STERNbusinessS P R I N G / S U M M E R 2 0 0 4

T h e L a t e s t M o d e l s

Robert NardelliRemodels Home Depot

Arthur Levitt Calls for New Role Models

Stern’s Nobel Laureate Debating Europe’s Financial Future

Unlocking Corporate BoardsSuper Models: Inner-city

Entrepreneurship Social Responsibility

Organizational Silence

a l e t t e r f r o m t h e deanBusiness schools

straddle the realms oftheory and practice.Any sound businesseducation provides stu-dents with an under-standing of the basicprinciples – of every-thing from accounting

to macroeconomics – and an appreciation of howissues play out in the world. An excellent businesseducation affords students the opportunity to dealwith both theory and practice at the highest level.

In our fields, we frequently construct models thatdescribe how things are supposed to work, or how wethink they should work. But we constantly test themby examining data, by working with and talking topractitioners, and by incorporating observations andexperience into our thinking.

At NYU Stern, the boundaries between the cam-pus and the business world are porous. And we havethe great geographic fortune to be located in NewYork, which is home to an unrivaled concentration ofbusinesses. As a result, our faculty and students havethe opportunities to validate their theories and mod-els with industry counterparts who are at the tops oftheir respective fields.

For example, NYU Stern’s proximity to WallStreet – and the prospect for collaboration it affords– was one of the factors that attracted Robert Engleto Stern in 2000. Professor Engle, was named aNobel Prize winner in economics last fall for hiswork in developing and applying models to analyzeand forecast volatility. Every day, on trading floors afew miles to the south of our campus, investors andanalysts put his models to work.

New York is home to a stunning array of non-profit organizations – symphonies and operacompanies, giant foundations and hospitals, andsmall neighborhood economic development groups.

All these organizations can benefit from the adapta-tion of management best practices, and our studentscan benefit from learning more about how theseorganizations work – and about the work they do.That’s why we developed the Stern Consulting Corps(SCC) program.

Under this innovative consulting internship pro-gram, which involves about 50 students each semes-ter, NYU Stern MBA students put into practice theskills and knowledge they gain in the classroom tohelp revitalize small and minority-owned businessesin New York City. SCC serves as the umbrella for aunique partnership among NYU Stern, non-profitorganizations such as the Harlem Small BusinessInitiative, the Robin Hood Foundation and SEED-CO; and management consulting firms such as BoozAllen Hamilton and A.T. Kearney. Working in part-nership, the non-profit organizations provide SternMBA students with their assignments, and volun-teers from the consulting firms serve as mentors onthe projects. In turn, businesses and non-profits ben-efit from the Stern MBA students’ expertise in every-thing from strategic and financial analysis to mar-keting and operations.

We take seriously our responsibility to be activeand productive members of a larger community. Andwe believe that these initiatives – and our ongoingefforts to attract the highest quality faculty and stu-dents – are among the many factors that make NYUStern a model for other business schools.

This issue of STERNbusiness features a greatdeal of innovative thinking on the part of NYU Sternfaculty members, and on the part of the many busi-ness and government leaders who participated inevents at Stern last fall. I invite you to explore it.

Thomas F. CooleyDean

STERNbusinessA publication of the Stern School of Business, New York University

President, New York University � John E. SextonDean, Stern School of Business � Thomas F. CooleyChairman, Board of Overseers � William R. BerkleyChairman Emeritus, Board of Overseers � Henry KaufmanAssociate Dean, Marketing

and External Relations � Joanne HvalaEditor, STERNbusiness � Daniel GrossProject Manager � Lisette ZarnowskiDesign � Esposite Graphics

Letters to the Editor may be sent to:NYU Stern School of BusinessOffice of Public Affairs44 West Fourth Street, Suite 10-160New York, NY 10012http://www.stern.nyu.edu

contents S P R I N G / S U M M E R 2 0 0 4

36Pocket ProtectorFormer SEC Head Arthur Levitt, Jr.,Discusses Reform

40Currency EventAn NYU Stern Panel Debates Europe’s Economic Future

44 Endpaper by Daniel GrossFord’s Most Enduring Model

Illustrations by:Dave CutlerGeorge AbeTimothy CookMichael GibbsBryan LeisterKen OrvidasTheo RudnakGlenn MitsuiMichael CaswellRobert O’Hair

T h e L a t e s t M o d e l s

SternChiefExecutiveSeries

InterviewRobert Nardelli, The Home Depot, Inc.Page 2

6 Model Behaviorby Daniel Gross

8 Ties That BindThe Problems Of Interlocked Boardsby Eliezer M. Fich and Lawrence J. White

14Going For Brokers

How Entrepreneurs NegotiateThe Inner-City Landscape

by Gregory B. Fairchildand Jeffrey A. Robinson

20Nobel PursuitInterview with NYU Stern’s Robert Engle,2003 Nobel Laureate in Economics

26 Responsible PartiesRoundtable Discussion on Corporate Responsibility

30 Sounds Of SilenceWhy Employees Don’t Speak Upby Elizabeth Wolfe Morrisonand Frances J. Milliken

CH: What did you find when

you got to Home Depot?

RN: It was a very rapid transi-

tion from General Electric to

Home Depot. It took place in

about a week. It was the first

time in the history of this com-

pany that an outsider was

CEO. Home Depot is a very

young company. We're the

youngest retailer to reach $30

billion, $40 billion, $50 billion.

And this year we’ll reach $60

billion. It is a company that had

grown up with its co-founders.

But, my assessment was that

what got us here wouldn't get

us where we wanted to go in

the future. We had a very

decentralized business model.

What I found was that the fun-

damental infrastructure needed

for sustainability in a variety of

economic cycles was missing.

The decentralization that had

served the company well was

a disadvantage going forward.

CH: At that point, you had

about 1,000 stores, each oper-

ating as a separate entity?

RN: By design. The co-

founders would go on a road

trip and say "If you've got a fax

from corporate, tear it up. If

you get a voice mail, dump it.

You're out here running the

business.” This was a company

in start-up mode for 22 years.

What I found was a need for

some very strong infrastructure

to put some pilings underneath

this house called The Home

Depot.

When I was transitioning in,

there was a tremendous

amount of anxiety. If there is

one message I can leave you

here tonight, it is think about

succession planning. I was an

outsider. This is a company

Robert Nardelli is Chairman, President and ChiefExecutive Officer of The Home Depot, Inc. With morethan 1,600 stores in North America and 2002 salesof $58.2 billion, Home Depot is the world's largesthome improvement retailer and the second largestretailer in the U.S.

Prior to joining Home Depot in December 2000, Mr.

Nardelli was President and Chief Executive Officer at

General Electric's power systems unit, where he trans-

formed the division into a $20 billion worldwide leader

in the energy industry. He began his career at GE in

1971. Mr. Nardelli received his B.S. in business from

Western Illinois University and earned an MBA from

the University of Louisville. Since Mr. Nardelli took the

helm at Home Depot in 2000, the company has seen a

28 percent increase in annual sales, and a 42 percent

increase in annual net earnings.

sternChiefExecutiveseries

Robert Nardellichairman, president and chief executive officer

The Home Depot, Inc.

2 Sternbusiness

that prided itself on internal

promotions, a family.

CH: How did you handle it?

RN: I have moved 11 times in

my career. I had gone through

it before. About 75 percent of

what you learn is portable. The

rest is something you have to

immerse yourself in. This was

like taking a dry sponge and

immersing it in a bucket of

water. You just have to absorb

a plethora of things. While at

the same time you're learning,

you have to continually calm

the waters that this new guy is

not going to wreck the culture

and bring order and discipline

to a very entrepreneurial envi-

ronment. When I came in

December of 2000, I could not

send an e-mail to every store

manager. We have fixed that,

of course.

CH: While you were going

through this transition did you

hit some snags?

RN: When I stepped in, this

was a company that had had

eight consecutive quarters of

downward spiraling compara-

tive sales. I visited nine differ-

ent buying offices and I found

different pricing, different terms

and conditions. So we put in

vendor buying agreements.

We went from negative $800

million in cash when I got there

in December, to $5 billion in

cash today. That's after a $2

billion stock buy-back last year.

And we will achieve another

billion-dollar stock buy-back

this year. We increased divi-

dends last year over 20 per-

cent. We've increased divi-

dends this year over 20 per-

cent and a quarter early. It's

working, but it wasn't without a

lot of skepticism. We've had to

make a lot of changes. We

changed merchandising. We

changed operations. We

changed systems. You are

either going to be e-literate or

you'll be illiterate. We're plan-

ning for the long term but we're

delivering on the short term

with some tremendous tech-

nology. We are reinvesting 100

percent of every hour of

increased productivity. We'll

spend about $400 million this

year in technology, and we'll

do that for the next two to

three years to get caught up.

CH: You've also made a lot of

people changes.

