Interlocking_Directorates_in_Corporate_Governance

Comparative Analysis of Corporate Governance The Role of interlocking directories in corporate governance Supervisor: Student: Dr. Maria Aluchna Andrea Tundo Academic Year 2009/2010 Introduction “They sit on the board of the largest companies in America, many sit on government committees. They make decisions that affect our lives. They rule” The quotation above, explains, somehow, the reasons why I chose this topic. Taking into consideration the historical changes of corporations in the last 20years, with the massive expansion of global companies, top management teams had to be read to face new challenges in order to maintain their competitive advantages towards rivals. Consequently, there have been several changes in corporate governance, with the substantial increase of interlocking directorates. Actually, interlocking directorates, like globalization, have always existed, especially between banks and firms, then they are a long-run historical evolution within board of directors and top management teams. These links boost particularly among SMEs. Hence, defining this phenomenon, we can say that this happen when we have two board of directors which share, at least, one director in common and it is illegal if the two companies are competitors. Coming back to the quotation, the choice of this topic is mainly driven by personal reasons, indeed being a passionate of political issues, the following theme, will demonstrate how interlocking directorates are an effective tool that influence political decisions. In fact, the majority of political decisions in the U.S. or in EU are made in order to facilitate the progress and growth of determined industries or companies, therefore to facilitate the elite groups. In fact, highlighting the last line of the quotation, it explains easily how political decisions affect our lives. Besides, I chose this topic reminding to myself, with regret, when artlessly I decided to leave my country in order to pursue a better life. Seeking opportunities in an emerging market of European Union, where I was sure to find a different environment compare to the Italian one. Unfortunately, in my country everything works thanks to networking and connections, the conflict of interests are ordinary and the current prime minister is the human evidence of how corrupt is the system. Sadly, after couple of years abroad, between Norway, Poland and UK, I figured out on my own experiences that the whole world is one big country, with the same strengths and weaknesses. In fact, interlocking directorates enable directors to be economic and social elites who share a sense of camaraderie and reciprocity.Therefore, it does not exist a full competitive system based on merit, but the advantages are created thanks to connections between important directors. 1. Theoretical Framework Taking into consideration the tripod of corporate governance, we can have a clearer picture about interlocking directorates. Company A Company B Figure 1: The potential connections between Company A and Company B. Therefore, we can have this situation in three main condition: 1)When a member of board of Company A sits also on the board of Company B (represented in Figure 1 by the red arrow); 2)When a member of the top management team of Company A is, as well, a part of the board of Company B (represented in Figure 1 by the green arrow); 3) When a close relative, like wife or father, of a member of the board of directors, of a top executive or even one of the owners of Company A serves as a member of the board of directors of Company B(represented in Figure 1 by all the arrows). This was a simple example between two corporations, the links among directors usually involve several firms. Interlocking directories have long been used by corporations to maintain and expand their power. Indeed, they were used in order to form a cartel, which is a form of collusion between firms in the same industry aimed at restricting output and increasing prices. This form is also used to gain bargaining power over major suppliers or customers. However, this tool has also positive features, it depends how it is used by organizations. In fact, interlocking directories enables the usage of different knowledge and skills, improving the creativity. In particular, new ideas can diffuse from one company to another fairly easily. Indeed, if a director at firm A sees that the company's new research unit is functioning quite well, he/she might suggest that a similar research unit be adopted at other companies on whose boards he/she sits. Vice versa, directors from those companies may transmit the idea to still other companies. Interlocking directories support the socialization process, improving the co-operation and the information sharing between companies and between firms and banks. In fact, historically the first interlocking between directors happened when a bank, after admitting a grant to a firm, was sending a reliable person to serves as member of the board of directors of the beneficiary company. Therefore, the bank was monitoring better all the activities of the