on a daily

basis, so its easy to leverage the law in

support o illicit activities.

While Russian law no longer allows

or pretrial sentencing in economic cases,

as in Konovalovs casethis changed

in 2010the surprise element hinders

business owners ability to fght well-

organized, authority-backed raids.

Filatov believes that corporate raiding

is under-reported and unaddressed or a

slew o reasons: law enorcement doesnt

want to appear incompetent, the media

attempts to remain impartial, and the

government is disinterested or too corrupt

to seek reorm.

Another reason the Russian govern-

ment is not ocused on creating good

conditions or private businesses? The

ARTICLE BY

ANNA MIARS

RUSSIAS CORRUPTFREE MARKET

In Russia, corporate raiding is simply the latest incarnation o propertyredistribution. The tactics have modernized over time: the use o hiredmuscle in the days o racketeering has been replaced by exploitation o legalloopholes and loose regulations. But the participation o government ofcials,which makes the whole system possible, remains intact.

proit gap between state-run oil and

natural gas companies and other indus-

tries. High tax rates on oil and natural gasprovide a majority o the countrys budget

revenue, making the independent busi-

ness community a distant second priority.

HOW RAIDING WORKS

There is a Russian saying: a fsh starts

rotting rom the head, said Filatov. I

corruption wasnt sanctioned at the top,

then it wouldnt be accepted at lower

levels as well.

Financial compensation is a strong

incentive or participation, or at least

passive tolerance. Everyone rom police

ofcers to judges and governors stands

to beneft by collecting a perormance

bonus, accepting a bribe, or pocketing

a uture avor.

I think, increasingly, people who are

doing the dirty work have been co-opted by

government ofcials who are oten the end

beneactor o the scheme, said Filatov.

Each o the three types o raiding

requires an inside man, a government

ofcial who can provide the necessary

leverage to accomplish a raid.So-called black raids are what movies

are made o: violence, including coercion,

threats, and kidnapping. Gray raids call

or a mixture o legal and quasi-legal

means, such as calling legitimate share-

holder meetings using orged documents.

Finally, white raids are perormed to the

letter o the law, though they oten violate

its spirit, according to Filatov.

Capitalizing on regulation violations

is a common method associated with

white raiding. An anonymous report

submitted to the court system can indi-

cate complicity and result in the removal

o executives or fnancial damage such as

fnes or suspension o business activities,

causing internal instability and devaluing

the companys shares.

Although violent acts against busi-

nessmen, or black raids, have largely

subsided, administrative methods that

achieve the same ends are still prevalent.

Raiding is more damaging to busi-

nesses than racketeering because oits goal to acquire complete ownership,

rather than just capture a portion o

the proft, Filatov said.

Filatov identiied the our most

common approaches to raiding in Russia:

Letter o the Law. Raiders uncover

and expose regulatory inractions

in order to destabilize the company

and prime it or the taking.

By Force. Raiders use administra-

tive sanctions or abricate criminal

cases to acilitate takeovers.

Hit Em Where it Hurts. Bank-

ruptcy schemes are eective ways

to undermine a business.

Dispute Ownership. By manipu-

lating the stockholder registry,

raiders can call the very ownership

o the company into question.

In general, inormation-based busi-

nesses and service providers are at alesser risk o raiding than those in the

fnance, retail, dining, construction, and

agriculture industries. However, there are

risk actors that cut across all industries.

For example, the dispersal o stock-

holder ownership aects whether raiders

will be able to abuse rules at stockholder

meetings. The presence o fxed capital

investmentssuch as valuable land, or

actoriesalso establishes the potential

or raiders proft. Finally, a companys

level o debt plays a role: frms with a

high debt burden are more vulnerable to

bankruptcy tactics.

There are a lot o interested parties,

said Filatov. The raiders themselves;

those who know about the raid but look

the other way; and the individuals that

commissioned the raid.

COLLECTIVE RESPONSIBILITY

Although Russian governmental agen-

cies are supposed to unction in a waythat ensures checks and balances, in

reality, ofcials are reluctant to incrimi-

nate their colleagues.

People advance by helping one

another in small groups, Filatov said.

Its known as krugovaya poruka, which

translates to solidarity or collective

responsibility. This is particularly preva-

lent within industry sectors.

The arrangement o mutual assis-

tance, a cultural carryover rom Soviet

rule, provides raiders who already have a

motive with the means and opportunity.

The environment is ripe or corruption.

Government support is essential to a

companys survival. One Russian corpo-

rate lawyer concludes,