RN: I think you have to identi-

fy your strategy and then

organize to support it. The real

differentiator is resource allo-

cation, both human capital and

physical capital. At the leader-

ship level we are going

through a major transforma-

tion. But one of my strongest

division presidents is a 20-year

associate. He started as a lot

attendant. I think we're getting

a wonderful blend of experi-

ence and culture to form this

new team.

CH: What competitors worry

you and what competitors do

you learn from?

RN: I have a great deal of

respect for Wal-Mart. A couple

of months ago Tom Coughlin,

the head of Wal-Mart’s U.S.

stores, invited me down to the

Saturday meeting at

Bentonville and introduced me

as “the enemy.” I admire them

because I think they have

great logistics, they've got

great operating systems, they

have tremendous commitment

and passion on the part of

their associates. I think Target

does a wonderful job in pres-

entation. I think one of the

things that has happened to

Home Depot is success breeds

complacency. Complacency

breeds arrogance. Arrogance

causes failure. Consumers

today are stressed. We want to

provide them with what I'll call

the orange experience. When a

customer walks into Home

Depot, it's aesthetically pleas-

ing. It's well lit. It's shoppable.

It's navigable. We have to have

a restlessness towards improv-

ing upon everything we do.

CH: Can you talk a little bit

about your own background?

RN: I had a wonderful set of

parents who are first-genera-

tion Americans. They instilled

in me a tremendous work

ethic. I had one older brother.

As a younger sibling, you're

always in competition. I felt a

need to compete both in high

school and in college. I had

great experiences in those

academic environments, and I

learned a lot about myself in

athletics. I played high school

football, got a scholarship and

played college ball. I enjoyed

the fact that you had to do

your job as an individual, and

you had to make sure the

team was coordinated. So it's

all about you, and it's about us.

It gave me a great advantage

from a leadership standpoint.

Never ask anybody to do

something you wouldn't do.

I've always believed in horizon-

tal promotions to make your

base as strong as it can be.

For the trauma that it created,

the wonderful thing about

being new to Home Depot was

that I wasn't tied to the past. I

had a respect for the past. The

toughest thing to change is

what you put in place.

CH: You spent a great many

years at GE, but at one point,

you left GE for a while and

went to a smaller company.

Tell us about that.

RN: It was a gut-wrenching

decision. I'm a second genera-

tion GE-er. Between my Dad

and me, we've got over 50

years with General Electric.

Leaving was emotional for me.

And, I never left with the notion

that I would come back. Then I

got a call a couple of years

later to come back to GE,

which was one of the best

days of my life. In typical Jack

Carol Hymowitz, senior editor at The Wall Street Journal, interviewed Mr. Nardelli.

Sternbusiness 3

“ We had a very decentralized business model . . .

The decentralization that had servedthe company well was a

disadvantage going forward.”

tremendous amount of corpo-

rate governance to start with.

Before it became the vogue or

mandatory, we required every

director to walk our stores so

they had a sense about what

was going on out there. Every

board meeting had an outside

director's meeting without me

there. Every director has to

stand for re-election every year.

Those are some of the things

we already had in place and

we're continuing to do it. In the

last two and a half years I

have personally set up teams

of directors to visit our division

presidents without me. Every

quarter we're rotating our

directors so that they have

unfiltered access to our leader-

ship team. We have put in a

whole new compliance review

process. We set up an entire

new corporate compliance

process where employees can

go straight to the head of our

audit committee if they have

concerns about corporate gov-

ernance. And, we have com-

Welch fashion, of course, I

was exiled. I went up to

Toronto and ran the Canadian

appliance manufacturing com-

pany for a year. He could not

bring me back and put me in a

position that might reinforce

that that is the way you get

promoted. So I went up and

did my penance in Toronto. I

did that for nine months and

then came back and took over

GE transportation in Erie, and

then a couple of years later

took over GE power systems

in Schenectady.

CH: What was it like to be in

the succession race at GE for

several years and then not get

the top job?

RN: It's the Super Bowl, the

last two minutes for two years.

It's very tough. The pressure,

the environment. You know

that you're being looked at

through a magnifying glass

every day. For me it was about

"How do I take a $5 billion

business and broaden it?" We

grew the business from $5 bil-

lion to $20 billion. We were the

strongest cash generator in the

company. We were the most

profitable segment in the com-

pany. We had a phenomenal

time during that three-and-a-

half-year period.

CH: You have said that being

a leader, you're judged on your

accomplishments, not on the

4 Sternbusiness

a few days because of busi-

ness demands? You have to

make tradeoffs. You've got to

set priorities.

CH: What are the global

opportunities for Home Depot?

RN: Let's talk about North

America. We'll open our 100th

store in Canada this month. In

Mexico we went from zero to

number one in 18 months.

That's a $12.5 billion market. If

we look to Europe, I don't think

it's any surprise real estate is

pretty well taken. If we go to

Europe, it would be an oppor-

tunistic acquisition of someone

that is in the market over

there. If you look to Asia,

you're going to go to China. It

is where the population and

the economy are booming.

The investments that U.S.

companies have made in

China are creating a tremen-

dous financial base over there.

I think when it's done, there

will be three trading blocs.

There will be the European

trading bloc. There will be the

Americas. There will be Asia.

Somehow we've got to be able

to coexist. We've got to create

the globalism that allows three

major trading blocs to get

along. China is where we were

at in the Industrial Revolution,

head down, working hard.

They are aspiring to be where

we are today.

CH: What are you trying to do

at Home Depot to assure good

governance?

RN: I'm very fortunate. I have

a great board. We had a

time you put in. But you do put

in an awful lot of time? What is

your schedule like?

RN: To use a sports analogy,

at the end of 60 minutes, it's

not about how hard you

played, it's about whether you

won or not. For me, having

moved a number of times, I

always felt that I was in a

learning curve. You have to

continually challenge yourself.

My goal is not to meddle, but

to understand. The more I

understand, the more process-

es and systems I can put in

place so that we have a con-

tinuum of performance

improvement. Retail is very

demanding. In the industrial

sector on Friday nights, you

kind of wind down. In retail,

you build to a crescendo. The

transactions happen Friday,

Saturday and Sunday.

I met my wife while we were at

school, in 1971. We've been

together since then. She has

been unbelievably supportive.

I've got a great family. I've got

one daughter and three sons.

They have been supportive. I

think it's a cop-out for you to

look back and say, "could

have, should have, would

have." You know exactly what

you're doing. Are you going to

take four, five hours for a

round of golf, or are you going

to spend time with one of the

children you haven't seen for

"For the trauma that it created, thewonderful thing about being new

to Home Depot was that I wasn't tied to the past."

municated it so that every

associate, every leader has

the comfort that they can get

to the board.

CH: What do you look for in

young managers when you're

hiring?

RN: What we're looking for is

someone that has demonstrat-

ed a tremendous amount of

energy, who has an ability to

energize, who has demon-

strated the ability to balance

academic and social. In this

business, you've got to love

people. We're looking for

people who want to continue

to learn, who understand the

importance of individual

accountability, but with the

ability to think laterally.

Student questions

Q: Will Home Depot be

expanding into Manhattan?

RN: We are going to put two

stores in Manhattan. There are

three customers that we're

looking to serve here. First are

the residential customers, peo-

ple that live in this area. The

second customer that we are

excited about is the building

superintendent. It's going to be

very important to provide mer-

chandise and service to that

building superintendent. The

third customer that we're excit-

ed about is the commuter. The

commuter shops in the morn-

ing, shops at noon, shops at

night, and then has it deliv-

ered. We may elect to deliver

out of one of our local stores.

Q: What sort of macroeco-

nomic trends are you seeing

now from your seat at Home

Depot?

RN: One of the first things I

did when I got there was put

together my own economic

model. We look at about 50

different indices. So what are

we seeing? We are seeing

sequential improvement in the

economy today. One, because

of the low interest rates we

see tremendous family forma-

tion relative to housing. It is

the American dream. People

want to own a home. We're

more excited about housing

turnover than we are new

housing at this point. We're

seeing consumer confidence.

What we saw post-9/11 was

people were staying home.

They were doing projects, but

not big projects. But we're see-

ing bigger projects come back

now. We have seen, since the

fourth quarter through the sec-

ond quarter of this year, a sig-

nificant improvement in overall

same-store sales. We saw

sequential improvement May

to June, June to July, July to

Sternbusiness 5

August, August to September.

We'll be reporting our earn-

ings in a couple of weeks, and

we're feeling good about the

momentum and the direction,

not only of our business, but

the sector that we serve.

Q: How do you retain a quali-

ty workforce?

RN: What are we doing to

make sure that our associates

don't feel the need for third-

party representation? One, we

pay above industry average,

at least 15 percent against

market wages in those com-

munities. Two, we offer one of

the best benefits packages.