recipient firm, in fact, as we will see later in the case studies, interlocking directorates are used as a trust substitute. Besides, these networks are easy to create and cheap to maintain, therefore they increase the social capital among companies. This is a positive aspect, in fact considering the definition of it, we may notice that an economic idea that refers to the connections between individuals and entities that can be economically valuable. Social networks that include people who trust and assist each other can be a powerful asset. These relationships between individuals and firms can lead to a state in which each will think of the other when something needs to be done. Along with economic capital, social capital is a valuable mechanism in economic growth. Using simple words, social capital is valuable because when there is high trust, there are low transaction costs. Moreover this phenomenon, if well deep rooted, can easily influence the political system, thus a monopoly can use it to help persuade other companies, even those in very different industries, to assist in lobbying efforts to prevent antitrust laws from being enforced with regard to the monopoly or to allow it to extend its monopoly to new product lines. In the U.S. those who sit on two or more corporate boards are more likely to be in policy-discussion groups and to receive appointments or becoming part of government advisory committees. Indeed, an evidence came from Frank Carlucci, a former Secretary of Defense and chairman of the Carlyle Group, that served on twenty boards at one time! Thus, becoming a director, and then an interlocking director, can help move a person to the heart of the power structure. Anyway, from a corporate governance perspective, interlocking directorates are particularly criticized. Although, interlocking directors may provide to the firms with new insight, thanks to their broad overview of the industry and competitive dynamics, at the same time they do not have so much knowledge on the company itself. In fact, critics say that such directors are not able properly to monitor the CEO/top management team activities, in fact the lack of effective monitoring, was one of the reason that led to Enron scandal, revealed worldwide during October 2001. Many theoretical orientations have been proposed to explain this phenomenon. Four foundations are known, explicitly the management control theorists, the environmental control and reciprocity theorists, the financial control theorists and the class hegemony theorists. According to the management control theory, this phenomenon is used as a tool for advice, criticism, prestige and also for business contact. The environmental control and reciprocity theorists analyze the event as a mean to facilitate cooperation to achieve mutual benefit, especially within an environment where scarce resources have to be shared between several organizations. More complicate is the perspective of financial control theorists, indeed they view interlocking directories as a instrument for financial institutions to have power over and influence investments. In fact, financial institutions that are interlocked with determined firms, help to stabilize their position within the business environment, with a strong and intensive supply of capital, harming companies with uncertain money resources. The last theory, class hegemony, describes interlocking directorates as a phenomenon based on social ties based of class and ethnic background. Highlighting that this occurrence is a way of promoting upper class cohesion, self-consciousness and consensus on social issues. Within this upper class cohesion, we find principally white men, followed by a small group of women, to conclude with a minority of African-Americans, Asian-American and Latin people. Anyway, the most important theoretical perspective for this topic is the understanding how networks are affiliated between them. There are two type networks: actors and events. To specify, in our case the boards of included companies correspond to events and the board of members are the actors. This dual perspective is very important, because in each case study, researchers use a matrix in order to show the connections and they use actors for the row index and events for columns index, therefore we can understand better how firms or directors are connected to each others. However in both networks, the degree of centrality play a strategic role. In fact, actors or events that are important, usually are located in strategic locations, where they have access to a wider variety of information. To conclude the theoretical part, I can say that the study of interlocking directors has been useful to me, in order to understand better how the corporate community and boards function. The analysis shows how directors do not, simply, sit at their home corporation, caring about their own business, but they react to the environment and to the historical changes, becoming stronger as elite group in order to lead the whole environment, then through meeting together on boards of directors, develop social cohesion and shared perspectives to go with their economic power bases. 