McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9 GROUP PROCESS Behavioral Corporate Finance by Hersh Shefrin

1 Three Features About Group Behavior 1.Accuracy: Groups outperform individuals in intellectual tasks, but not judgmental tasks. 2.Polarization: Groups become polarized in respect to risk tolerance. 3.Unwarranted Acceptance: Group discussion leads members of a group to accept a decision readily. illusion of effectiveness

2 General Reasons for Group Errors Three main factors that underlie group inaccuracy and unwarranted acceptance. 1.groupthink 2.poor information sharing 3.inadequate motivation

3 Enron's Board and Special Purpose Entities  CFO Fastow and aide Michael Kopper used special purpose entities to enrich themselves at the expense of Enron’s shareholders.  Enron’s board approved use of special purpose entities to obscure failure of its investments through off-balance sheet items.  Board waived Enron’s code of ethics for CFO Fastow, allowing him to gain financially from leading the partnership.

4 Board Looked Good on Paper  Were there not enough independent directors on Enron's board?  Enron’s board complied with conventional corporate governance standards. The majority of its board was indeed made up of independent directors. Board had an independent nominating committee. Audit committee chaired by financial expert.

5 Groupthink at Enron  Enron's directors asked few questions, readily accepted answers they received, and cast no dissenting votes.  Established no mechanisms to monitor for conflicts of interest on the part of Enron’s CFO.  Did not ask to see the partnership prospectus material that identified the conflict.

6 Contrasting Enron's ROE and Free Cash Flows

7 WorldCom  CEO Bernard Ebbers borrowed $253 million to acquire land, yachts, and boatyards.  Collateral was WorldCom stock.  When the stock price fell and bank required more collateral, WorldCom's board approved a loan to Ebbers instead of asking him to sell some his personal assets.

8 PSINet  Both WorldCom and PSINet grew quickly by using debt-financed acquisitions.  Between 1997 and 2000, PSINet made 76 acquisitions.  However, on May 1, 2001, PSINet began to default on its $400 billion debt, and its stock was delisted.

9 Poor Information Sharing at PSINet  CEO Bill Schrader and CFO Pete Wills separately pursued acquisitions, from Lebanese Internet service providers to Chicago-based consultancies.  At times without telling the board, or each other.  Through it all, no one on the board, in the executive suite, or on Wall Street stopped to caution that PSINet’s addiction to debt threatened its existence.

10 Debiasing Illustrative Example SRC’s processes are built around five components: 1.Standards 2.Planning 3.Compensation 4.Information sharing 5.Employee stock

11 Standards and Planning  Standards  identify critical numbers.  Planning  In the spirit of avoiding groupthink, formed a task force to challenge assumptions underlying the forecast. “It’s in everybody’s interests that we identify any problems, false assumptions, unrealistic expectations, and hidden risks.” Jack Stack, CEO

12 Incentives “What a bonus plan does is communicate goals in the most effective way possible— by putting a bounty on them… When you do that you’ll get people’s attention very fast. You’ll send them a strong message. You provide them with a focus.” Jack Stack, CEO

13 Huddling  SRC calls their information sharing process “huddling” and it is the heart of their communication system.  SRC’s huddle is a weekly meeting.  Selected representatives from across the company meet to exchange forecasts. How the actual financial statements will turn out at the end of the current month.  These forecasts feature accountability.

14 Employee Stock  By its nature, the compensation plan, and attendant communication focuses on performance for the current fiscal year.  However, value creation is a multi-year proposition.  Employee stock ownership serves to discourage the tendency to take decisions that improve short-term performance, but destroy value.