We’ve implemented benefits

for part-time associates for

the first time in the history of

the company. We accelerated

tuition reimbursement. We put

in what I'll call success shar-

ing. That means if you hit the

sales plan and other metrics

within your store, you'll get a

financial reward. Sixteen mil-

lion dollars went to associates

through that program. I firmly

believe that when you invest

in an associate, that skill is

portable. We hope they stay

with us and use it but it's

something they can take

wherever they go. We have a

real passion, a real commit-

ment about attracting, moti-

vating and retaining a high-

performance workforce. �

“Before it became the vogue ormandatory, we required every directorto walk our stores so they had a sense

about what was going on out there.”

hich comes first, theory or practice?Theory – whether it was Charles

Darwin’s Galapagos-inspired writings onevolution, or Sir Isaac Newton’s apple-

induced discovery of gravity – is informed by practice andobservation. And yet practices frequently follow from the-ory. Think, for example, of how management models likeTotal Quality Management or Six Sigma have altered thestrategy, actions, and bottom lines of massive companies.

In fact, innovation is the product of a constant cyclewhereby theory and practice are continually informed byone another. As a result, bridging the gap between theo-reticians and practitioners is crucial. And one of the bestways for doing so is by constructing, using, and revisingmodels. Models represent the marriage of real-worldobservation to imaginative thinking. And they provide aframework for teaching, for discussion, for inquiry, forunderstanding, and, ultimately, forenacting change.

Each year, Sweden’s Nobel PrizeCommittee recognizes researcherswhose theoretical work finds appli-cations in the real world. And lastyear, NYU Stern finance professorRobert Engle received a share of the2003 Nobel Prize in Economics fordeveloping an innovative and highlyuseful economic model called “Autoregressive ConditionalHeteroskedasticity.” In English? “It’s a way of trying tomodel and describe and forecast this thing we call volatil-ity,” Engle said in a town hall meeting held in his honorlast fall. (“Nobel Pursuit,” pg. 20)

Currencies have been among the more volatile assetclasses in the past year. After years of strength, the dollarhas weakened substantially against currencies such as theBritish pound and the euro. The advent of the euro in 2000was the latest step in a continuing effort to build a newmodel for European political, social and economic reloca-tions. But last fall, the future of Europe’s united fiscal andmonetary policy seemed in doubt as countries faced a con-flict between meeting Europe-wide financial mandates and

internal policy goals. Amid the crisis atmosphere, apanel sponsored by NYU Stern and BlackwellPublishing, Inc. gathered to discuss present andfuture prospects for Europe and the Euro. (“CurrencyEvent,” pg. 40) While the panel’s members, whoincluded NYU Stern Dean Thomas Cooley, largelyagreed on the diagnosis of Europe’s ills, they offered

different – and provocative– cures.

When something breaksdown – a monetary system,a car, or a system of corpo-rate governance – it’s timeto go back to the drawingboard. And in the past fewyears, a series of board-room scandals and failings

have exposed the flaws in the ways publicly held com-panies are governed. In their article, (“Ties ThatBind,” pg. 8) Lawrence White and Eliezer Fich dissectthe current model and analyze how the make-up ofcorporate boards, and chief executive officers’ rela-tionships with corporate directors, influence crucialoutcomes such as compensation.

As Chairman of the Securities and ExchangeCommission from 1993 to 2001, Arthur Levitt, Jr.implemented a series of reforms aimed at alteringsuch relationships. In remarks prepared for theCitigroup Leadership and Ethics Program at Stern,(“Pocket Protector,” pg. 36) Levitt called for a“cultural change” in the way directors and CEOs

6 Sternbusiness

“Models represent the marriage of real-world observation to

imaginative thinking. And theyprovide a framework for

teaching, for discussion, forinquiry, for understanding, and,

ultimately, for enacting change.”

W

M O D E L B

ILLUSTRATION BY GEORGE ABE

approach their jobs. “We need private sector leaders at alllevels to dedicate themselves to creating a culture ofaccountability and foster an ethic of service,” he said.“We need to change who our role models are.”

Whistle-blowers – employees within organizationsthat see unethical behavior and alert associates, regula-tors, or law enforcement agencies – are frequently cru-cial to creating accountability. But in corporations today,forces discourage employees from speaking out. “Inmany organizations, employees know the truth aboutcertain issues and problems facing the organization yetthey do not dare to speak that truth to their superiors,”as Elizabeth Wolfe Morrison and Frances J. Milliken note.In their article, (“Sounds of Silence,” pg. 30) drawing onsociological and psychological insights, they propose amodel for understanding the phenomenon of organiza-tional silence and suggest means through which man-agers can turn up the volume.

Whether you own a house or run a company, you’recontinually in a state of remodeling. Robert Nardelli, thechief executive officer of The Home Depot since 2000, issimultaneously trying to remodel the home improvementchain’s massive store base while figuring out how best tohelp Americans remodel their homes. “We had a verydecentralized business model,” said Nardelli, who spokeas part of the Stern CEO Series. (Interview, pg. 2). “WhatI found was that the fundamental infrastructure neededfor sustainability in a variety of economic cycles wasmissing. The decentralization that had served the com-pany well was a disadvantage going forward.”

Part of Home Depot’s current growth strategy is to

push into more heavily populated urban areas like NewYork. Indeed, the company plans to build a large storein East Harlem. In so doing, Home Depot is joining along list of companies that are investing in whatGregory Fairchild and Jeffrey A. Robinson call“America’s emerging markets.” (“Going for Brokers,”pg. 14). Fairchild and Robinson examine the phenome-non of white entrepreneurs and business owners operat-ing in central city locations. Their suggestion: socialbrokers – institutions and individuals that can bridgethe gaps between minority neighborhoods and non-minority business people – can help facilitate growth,profits, and development.

y opening stores in areas that have beenhistorically underserved, companies likeHome Depot can both do good and do well.Indeed, there’s growing evidence that thereputed conflict between companies’ social

responsibilities and their responsibilities to shareholdersto maximize profits may not be so great after all. Apanel discussion jointly sponsored by NYU Stern andResources for the Future brought together environmen-tal activists and executives to discuss the ways in whichbeing green can translate into more green in the corpo-rate coffers. (“Responsible Parties,” pg. 26) Pursuing agoal of zero waste and emissions has “saved us abouttwo billion dollars in energy costs,” said Paul Tebo, vicepresident of health, safety, and environment at DuPont.“Working on energy and keeping it flat while you growis a terrifically good strategy.”

Understanding business models – and creating newmodels for understanding business – is an importantcomponent of the work done at NYU Stern by students,by faculty, by administrators, and by the practitionerswho are part of the larger Stern community. In chal-lenging conventional wisdom, in bringing newinsights to bear on longstanding issues, this issue ofSTERNbusiness should stand as, well, a model for otherperiodicals.

D A N I E L G R O S S is editor of STERNbusiness.

Sternbusiness 7

B

E H A V I O R

8 Sternbusiness

Ties That

n the recent wave of corpo-rate scandals, from Enron toTyco, poor corporate gover-nance structures have clearlybeen a contributing factor.The tales of excess compensa-tion, poor capital allocation,

and, occasionally, outright theft,have shone a harsh spotlight on therelationships between chief execu-tive officers and the boards of direc-tors. Too frequently, directors – whoare supposed to represent the share-holders – have acted in ways thatenrich CEOs and other favoredexecutives while impoverishingcommon shareholders.

On many boards, two (or more)directors serve together on a differ-ent company’s board. For example,General Motors Corp.’s April 2002proxy revealed that the GM boardhad two mutual interlocks: CEOJohn F. Smith, Jr., and DirectorGeorge M.C. Fisher were also direc-tors on the board of Delta Air Lines,Inc.; and Smith and Director AlanG. Lafley were also on the board ofthe Proctor & Gamble Co. (whereLafley is the CEO). We dub these

I

Sternbusiness 9

ILLU

STR

ATIO

N B

Y M

ICH

AE

L G

IBB

S

When corporate directors serve together on multiple boards, the chief executive offi-

cers tend to earn more money and enjoy longer tenures. Such mutual interlocks are

plainly good for the bosses. But are they good for shareholders? Not necessarily.

By Eliezer M. Fich and Lawrence J. White

locks for several decades. And atfirst it appeared that interlocks werea sign of weakness. In one of the ear-liest such U.S. studies, economistPeter Dooley in 1969 found thatless-solvent firms were likely to bedirector-interlocked with banks.Later studies also reported thatfirms with high debt-to-equityratios, or that had an increaseddemand for capital were likely tohave interlocks. The reason:Financially stressed firms may seekto add bank officers to their boardsto receive more favorable considera-tion. Or banks may demand boardseats so they can monitor firms moreclosely.

Organizational behavior expertshave examined the extent to which aboard is an instrument of manage-ment interests. Some have arguedthat companies use board interlocksas a mechanism to improve con-tracting relationships, or to reducethe information uncertainties cre-ated by resource dependenciesbetween firms. This stream ofresearch suggests that the composi-tion of boards, including interlocks,

associations “mutual interlocks.”And in a sample of 366 large com-panies, 87 percent had at least onemutual interlock in 1991.