2. The Analysis 3.1. Methodology used and research The methodology used to develop this paper, consists of literature review and research about the historical evolution and countries comparison, the use of online tools in order to comprehend how these links work, collecting data and news about companies involved and two cases studies that show a different use of interlocking directories. After analyzing deeply the theoretical perspective, I revised the definition given in the introduction, focusing mainly on the last part, when it says that the action of interlocking directories is illegal if the linked directors work in competitors firms. Then, thanks to online tool, like the website, theyrule.net, I made some research, in order to get a clearer picture of the situation. The online website, provides info about how American firms are interrelated to each others, showing the shortest paths that connect the companies through their directors. The results were unbelievable! I chose two huge competitors of the food/beverage industry: Coca Cola and Pepsi. It resulted that the connection path between two big competitors is relatively short. Indeed, Figure 2 below shows that: Figure 2: The relation between members of Board of Directors of Coca-Cola and PepsiCo Robert E. Allen and James D. Robinson III serve as members of the board of directors of Bristol-Myers Squibb. Obviously, in this case, there is not a pure interlocking directorates, but at the same time we may assume that during their meetings together on the board of directors of Bristol-Myers Squibb, they are able to develop social cohesion and shared perspectives about future companies strategies, in order to maintain their market predominance towards other competitors. Clearly, these are only my assumptions, probably it is political fiction, driven by my perceptions and ideas, but there is still a small chance that I am not mistaken. Anyway, this example clearly represents another theoretical concept, defined as betweeness centrality. This notion says that an actor/event may connect two nonadjacent actors/events serving as a link between them. Therefore, we can assume that these actors/events, in the middle, are in strategic positions that can increase their importance within the network. At the same time, specifically for actors, thanks to this strategic position, they can act as gatekeepers controlling the flow of information between other actors. Then, in this specific case, Coca-Cola and Pepsi are not connected through an actor, but through an event represented by Bristol-Myers Squibb. The website, provides, all the potential connections and it is an extraordinary tool for this topic. 3.2. Countries comparison and historical evolutions As I mentioned in the introduction, these networks create elite groups that with their decisions affect the current and the future of many people. How long this phenomenon exists' These links have been existed from long time and in different countries, from EU, certainly US and also in Asia, in fact we can find them massively in the Asian cultures. In the latter case, the importance of connections is highlighted in Japan with keiretsu, in China with guanzi and in South-Korea with chaebol. Three different names, but identical tool, the people belonging to a certain network, can receive facilitations and favors from members of the same system. In U.S.A., historically, the influence of interlocking directories was a privilege for a very narrow group of people and thanks to them the central bank was able to develop the seignorage. Moreover evidence from US shows that this phenomenon is quite diffused, in fact taking into account the 15 largest companies in the US, we can notice that four of these 15 share, at least, two board members with another of the 15 and that 11 of them have two board members that sit together on another company’s board. In Europe, interlocking directories were/are used in different ways. In Germany, already at the beginning of the twentieth century, there were connections between German big banks and industry. These relations, enabled, thanks to the strong supply of capital from banks, the monopolization of certain industries, in fact it was published a research in 1931 that shows the relationship between boards of major banks with the board of major industrials. Anyway, the centrality of banks in Germany has declined over the years, at the same time it has increased the links between industrial companies, becoming, somehow, strong and similar to the Japanese keiretsu. In France as in Italy, historically, the connections were mainly between politicians and executives. We can find a similar situation, in Greece, where the strong industrial families were governing the country. 