Director interlocks have clearconsequences for shareholders. Ourempirical analyses show that CEOcompensation tends to increase andCEO turnover tends to decreasewhen the CEO’s board has one ormore pairs of board members whoare mutually interlocked withanother company’s board. Why? Onthe one hand, mutual interlockscould be an indication of and a con-tributor to CEO entrenchment, fromwhich higher compensation andlower turnover naturally follow. Onthe other hand, mutual interlocksmay indicate the strengthening ofimportant and valuable strategicalliances. And the higher CEO com-pensation and lower turnover maybe a just reward for orchestratingsuch alliances. We believe that thefirst interpretation is more accurate.

Director InterlocksResearchers from several disci-

plines have been looking into inter-

Bind

TIES THAT BIND

is largely determined by the effortsof CEOs to influence the selection ofnew directors so that they areresponsive to that particular CEO’sinterests.

Financial economists have exam-ined interlocks as well. KevinHallock of the University of Illinoisfound that CEOs serving in employ-ee-interlocked firms earn highersalaries than they otherwise would.Nevertheless, existing researchhas not documented a connectionbetween director interlocks and totalCEO compensation. And in our sur-vey of previous studies, we did notfind any associations between inter-locks of various kinds and firm per-formance. That leads us to believethat interlocks aren’t designed toserve a firm’s strategic goals, anddon’t serve them in practice.

Compensation and TurnoverSeveral recent studies have

examined the relation between topexecutive compensation and boardcomposition. And they report mixedresults. For example, some authorshave found a positive associationbetween CEO compensation and thepercentage of outside directors onthe board. Other studies have foundno relation between a board majori-ty of outside directors and top man-agement compensation. The level ofincentive-based executive compen-sation appears to be positivelyconnected with firm performance,and incentive-based compensationappears to be used more extensivelyby outsider-dominated boards.

Other scholars have found aninverse relation between the proba-bility of a top management changeand prior stock price performance.After poor firm performance, CEOsare more likely to be dismissed if theboard of directors has a majority ofoutsiders. Empirical analyses indi-cate that the probability of top man-agement turnover is reduced if thetop executives are members of thefounding family or if they own high-

er levels of stock.Executive turnoveris also negativelyrelated to the own-ership stake of offi-cers and directors inthe firm and positively related to thepresence of an outside blockholder.Other studies have found that thelikelihood of CEO departure isinversely associated with both thedollar value of stock option compen-sation in relation to cash pay andthe amount by which a CEO’s com-pensation is higher than would beexpected from comparisons with thecompensation of other CEOs. Butthus far, no study has considered thepossible effects that boards withmutual director interlocks have onCEOs’ total compensation andturnover.

The DataWe looked at CEO compensation

and CEO turnover for 452 industri-al firms, first compiled by NYUStern professor David Yermack.These firms were drawn fromForbes magazine’s lists of the largest500 U.S. companies in categoriessuch as total assets, market capital-ization, sales, or net income. Thedata set includes all companiesmeeting this criterion at least fourtimes during the 1984-1991 period.Compensation data were collectedfrom the corporation’s SEC filings.Directors who were full-time com-pany employees were designated as“inside” directors. Individuals close-ly associated with the firm – forexample, relatives of corporate offi-cers, or former employees, lawyers,or consultants, or people with sub-stantial business relationships withthe company – were designated as“gray” directors. All the rest weredesignated “outside” directors. Wealso drew on the data assembled byKevin Hallock, who analyzed 9,804director seats held by 7,519 individ-uals in 1992. We took as our finaldata set the 366 industrial firms

for the 1991 proxy season thatappeared in both the Yermack andthe Hallock data sets. (Utility andfinancial firms were excluded fromthe study because government regu-lation may lead to a different role fordirectors.)

In order to examine how directorinterlocks may affect CEO compen-sation, we used a measure of totalremuneration that included salaryand bonus, other compensation, andthe value of option awards whengranted. We believe that this sum isa more accurate measure of whatboards intended to pay, which couldbe different from what CEOs earn,since CEOs often exercise optionsearly, thereby sacrificing a signifi-cant portion of the award’s value.

As an estimate for CEO turnover,we used a dependent variable thatwas set equal to one if a CEO leavesoffice during the last six months ofthe current fiscal year or the first sixmonths of the subsequent period. Inorder to control for retirement-relat-ed voluntary departures, we includ-ed in the analysis the CEO’s age.Turnover events occurred in 9.0 per-cent of the sample (thirty-threefirms).

Considering InterlocksThe key explanatory variable of

this study was the number of mutu-al interlocks on the firm’s board.While two boards can be interlockedif they share one director, they aremutually interlocked if they share atleast two directors. For any givenboard, a director could be part ofmore than one pair of mutual inter-locks, so it is quite possible that aboard may have a greater number ofmutual interlocks than directors. Inour sample of industrial firms,board sizes ranged from four to 26,

10 Sternbusiness

“After poor firm performance,CEOs are more likely to be dis-missed if the board of directors

has a majority of outsiders.”

with an average of 12.18. The num-ber of mutual interlocks rangedfrom zero to 42, with an average of12.15.

Other independent variables usedin the study were based on theirlikely relevance and effects on CEOcompensation and CEO turnover, asestablished by other authors. As innumerous other studies, Tobin’s Q(the market value of assets dividedby the replacement cost of assets)was used as a proxy for the growthopportunities of the firm.

Table 1 presents descriptive sta-tistics of the key variables in thisstudy and their correlation with thenumber of board director interlocks.As seen, the mean number of direc-tors who are CEOs of other firms is1.94. This result is similar to thatreported by James Booth and DanielDeli, who found the mean to be 1.87

for 1989-90 data. The mean num-ber of outside directors serving onthe board was 6.94, which is alsoconsistent with the previous litera-ture.

Two HypothesesIf the CEO dominates the selec-

tion process of directors to theboard, and if the CEO is in fact fill-ing the director positions with sym-pathetic members, then we wouldexpect a positive associationbetween the fraction of these favor-able board members and the com-pensation of the CEO. In otherwords, our first hypothesis stipulatesthat boards with a larger number ofmutual director interlocks will pay ahigher compensation package to theCEO. Our second hypothesis statesthat there is an inverse associationbetween the presence of mutual

interlocks and the likelihood of CEOdeparture.

What do the results show? Thecorrelations reported in Table 1suggest the existence of a relation-ship between the number of mutualdirector interlocks and the compen-sation of the CEO. It is not surpris-ing that larger boards have moreinterlocks and that a preponderanceof interlocks appears to be positive-ly connected with outside directorsand with directors who are CEOs ofother organizations. Mutual directorinterlocks appear to be curtailed byclose ownership and governancestructures. Our results show a nega-tive and significant correlationbetween this variable and the indi-cators for CEO-as-founder and fornon-CEO chairman.

Since director interlocks couldjust be indicators of strategic powerrelationships between firms at thehighest level, it cannot be automati-cally concluded that CEOs andinterlocked directors exploit net-works of board memberships fortheir personal gain simply becausethese multiple board affiliationsexist. In fact, CEOs could berewarded with additional compensa-tion and long job durations for suc-cessfully establishing mutual inter-locks that serve the strategic goals ofthe firm.

But the data show a significantnegative relationship between thenumber of mutual interlocks and thenumber of “gray” directors, many ofwhom could represent companiesthat have supplier or customer rela-tionships with the company. Thisnegative relationship reinforces ourskepticism as to the likelihood thatthe mutual interlocks serve thestrategic goals of the firm.

Extra CompensationTo test our first hypothesis, we

ran an ordinary least square regres-sion to estimate the effect that mutu-ally interlocking boards have on thetotal compensation of the CEO.

Sternbusiness 11

TABLE 1: DESCRIPTIVE STATISTICS FOR KEY VARIABLES

CEO Characteristics and Compensation

Board Composition

*** Significant at the 1% level. s

Mean

12.152

12.177

3.943

6.940

1.294

1.943

58.269

0.023

1099.000

388.354

775.313

9.103

26.000

Variable

Number of mutually paireddirector interlocks

Board size

Inside directors

Outside directors

Gray directors

Directors who are CEOsof other firms

CEO’s age

CEO’s percentage of stockowned

CEO’s salary + bonus(in thousands of dollars)

CEO’s other compensation(in thousands of dollars)

Value of options when granted(thousands of dollars)

Tenure as CEO (in years)

Tenure in the firm (in years)

Standarddeviation

8.852

3.075

1.989

3.012

1.501

1.667

6.612

0.063

662.323

803.518

1739.000

8.533

12.027

Correlation withnumber of interlocks

1.00

0.537***

-0.039

0.660***

-0.175***

0.565***

0.016

-0.296***

0.156***

0.193***

0.197***

-0.187***

0.134***

These calculations took into accountfactors such as interlocks, firm size,tenure of the CEO, firm perform-ance, and stock ownership of theCEO. The results of this estimationare presented in Table 2. As expect-ed, the number of mutual directorinterlocks is found to be significantand positively associated with totalcompensation. This finding suggeststhat the links created by themutual interlocking relationsbetween boards actively benefit theCEO. In other words, with the aidof mutual interlocks, CEOs are ableto extract significantly larger com-pensation packages from their firms.The robustness of this result isupheld through further investiga-tions of the components of theCEO’s pay package.

When we repeated the analysisusing the natural log of only the sumof the CEO’s salary and bonus as thedependent variable, the coefficientfor mutual directors was positiveand significant. That suggests thateven just the sum of the CEO’s basicsalary and bonus tends to increaseas a consequence of the mutualdirector interlocks. In fact, we foundthat a mutual interlock adds anaverage of $143,000 (approximate-ly 13 percent) to the average CEOsalary and bonus.

The evidence presented in Table2 is in line with the view thatmutual interlocks may indeedassist the CEO in extracting lucra-tive remuneration packages fromthe firm. The networks and trafficof influences created by mutualinterlocking directorships haveprobably been utilized by CEOs inexerting control over the majority ofboard members. This finding sug-gests that directors may not be mak-ing decisions that benefit the firm’sshareholders the most. Mutuallyinterlocking directorships could beweakening the control mechanismsput in place to ensure that directorsfulfill their fiduciary duty and act inthe best interest of the shareholders.

When we ran other regressionswith these data we found that stockoption compensation appears not tobe judiciously used by boards incompensating their CEOs in thepresence of mutual interlocks. Webelieve this reflects cronyism andweakens the board’s monitoringfunction. This interpretation is con-sistent with the view of academicsand corporate governance activistswho perceive interlocks generally ascorrupt. Thus, although other studiesfind that markets react favorably tothe adoption of stock option plans tocompensate top executives, we find

that stock options can be misused ifthe board’s monitoring activities areweakened by interlocks.

Other results in these regressionsare consistent with the previous lit-erature. We found that CEO pay isinversely related to the fraction ofequity held by the CEO. And aseconomists Sherwin Rosen, CliffordW. Smith, Jr., and Ross L. Wattshave found in other studies, we findthat large companies and firms withgreater growth opportunities paymore to their CEOs. A company’snet-of-market stock return wasfound to have a positive and signifi-cant association with total CEOcompensation, consistent with pre-vious studies.

CEO TurnoverTo test our second hypothesis, we

investigated whether the presence ofmutual interlocking directorshipsdecreases the board’s ability to mon-itor the CEO, thereby decreasing thelikelihood that the CEO will depart.We analyzed the data, includingCEO and company characteristicsthat should be associated with theprobability of turnover. MichaelJensen and Kevin Murphy have sug-gested that one obvious CEO featurelikely to affect the turnover processis age. To control for this influencewe included the CEO’s age in theestimation. And to control for firmperformance, we included the firm’scurrent and previous year stockreturns net-of-market as well as thecurrent period return on assets.Further control variables includedproxies for growth opportunities(the ratio of research and develop-ment {R&D} over sales), the ratio oflong-term debt to total assets, com-pany size, and the fraction of com-mon stock held by the CEO or hisimmediate family.

Table 3 presents coefficient esti-mates for the CEO turnover model.And the results are as hypothesized:The coefficient on the mutual inter-lock variable is negative and signifi-

12 Sternbusiness

TIES THAT BIND

TABLE 2: EFFECT OF INTERLOCKS ON CEO COMPENSATION

Estimate

4.956

0.010

0.288

0.019

-0.012

0.428

-3.000

0.170

Variable

INTERCEPT

Director interlocks

Natural log of total assets

CEO tenure as CEO

CEO tenure in firm

1991 stock return

Stock ownership by CEOor family

Tobin’s Q

Std. Error

0.304

0.005

0.038

0.005

0.003

0.107

0.641

0.047

p-value

0.0001

0.0371

0.0001

0.0001

0.0001

0.0001

0.0001

0.003

cant as predicted, implying that thepresence of mutual board interlocksis inversely associated with the prob-ability of CEO turnover. We inter-pret this result to indicate thatmutually interlocking directorshipsweaken the monitoring power thatthe board has over the chief execu-tive. Further, mutual interlocks con-tribute to the possible entrenchmentobjectives of the CEO. This result isin agreement with the notion thatboards are ineffective in controllingthe CEO, who is likely to control thenomination and selection process ofthe directors.

These results are consistent withother theories and research on CEOturnover. As previous studies havenoted, we found that CEOs are less

likely to leave officeif they own a largefraction of equity inthe firm or if com-pany performance is

strong. And we found that age ispositively associated with the proba-bility of CEO turnover. Firm size, asproxied by the natural log of thefirm assets, does not appear to playa role in the likelihood that the CEOleaves office.

ConclusionAcademics and the popular press

have suggested that corporateboards are ineffective in monitoringCEOs, since CEOs frequently domi-nate the director selection process.Boards filled with CEO-sympatheticdirector appointees are likely toovercompensate and undermonitorthe chief executive. Our view is thatthe mutually interlocking director-

ships that are prevalent among firmsare responsible for the production ofsympathetic directors. These direc-tors have the opportunity to pay andre-pay each other favors because oftheir multiple board membershipsand may well be doing so in leaguewith the CEOs who nominatedthem.

Our results indicate that thepower alliances created by directorswith multiple memberships are usedby self-serving CEOs to extracthandsome remuneration packagesfrom firms and to strengthen theirentrenchment. Boards that overcom-pensate and undermonitor the CEOare not fulfilling their fiduciaryduties to the shareholders. As aresult, board mutual interlocksweaken the firm’s governance struc-ture, promote cronyism, and exacer-bate the firm’s agency problems.

The results reported here indicatethat it is at least plausible thatmutual director interlocking rela-tionships between different corpo-rate boards might affect the votingpatterns and decisions that theseboards make on other mattersbesides CEO compensation andturnover.

Overall, our research suggeststhat inter-board relationshipsshould be more closely scrutinized todetermine whether these relation-ships encourage decisions thatenhance shareholder wealth orinstead facilitate empire building byself-serving CEOs. If, as we suspect,the latter is the case, then closermonitoring – private and/or public –of boards is needed.

ELIEZER M. FICH, Stern Ph.D. 2000, isvisiting assistant professor of finance atthe Kenan-Flager Business School at theUniversity of North Carolina.LAWRENCE J . WHITE is Arthur E.Imperatore professor of economics atNYU Stern.

This article is adapted from an articlethat appeared in the Fall 2003 WakeForest Law Review.

Sternbusiness 13

TABLE 3: PROBIT COEFFICIENT ESTIMATES: CEO TURNOVER

Estimate

-6.83

-0.98

0.72

0.09

0.01

-0.60

-0.30

3.35

0.04

-47.49

0.01

0.39

1.52

0.06

VariableEstimate

INTERCEPT

Mutual directorinterlock indicator

% of board directors whoare CEOs of other firms

CEO’s age (in years)

Option compensation/(salary + bonus)

Stock return net-of-market

Stock return net-of-market(lagged one year)

R&D expense/sales

Firm size (natural logof total assets)

% of equity held by CEOthrough direct stock ownership

Tenure as CEO (years)

Leverage (long termdebt/total assets)

Return on assets (ROA)

CEO is member of foundingfamily

Std. Error

1.531

0.512

0.891

0.024

0.054

0.364

0.351

2.374

0.102

26.806

0.016

0.705

1.788

0.498

p-value

0.0001

0.0548

0.4191

0.0001

0.8344

0.1000

0.3937

0.1587

0.6819

0.0764

0.3516

0.5824

0.3951

0.8972

“Interlocking directorships weakenthe monitoring power that the board

has over the chief executive.”

14 Sternbusiness

Entrepreneurs operat ing in America’s emerging markets — once-abandoned central c i t ies —

early 40 years after thepassage of the CivilRights Act, residentialand commercial segre-gation remain a fact of

life in America. Due to prevailinginstitutional, residential andsocial segregation, demographicgroups that are generally in theminority – African-Americans,Asian-Americans, Hispanics andimmigrants – predominate withinurban central cities. And yet inmany of those same areas, a major-ity of business owners are white.

White entrepreneurs in centralcities face the novel experience ofworking in a social context in whichthey are racial minorities, while atthe same time they are a part of thedominant coalition of firm ownersand are members of the majoritywithin the larger society.

Entrepreneurs in urban contextsfind that they must build relation-ships across racial and ethnic bound-aries. But “tokens” – numerical

sonally, they may also establish rela-tionships with other institutions orindividuals – “social brokers” – thatcan provide links to immigrant andethnic groups. Government agencies,non-profit and service organizations,religious institutions, and even cur-rent customers or employees canserve as social brokers, yet not beexplicitly dedicated to this practice.We set out to determine the role andsignificance of social brokers in help-ing white entrepreneurs in central-city locations forge cross-racial andcross-ethnic links with employeesand customers.