3.3. Current picture Taking into consideration, the current picture of interlocking directories relations, we may find two different perspectives. According to the first, this phenomenon decrease, rapidly, post Enron scandal, instead the second point of view says the opposite. Personally, I can say that this practice, definitely, did not decrease after what happened in 2001, actually firms react to the environment of globalization, thanks to connections, making stronger a small group of people that rule the MNEs. Interlocking corporate directorates have replaced, somehow, the role of institutions in the industrial environment. In fact, the role of institutions is to reduce the uncertainty in the environment where firms operate and thanks to this phenomenon, some companies use interlocking directorates as trust substitute. Nowadays, authorities are monitoring activities that may lead to potential collusions, in the US the Anti-Trust authority looks out on what happening in the American territory. In Europe, the EU Commission monitors the situation. Anyway, these supervisory bodies cannot consider interlocks as evidence of abuse or market collusion, because these connections among directors are merely indicators of potential relations between actors or events, they cannot intervene, if it is not confirmed the “flagrante delicto” of an illegal act among actors or events. 3.4. Analysis of the case studies In the analysis, I will show two different perspective of utilize for interlocking directorates, to be more specific, I will show the negative and the positive features of this phenomenon within business environment. The first case, deals with insurance system in Italy, how interlocks affect market shares, enabling few insurance companies to create a cartel for the non-life sector. The second case, shows how interlocks are used, unusually, between e-commerce firms. 2.4.1 The Italian non-life insurance industry Two professors from University of Teramo, made a study about Italian insurance sector, showing how interlocks between directors, have deregulated completely the industry performance. Taking into account the Italian laws, there is no explicit reference to interlocking directorates, the system consider it only indirectly through the norms on the conflict of interests, regulated by article 2390 of the Italian Civil Code. Therefore, companies in the same sector cannot be in contrast to the mentioned article, thus the law should prevent the co-occurrence of impeach decisions of the board of directors. Taking into consideration, briefly, the historical changes of the Italian insurance industry, we can see that in 1994 the sector shifted from a strong protectionist context to a free market system. The reform was aimed to improve the sector efficiency and performance, unfortunately only six years later the first sign of market failure was represented by the action of the Italian Anti-Trust authority with 361,5 millions € of fines. Four years later, in 2004, ANIA (Italian Association of Insurance Companies Yearbook) was fined, again, with 2 millions €, because ANIA was, somehow, favoring the creation of a cartel among non-life insurance companies, coordinating their price strategies. However, although the action of the Anti-Trust authority, the formation of this lobby was proceeding. In fact, when boards of directors are interlocked, managers can easily coordinate their strategies through informal talks or worst, they can take effective actions during management meetings. The Italian professors used, for their analysis, a matrix system based on a dataset built through ANIA yearbook. The system was composed of incidence axis, represented by relation between directors of several companies and adjacence axis, represented by three different levels of insurance industry. Therefore the whole sector, the life and non-life companies.187 companies were analyzed in this matrix system and the results shown the existence of several social networks. In fact, we may see the network of insurance companies, for the whole sector, and their directors, the network of life insurance companies and their directors and the most interlocked, the network of non-life insurance companies and their directors. The latter affect, particularly, the market share of the mentioned sector. In fact, despite the presence of 100 competitors, the biggest eleven companies, of the sector, have the 78% of total market shares. The studies of the professors from University of Teramo, shows, clearly, the relation among companies and directors, between the biggest ten companies. Then, these corporations that constitute only the 11% of the firms operating in the market, have a huge power, instead some smaller independent companies that represent the 18% of the business, got an aggregate market share of 0,02%! Therefore, we have an high degree of concentration and a very low degree of competition. There is a similar situation for insurance firms of life sector, but with an inferior percentage of market shares and power. Anyway, we have to take in consideration that two companies operating in the non-life sector can also be connected by an indirect link through a common director in the life sector. Here, it comes again the importance of centrality and betweeness of centrality, it is not easy and clear to identify all the connections or potential connections within firms, with a matrix system. However, we should not forget that in a full competitive system, in this case, there should be no interlocking directories and linked connections, especially because these links are between firms of the same sector, therefore they should be direct competitors. To conclude, in this case interlocking directorates are used, as substitutes for the role of institutions. Thus, to reduce uncertainty, creating trust between companies, indeed thanks to this created trust non-life companies maintain their stability. Therefore, placing a director on a competitor board, enables really the creation of a cartel. Then, each cartel member will have an observer who can monitor activities of the companies, therefore this monitor activity will avoid actions like reduce price, expand capacity of introduce new products that could destabilize the cartel agreement. 2.4.2 Interlocked directorates within e-commerce firms This second case, shows a positive use of interlocking directories between firms. This case is particular, because e-commerce industry works in a different way compare to the traditional business. We all know, the dynamism of the industry and especially how volatile tend to be e-commerce firms, but this case from University of Pittsburgh, represents again the importance of betweeness of centrality. In fact, thanks again to a matrix system of incidence and adjacency, connections among board of directors of the top 50 e-commerce firms of US market are demonstrated. This time, analyzing the networks created, among the American top 50 e-commerce companies, we may see that the density is quite low. Therefore a second analysis was made, taking into consideration the networks between the most important e-commerce companies and the traditional firms. Here we find an high density of network, but the result of interlocked firms do not show that the e-commerce firm with more tie is the one with higher market shares, but it shows that it is the most visible. Therefore, for e-commerce firms, interlocking directories are used not with the aim of create a cartel or a form of collusion, instead e-firms sacrifice profitability for visibility. These firms measure their centrality not with their market share, but they use a measure of visibility, determined by the number of times that they are cited in the Wall Street Journal. Therefore for these firms the degree of centrality is not important, it is more important the betweeness centrality, therefore being associated with an important traditional firm will lead to gain a bigger visibility. At the same time, this phenomenon, got a positive aspect because both firms (traditional and e-firm) will benefit of mutual reciprocity. In fact, the technology developed by the e-commerce firm may be used to support the traditional firm. Indeed, e-commerce can be seen as an alternative outlet for traditional firms, thus traditional firm may gain in business electronically knowledge. Therefore the creativity of the members of board of e-firms can generate a new business insight for traditional one and at the same time directors of traditional firms can transfer their experience and knowledge management in order to implement the strategic choices of the e-firm. To conclude in this particular case, there is a benefit reciprocity between companies thanks to interlocked directorates. 3. Conclusions To conclude, after a theoretical perspective and the analysis of two different case, I still perceive interlocked directorates as something negative. Obviously, it has also positive features, especially within e-firms. Anyway, sooner or later, it will be used anymore in a improper way. The nature of human being is selfish, therefore we will not have a mutual knowledge transfer between companies, there will always be the possibility for a firm to lose its valuable and rare key success factors. In fact, five years ago started the co-operation between Google and Apple, in order to improve both companies products, thanks to the exchange of their knowledge thanks to interlocks. This year, they interrupted their connections, because they become competitors within three sectors: mobile phones, browsers and soon operating systems. Therefore, this interlocks are illegal according to American laws, anyway there has been an exchange of accuses, from both parties, blaming each other of knowledge exploitation in the case of mobile phones and operating systems. Therefore, I believe that this is a tool used by firm only to influence, exploit or monitor in the case of collusion. Besides, as I mention in the introduction, this instrument is also used to affect political decisions. There have been several episodes connected with attempts of interlocked directorates aimed to influence some political decision, the most famous is related with Melinda Gates, wife of Bill Gates. She was serving the board of directors of Washington Post, during a short period in 2004, this was mainly a strategic move for Microsoft in order to help the company on its battle against Anti-Trust legislation. The newspaper has a strong influence on the American politicians. Anyway, the existence of this links, often cannot be used as evidence of an active relation or an abuse of market power, indeed they are only