Then and NowIn his classic 1973 study of dis-

crimination in hiring, sociologistHoward Aldrich examined patternsof firm ownership in the pre-dominantly black neighborhoodsof Roxbury (Boston), Fillmore(Chicago) and Northern Washington,DC. The majority of the employers(55 percent) in these areas were

N

Sternbusiness 15

ILLU

STR

ATIO

NS

BY

TIM

OTH

Y C

OO

K

By Gregory B. Fairchild and Jeffrey A. Robinson

f ind that socia l brokers can bridge ethnic and racia l gaps. They can a lso help bui ld prof i ts .

minorities in organizations or con-texts dominated by the majority –face considerable challenges in doingso. That’s because cross-race rela-tionships, within and outside oforganizations, remain relativelyunusual. In his 1987 study of corediscussion networks, Harvard soci-ologist Peter Marsden found thatonly eight percent of Americansreported any racial or ethnic diversi-ty in their networks, with whiteAmericans having the greatesthomogeneity.

In the inner-city context, then,those with the least experience inforging cross-racial relationshipshave the greatest need to do so.White entrepreneurs in central citiesusually cannot leverage their per-sonal knowledge of co-ethnic cus-tomer tastes and appeal to boundedsolidarity to build protected mar-kets.

While these firm owners maychoose to focus on building cross-race, central city relationships per-

GOING FORBROKERS

white, and whites were minorities inthe residential population (rangingfrom 10 percent of the population inFillmore to 28 percent in Roxbury).Aldrich also found that 80 percentof the white firm owners were“absentee owners.” White firm own-ers were more likely to hire peoplewho lived outside of the neighbor-hood and were more likely to hirewhite employees than non-whitecentral city firm owners. Other stud-ies at the time found similar owner-ship patterns in other cities.

Do these conditions still persist?In 1970, when Aldrich’s data wascollected, each of the neighborhoodsstudied had only a decade earlierbeen predominantly white. Aldrichtied the pattern of white firm owner-ship to an inability of white firmowners to leave as rapidly as whiteresidents.

But the “white flight” context ofthe early 1970’s no longer exists incentral cities. White residents havelong been gone from these neighbor-hoods, and the absolute number ofbusinesses has declined significantly.So today’s central city firm ownersare more likely to be located thereby choice. A second difference is theconsiderable influx of non-whiteimmigrants from Asia, CentralAmerica and the Caribbean.Previous studies have shown thesegroups to have high incidence ofentrepreneurship.

To update Aldrich’s study, weanalyzed a subsection of employerrespondents from the Multi-CityStudy of Urban Inequality (MCSUI).This data was collected by

researchers in Atlanta, Boston,Detroit and Los Angeles between1992 and 1995 to examine labormarket dynamics, with a particularfocus on jobs requiring no more thana high school education. Table 1presents the incidence of white firmownership by metropolitan areasubsection, based on 510 respon-dents.

As found in studies from the1970s, the dominant coalition offirm owners are white (84.9 per-cent), and seven of every 10 firmowners in predominantly non-whitecentral city areas are white. The per-centage of white firm ownership incentral city areas is even greaterthan in studies from the early1970’s. Why? It has long beenargued that whites have greateraccess to critical capital stocks,making them better able to startfirms and to weather economichardships than their black andHispanic counterparts. Second,black central city neighborhoodshave been especially hard hit by theexit of the middle class, who hadoptions to move after segregationdeclined in the 1970’s.

We then analyzed responses offirm owners regarding the incidenceof white customers and employeesby city subsection. In central cityareas, where the majority of the res-idents are non-white, the white/non-white composition of the customerbase and employee base is evenlysplit (50.1 and 47.5 percent, respec-tively). However, there is consider-able variation across firms in termsof their customer and employee

demography. The standard devia-tion was 35.1 percent for white cus-tomers, and 40.5 percent for whiteemployees.

Hiring PatternsNext, we set out to determine the

influence of owner race on racialcomposition of the employmentbase. Because Aldrich found thatdifferences in firm type (e.g., retail,service or manufacturing) account-ed for some of the differences in hir-ing patterns, we controlled for sectorof employment in our analysis.

In line with the findings of stud-ies from a generation ago, we foundthat the race of the firm owner influ-ences hiring patterns, even whenadjusted for firm location andindustrial sector. White firm owner-ship increased the percentage ofwhite employees by an average of 40percent.

Aldrich generated four hypothe-ses regarding the possible role of dis-crimination in hiring patterns. First,white employers may simply preferassociating with whites over blacks.Second, white employers mightpractice statistical discrimination, inwhich negative beliefs about thework fitness of blacks cause employ-ers to prefer not to hire blackemployees. Third, white employersmight avoid hiring blacks because ofnegative reactions of other employ-ees or the firm’s customers. Fourth,white employees might be over-rep-resented because whites who workedin the firms prior to the wholesalewhite exodus from the neighborhoodhung on to their jobs in these neigh-borhoods. Aldrich was ultimatelyunable to determine whether dis-crimination accounted for the over-representation of white employees inwhite-owned firms located in blackneighborhoods.

Today, two of these hypothesesare less useful. The customers offirms in today’s central city areas are

16 Sternbusiness

GOING FOR BROKERS

Table 1: PERCENTAGE OF WHITE OWNERS BY FIRM LOCATION IN CITY SUBSECTION

All locations Central City Suburban Univariate F-locations and Other Statistic

locations

Mean % white owners 84.9 68.8 89.8 31.23**

** statistically significant at the .001 level

as likely to be white as non-white.And because white flight is nolonger a recent phenomenon – as itwas in the 1970s – there is a lowpotential that the current set ofwhite employees were unable to findwork elsewhere. The second hypoth-esis, that white employers havedeveloped a “distaste” for non-whitelabor, has been examined by otherresearchers. In interviews with whiteemployers in central city areas,employers expressed their tendencyto practice statistical discriminationwith black applicants because ofpast experiences with negativeworkplace attitudes and behaviors.Sociologist William Julius Wilson in1996 examined blackemployers from thesame neighborhood,and found that theyexpressed similarviews of the attitudesand work ethic ofcentral city blackemployees.

But employer distaste probablydoesn’t explain the differences inhiring patterns by race of ownerobserved above. Perhaps whiteemployers, like other tokens, facebarriers in establishing cross-racerelationships that might assist themin locating the most qualifiedemployees from the local pool oflabor. Given the generally low opin-ion employers appear to have ofcentral city labor, reference-basedhiring may be one of the primemeans of ensuring labor quality.

Weak TiesIn his classic 1973 study of per-

sonal contacts in job-seeking, sociol-ogist Mark Granovetter found thatthe overwhelming majority (83 per-cent) of managerial and professionaljob seekers found their jobs throughacquaintances with whom theyspoke occasionally or rarely. Thisfinding of the “strength of weak

ties” is one of the more influentialideas in the social sciences.

But Granovetter’s reanalysis ofStanley Milgram’s data on interra-cial acquaintance chains has beenless discussed. Granovetter reana-lyzed the success rate of whitesenders who attempted to deliver abooklet to black targets throughacquaintance chains, if the first con-nection between a white sender anda black recipient described the blackperson as a “friend” or an “acquain-tance.” Granovetter found that theweak tie instances – those where thefirst black connection was describedas an acquaintance – were twice aslikely to result in a successful com-

pletion to the eventual target. Weakacquaintance ties were more suc-cessful than strong friendship ties inreaching cross-race targets.

Given this, we hypothesize thatcross-race weak ties might alsoassist in the recruitment of employ-ees. And institutions or individualsthat bridge socially segregatedgroups are a form of weak tie rela-tionship that employers can use tomediate their token status.Connections through communityservice organizations, religious insti-tutions, civic leaders, and currentemployees might assist employers inlocating qualified minority employ-ees and result in larger numbers ofminority employees.

Using Social BrokersHiring proper employees is a crit-

ically important task for a firmowner. But when the employer iswhite and the employees are gener-

ally non-white, the hiring challengemay be especially difficult. A racial“outsider” may find it tough toaccurately screen an applicant dur-ing the hiring process and revealpotential behavioral or attitudinalmis-hires. Once employees arehired, white employers may worrythat negative on-the-job feedbackwill result in accusations of racialprejudice. Given the distrust, doubtand accusations that can sometimesaccompany cross-race interactionsin central cities, some entrepreneursmay choose to avoid central citylocations or minority employeesaltogether.

The MCSUI contained a series ofquestions regard-ing the methodsused by employersin hiring for theirlast employmentvacancy. The posi-tions were thosetha t d id no trequire the appli-

cant to hold a college degree. Weinvestigated the influence of hiringmethods that involved social brokerson minority hiring rates in centralcities. Table 2 presents the results ofthree linear regression analysesusing dummy variables to determinethe influence of the race of owner,city subsector, industry sector andhiring methods on the percentage ofnon-white employees in the firm.

The analysis of the full set offirms shows that manufacturingfirms are more likely to hire non-white employees. This is likely dueto the greater need for unskilledlabor in these firms. The first evi-dence of social brokerage is found inthe strong influence of employeerecommendations on the percentageof non-white employees. Both themagnitude of this coefficient and itshigh level of significance is persua-sive evidence of the use of this prac-tice among entrepreneurs. The use

Sternbusiness 17

“Given the distrust, doubt and accusations that can sometimes accompany cross-race

interactions in central cities, some entrepreneurs may choose to avoid central city

locations or minority employees altogether.”

of help wanted signs was also shownto increase the percentage of non-white employees. Help wanted signsare a strategy for employers seekingto attract employees that happen topass the firm location, and may be ameans to hire from the local com-munity without aid of brokerage.

Private-service temporary agen-cies appear to serve as brokers forfirms seeking to hire white employ-ees, while community agencies servefirms seeking non-white employees.These differences are likely generat-ed by the divergent customer needsthat each agency serves.

Even after controlling for citysubsection, industry and hiringmethod, the strongest influence onpercentage of non-white employeesis still the race of firm owner. Thissuggests that our analysis has failedto account for other factors influenc-ing the hiring choices of white own-ers, and that these results do notrule out preferences for homophily.

Help WantedSplitting the files by city subsec-

tion allowed us to compare the inci-dence of brokerage strategies byfirm location. We found that outsidecentral city areas, manufacturingfirms have a greater tendency to hirenon-white employees, and helpwanted signs increase the percent-age of non-white employees. Analternative perspective is thatemployers located in suburban areasare familiar with available locallabor (predominantly white), anduse help wanted signs as an “affir-mative action” strategy, designed toattract potential employees that arenot in their current social network.

Employers may find that non-white applicants that learn of theiropenings by passing their locationare more likely to be “acculturated”or familiar with the workplacebehaviors necessary to work in sub-urban contexts. The positive findingfor all firms appears to be driven by

the use of this brokerage strategy incentral cities. Outside of centralcities, employers utilize currentemployees as brokers for non-whiteemployees, though to a lesserdegree. Private-service temporaryagencies play a strong role in bring-ing white employees into firms.Finally, referrals from educationalinstitutions enhance non-white hir-ing outside central cities. It appearsthat for firm owners in these areas,educational institutions play a bro-kerage role in assisting in the hire ofnon-white employees.

Customer RelationsEntrepreneurs must also manage

another critical constituent groupon the demand-side of the equation:customers. Customers are not only afirm’s source of revenue, they are aprime means of attracting new cus-tomers through word-of-mouth. Butfor white entrepreneurs operating incentral city areas, building relation-ships with customers from the localcommunity may present many ofthe same challenges found in locat-ing employees. White firm ownersare less likely to be personallyfamiliar with community membersand are less likely to be personallyaware of emerging customer tastesand needs. Non-white customersmay resent the presence of whitefirm owners, and customer dissatis-factions may take on an accusatorytone generally not experienced incontexts where the customers arepredominantly white. There is a his-torical legacy of mistreatment ofminority customers in businessesowned by white proprietors. Whitecentral city entrepreneurs maytherefore attempt to use employeesas brokers to manage potentiallyfractious relations with a substan-tial base of non-white customers.

We set out to determine the influ-ence of customer demography on themakeup of a firm’s labor pool. Ifincreasing percentages of non-white

18 Sternbusiness

GOING FOR BROKERS

Table 2: MODEL RESULTS

Dependent Variable: mean % nonwhite employeesFull Sample Central City Suburbs

& Other(n=474) (n=164) (n=310)

Adj. R2 .250 .205 .224Std. Error of estimate .3286 .3496 .3169F 10.990 3.961 7.039Independent Variables:Constant .519 *** .638 *** .543 ***Central city location .093 **White firm owner -.435 *** -.380 *** -.490 ***Manufacturing firm a .082 * -.006 .124 *Service firm -.060 -.091 .045Used help wanted signs .082 + .019 .120 *Used newspaper ads -.031 -.127 * .023Accepted walk-in applicants .008 .016 .014Used employee referrals .152 *** .162 * .126 **Used state employment agencies .007 .067 -.024Used private-service temp agencies -.115 * -.096 -.135 *Used community agency referrals .115 * .162 + .046Used union referrals .109 .009 .023Used school referrals .021 .003 .370 *a dummy variables for manufacturing and service firms, retail firms are the base

+ p<.10 * p<.05 ** p<.01 *** p<.001

customers positively influences thepercentage of non-white employees,it would suggest that employers useemployees as social brokers to man-age relationships with customers. Toinvestigate, we ran a linear regres-sion analysis of race of firm owner,industry sector, firm location, andpercentage of non-white customerson the mean percentage of non-white employees.

The results of this analysis areconsistent with the hypothesis thatcustomer demography explainssome of the variance in employeedemography even after controllingfor race of firm owner. Subsequentanalyses of these influences by firmlocation showed the same pattern ofresults throughout. However, themagnitude changes of coefficientsprovided some interesting findings.First, when compared with the prioranalysis of employer race influenceon employee demography, the coef-ficient for white firm ownersdecreased when the predictor vari-able for customer demography wasentered. Some of the varianceexplained by employer race in theearlier analysis is now shown toresult from customer demography.Second, white customers have a pos-itive influence on the number ofwhite employees in all locations,although the relationship becamestronger in suburban areas. Third,white firm owners have an evengreater positive influence on the per-centage of white employees in cen-tral city areas. This suggests one oftwo alternative hypotheses: a) whitefirm owners in central city locationshave an even greater preference forwhite employees than in suburbanareas; b) white firm owners faceeven greater challenges in locatingnon-white labor in central cityareas. Given our theoretical framingof white firm owners as tokens wesuspect the latter.

Emerging MarketsTaken together, our findings sug-

gest that relationships play a criticalrole in job seeking, especially whenoperating cross-racially. And under-standing this dynamic is becomingmore important. For over the pastseveral decades, patterns of socialand racial segregation have createdstructural holes, which in turn havecreated economic opportunities incentral cities – America’s emergingdomestic markets.

Entrepreneurs of all races andethnicities are figuring out how tobuild wealth while providing jobsand leadership that diminish manyof the social problems we’ve come toassociate with inner city communi-ties. In May 2003, Inc. magazinereleased its annual list of the mostrapidly growing inner-city firms.The characteristics of the membersof the Inner City 100 may seem sur-prising: average sales of over $25million, and five-year growth ratesover 600 percent.

Social brokers will play animportant role in developing thesemarkets further. America’s inner-city neighborhoods will increas-ingly show promise as sites forinvestment, and many of theentrepreneurs pursuing theseopportunities will not be ethnicand racial minorities. On Inc.’slist, 62 percent of the firm ownerswere white. Locating high qualityemployees in a cross race situationrequires the recognition that rela-tionships matter and that relation-ships tend to stay within the samerace. Without building social bro-kerage relationships, employers runthe risk of missing the most quali-fied members of the labor pool.

GREGORY B. FAIRCHILD is assistantprofessor of management at DardenGraduate School of BusinessAdministration at the University ofVirginiaJEFFREY A. ROBINSON is assistantprofessor of management at NYU Stern.

Sternbusiness 19

20 Sternbusiness

On October 8, it was announced that Robert Engle, Michael Armellino

Professor of Finance at NYU Stern, was awarded the Nobel Prize in

Economics along with Clive Granger, his longtime colleague at the

University of California at San Diego. Engle, 60, a Stern professor since

2000 and a pioneer in the field of econometrics, was cited for the develop-

ment of Autoregressive Conditional Heteroskedasticity (ARCH), a method

that allows researchers and analysts to measure volatil ity over time. On

November 4, Stern faculty, staff, and students, led by Dean Thomas Cooley

and William Greene, former chairman of the department of economics,

gathered at the Henry Kaufman Management Center for a town hall meet-

ing to honor Professor Engle and discuss his work.

Sternbusiness 21

Dean Thomas Cooley: It's a good thing when good things

happen to deserving people, and when your friends and col-

leagues get recognized for their accomplishments. We are just

overjoyed at the great news that we all got this fall.

Bill Greene: I'm going to throw Rob some easy questions and

then I'll turn this over to the audience to follow up. So let me begin

with the easiest ones of all. Can you tell us a bit about yourself and

where you come from?

Robert Engle: I grew up in

Philadelphia. And I was an East Coaster

for many, many years. My Ph.D. is from

Cornell, where I went to study physics

and then changed my mind. I actually

taught at the Massachusetts Institute of Technology when Tom

[Cooley] and I knew each other. And then in the mid-1970s, I went

to the University of California at San Diego, and spent 25 years

there. I came back east to Stern in 2000.

Greene: Why economics and not physics?

Engle: Well, when I got to graduate school, I joined the laborato-

ry studying superconductivity. It was in the basement of the

physics building, and the only people you ever saw were a few

other graduate students. I just decided I wanted to do something

that had a little wider relevance. And I wanted to switch into a field

that used some of the same ways of thinking that physics does.