indicators of potential power relations. Therefore, in many countries the majority of political decision are, mainly, corporate oriented. In fact, despite my personal conclusions may seem too sectarian, I truly believe that the world is ruled by an elite group, these people are leading the biggest corporations and they are taking the decisions that are changing our lives. Therefore, quoting, partly, Ned Beatty in the role of Mr. Jensen in Sidney Lumet’s movie, Network: “There are no nations, there no people, there is only one holistic system of system. One vast and immane, interwoven, interacting, multi-variant, multinational dominion of dollars! That is the natural order of things today. There is no democracy, there is only IBM, ITT, AT & T, Du Pont, Dow, Union Carbide and Exxon. Those are the nations of the world today. We no longer live in a world of nations and ideologies. The world is a college of corporations, inexorably determined by the immutable bylaws of business. The world is a business.” Therefore, we can say how a movie of 1976 perfectly shows the sad current picture of business and political environment. References Bibliography: 1. Andrea Everard, Raymond Henry; A social network of interlocked directorates in electronic commerce firms; University of Pittsburgh; 2008, pag. 225-233 2. Barnes, R. C., & Ritter, E. R.; Networks of corporate interlock; Critical Sociology, 27, 2001; pag. 192-220 3. Davide Carbonai, Giovanni Di Bartolomeo; Interlocking Directorates as a Trust Substitute: The Italian Non-life Insurance Industry; University of Teramo; 2008; 4. Derek Fielding; Syros Grecia, storia industriale; Ezinearticles.com; February 2008 5. Domhoff, G. W.; Who rules America' Power, politics, and social change (Fifth ed.); New York: McGraw-Hill; 2006 6. J.A. Sonquist, T. Koenig; U.S. Interlocking directorates in the top, corporations: a graph theory approach; The Insurgent Sociologist 5; 1995; pag. 196-229 7. L.B. Stearns, M.S. Mizruchi; Board composition and corporate financing: the impact of financial instution representation on borrowing; Academy of Management Journal 36; 1993; pag. 603-618 8. L.C. Freeman; Centrality in social networks: Conceptual clarification; Social Networks 1 (1999), pag. 215-239 9. Maria Aluchna; Lectures slides: Comparative Analysis of Corporate Governance; Lecture 8; pag. 4 10. Mike W. Peng; Global Strategic Management; South-Western Cengage Learning; 2009; pag. 387 11. Steven L. McShane, Mary Ann Von Glinow; Organizational Behavior, second edition; Mc Graw-Hill, 2009; pag. 276 12. S. Wasserman, K. Faust; Social Network Analysis: Methods and Applications; Cambridge University Press; 1994 Websites: 1. Investopedia.com 2. Investorwords.com 3. http://www.linfo.org/interlocking_directorship.html 4. TheyRule.net 5. http://www.youtube.com/watch'v=RzSj1yNZdY8 -------------------------------------------- [ 2 ]. Quotation from the website TheyRule.net [ 3 ]. Investorwords.com [ 4 ]. Mike W. Peng; Global Strategic Management; South-Western Cengage Learning; 2009; pag. 387 [ 5 ]. http://www.linfo.org/interlocking_directorship.html [ 6 ]. Investopedia.com [ 7 ]. Full definition taken from Investopedia.com [ 8 ]. Barnes, R. C., & Ritter, E. R.; Networks of corporate interlock; Critical Sociology, 27, 2001; pag. 192-220. [ 9 ]. Mike W. Peng; Global Strategic Management; South-Western Cengage Learning; 2009; pag. 387 [ 10 ]. Domhoff, G. W.; Who rules America' Power, politics, and social change (Fifth ed.); New York: McGraw-Hill; 2006 [ 11 ]. J.A. Sonquist, T. Koenig; U.S. Interlocking directorates in the top, corporations: a graph theory approach; The Insurgent Sociologist 5; 1995; pag. 196-229 [ 12 ]. S. Wasserman, K. Faust; Social Network Analysis: Methods and Applications; Cambridge University Press; 1994 [ 13 ]. TheyRule.net [ 14 ]. L.C. Freeman; Centrality in social networks: Conceptual clarification; Social Networks 1 (1999), pag. 215-239 [ 15 ]. Steven L. McShane, Mary Ann Von Glinow; Organizational Behavior, second edition; Mc Graw-Hill, 2009; pag. 276 [ 16 ]. Maria Aluchna; Lectures slides: Comparative Analysis of Corporate Governance; Lecture 8; pag. 4 [ 17 ]. L.B. Stearns, M.S. Mizruchi; Board composition and corporate financing: the impact of financial instution representation on borrowing; Academy of Management Journal 36; 1993; pag. 603-618 [ 18 ]. Derek Fielding; Syros Grecia, storia industriale; Ezinearticles.com; February 2008 [ 19 ]. Davide Carbonai, Giovanni Di Bartolomeo; Interlocking Directorates as a Trust Substitute: The Italian Non-life Insurance Industry; University of Teramo; 2008 [ 20 ]. Davide Carbonai, Giovanni Di Bartolomeo; Interlocking Directorates as a Trust Substitute: The Italian Non-life Insurance Industry; University of Teramo; 2008; pag. 5 [ 21 ]. Davide Carbonai, Giovanni Di Bartolomeo; Interlocking Directorates as a Trust Substitute: The Italian Non-life Insurance Industry; University of Teramo; 2008; pag. 15 [ 22 ]. Andrea Everard, Raymond Henry; A social network of interlocked directorates in electronic commerce firms; University of Pittsburgh; 2008, pag. 225-233 [ 23 ]. http://www.youtube.com/watch'v=RzSj1yNZdY8