That's one of the reasons I switched to economics – and particu-

larly why I became an econometrician. The best physics, of

course, has both empirical work and theory. And I think econo-

metrics provides exactly that intersection for economics.

Greene: So where were you when you got the call?

Engle: Well, you probably noticed that I haven't been here this

fall. That's because I’ve been on sabbatical in France, in a town

called Annecy in the French Alps. I had just been out to lunch with

my wife, when I went out to do an errand and she came back to

the apartment and got the phone call. The woman on the other end

said, "Tell him that this is a very important call from Stockholm."

And when the phone call came in again, the connection was not

clear. The head of the Nobel committee has a relatively thick

Swedish accent. Eventually I came up with the inference that yes,

it was indeed that I had won the Nobel Prize. And I won it with my

long-time colleague, Clive Granger from San Diego.

The head of the committee said, "Your life will not be the same

again; the press will be all over you." So when we hung up, we

looked at each other. And here we are in this little medieval town

in France. First of all, how did anybody ever find that phone num-

ber? But second of all, is the press really going to find us? Some

of the press found us, but not too much. But mostly it was phones

ringing in our home, in my office, and a lot of e-mails. I must have

received hundreds of e-mails that day.

Greene: The New York Times had an article a few days ago, in

which they described econometrics as a

rarefied field. But seven Nobel Prizes

have been given to econometrics. Why

do you think they have such an interest

in this field?

Engle: Econometrics is the tool. And in

some ways, at its best, it is really what economics is about. I think

it is a way of trying to make sense out of the world around us. The

world around us is the data. And an econometrician is a person

that looks at the data.

Greene: Well, let's turn to your work. What is the contribution that

you made that got the prize committee's attention?

Engle: The prize citation says it is for “models of time varying

volatility, parentheses ARCH.” Now they didn't tell you what ARCH

stands for. I will, but only if you promise not to be put off by what

it really stands for. It stands for Autoregressive Conditional

Heteroskedasticity. If you take my class, I'll teach you how to say

that, but other than that, it's just ARCH. It’s a way of trying to

model, describe and forecast this thing we call volatility. In finan-

cial markets, we're so interested in the volatility of asset prices.

Because when stock prices wiggle around, your portfolio can go

up or down. And volatility is an important consideration as to what

we can expect as you go forward in our portfolio. So the prize was

for developing new methods for analyzing volatilities, which

change over time. And the applications are pretty widespread.

Greene: And this work began when you were in the U.K., study-

ing inflation. How did you make this transition to financial markets?

Engle: Well, I was trying to solve a macroeconomics problem

when I came up with the ARCH model. I was living in London as a

visitor at the London School of Economics. And every day, I'd go

to lunch with David Hendry and Jim Durbin and Dennis Sargan,

and all these famous econometricians. And we talked about these

models. But what I really wanted to address was the following

question: Is the uncertainty in inflation an important determinant of

business cycles? Milton Friedman had argued that it was. So I

wanted a method that would look at the volatility of inflation.

22 Sternbusiness

NOBEL PURSUIT

“[Econometrics] is a wayof trying to make sense of

the world around us.”

But the method we developed didn't really work very well in

macroeconomics. It didn't explain things like business cycles or

consumer spending very well. So it was considerably later that the

finance applications really surfaced. In finance, we study how

much risk you’re taking and what you’re getting for it, the tradeoff

between risk and return. And this is a way of scientifically meas-

uring the risk part of this equation.

Greene: How do researchers use these techniques?

Engle: Well, in a lot of different ways. When you try to calculate

what can go wrong with a financial portfolio, or how you can diver-

sify to reduce risk, you can look at the volatility. So one direction

is how you can form optimal portfolios. And once you have evi-

dence about how volatilities are changing over time, some

dynamic portfolio strategies that make sense may emerge.

Another important application is in measuring what's called value

at risk, which is how much your portfolio might go down in the next

day. A third application, which is quite closely related, is the pric-

ing of derivatives and options. Options can function like insurance

contracts to protect against declines in your portfolio. But what is

the fair price for this kind of insurance? And the answer, of course,

depends on how volatile your portfolio is.

Greene: Can individual investors use these techniques?

Engle: Institutional investors do this every day. Institutional

investors calculate the value at risk, not only of the company as a

whole, but of their fixed income portfolio, and of their Japan port-

folio, and of their yield portfolio. So there is a very scientific

approach to calculating risk in an investment bank. But individual

investors do not very often build ARCH models. I would think it

would make a lot of sense, when you have a brokerage account

at Merrill Lynch or Charles Schwab, to be able to use their stan-

dard software and calculate the value at risk every day. The indi-

vidual investor could really look at that. It would help them realize

whether the market is getting more volatile and whether they

might want to shed some risk, just like an institutional investor.

Greene: What are you working on now? What's next?

Engle: Well, there are two directions that these models are going

that I'm very interested in. First, instead of just talking about

volatilities of one asset at a time, or one portfolio at a time, I’m

interested in looking at many assets at once. The multivariate

extension of this has been a problem for many years. There’s no

widely accepted multivariate model. But I have a candidate. I gave

a lecture series on this at Erasmus University last summer, and

I'm writing a book about it for Princeton University Press.

The other direction is to use higher and higher frequency data. We

Sternbusiness 23

NYU Stern Professor Robert Engleaccepted the Nobel Prize inEconomics from His Majesty, King Carl XVI Gustaf of Sweden onDecember 10, 2003 in Stockholm.

24 Sternbusiness

often look at these models once a day or once a month. But

really, every time there is another transaction or another price

quoted, you could update your volatility model. And that has lots of

implications for trading.

Audience Questions:

Question: Clearly inputs to the Black-Scholes options pricing

model assume that volatility is constant. How does ARCH and

ARCH models alter that or update that

model?

Engle: Right, well, that's absolutely

right. The Black-Scholes model is

based on the assumption that volatility

is constant. And yet practitioners, of

course, know it's not. So Wall Street has figured out a solution.

They talk about implied volatilities, and watch how they change.

So a simple answer is that over time, you would keep updating

your ARCH model and forecast what the volatility would be. And

you could use that as an input to the Black-Scholes formula. More

sophisticated methods would chang the formula.

Question: Do you think that the extension of your model will

finally apply to macroeconomic data?

Engle: I didn't mean to say that it didn't apply to macroeconomic

data now. When you apply these models to macroeconomic data,

you get an interesting interpretation. It turns out that the way you

think about it is that if you're going to make macroeconomic fore-

casts, just like you forecast the stock price, there’s going to be

some uncertainty surrounding it. That's what we call the uncer-

tainty, or the volatility. When you forecast a macroeconomic

variable, like Gross National Product, or something like that,

we've got a confidence band around that. We've got some

measure of uncertainty. And the ARCH model is a way of

measuring that uncertainty.

What we've learned is that by any reasonable way of looking at it,

macroeconomic uncertainty seems to be going down all the time.

The macroeconomic aggregates

seem to be more predictable than they

used to be. And so it's sort of like

we've got better and better measure-

ment tools for seeing these things.

That's not the case in finance. And if

you did this as a multivariate problem

in macroeconomics, I'm sure you'd see the same sort of thing. But

you would also see correlations between errors that you make in

forecasting inflation, and errors that you make in forecasting

unemployment.

Question: When you came up with the ARCH concept in 1980

or so, did you ever think it would lead eventually to this?

Engle: When I discovered this ARCH concept, I did think it was

a good idea. But it wasn't that easy to get it published. I had to do

a lot of revisions and arm wrestling with the journals. But I had no

idea that it would be this good an idea. What made it turn out to

be an idea that had such mileage in it? I think it was the applica-

tions that I didn't think about – the applications in finance.

NOBEL PURSUIT

“By any reasonable way oflooking at it, macroeconomicvolatility seems to be going

down all the time.”

Professor Engle discusses his researchwith Stern students ata Town Hall meetingon November 4, 2003.

models are pretty esoteric models in statistics. And he had pro-

posed this test. And he said, "See, I'll show you it works." Square

your residuals and fit this autoregression. So I squared the resid-

uals of this little model, fit the autoregression, and it was very sig-

nificant. And I thought, "Oh, my goodness, isn't that amazing. This

really works on real data."

But in the back of my mind, I thought even at the time, I don't think

this test is a test for a bilinear model. What is this test really a test

for? And so when you know what the data looks like and you know

what the test is, you can sometimes reverse engineer it and ask

what model this test is good for. And that was the third piece. When

those three pieces came together, that was the ARCH model.

Question: Can you tell us about what brought you to NYU?

Engle: Yes. This

evolution in my inter-

est from macroeco-

nomics to finance

meant that I was con-

tinually working in

areas where I didn't

really have col-

leagues, and where I

was pretty far away

from financial mar-

kets. So I was actual-

ly very anxious to

have the kinds of

excellent colleagues

that I have here.

Stern has a great

finance department and the faculty is interested in all sorts of

areas of finance, many of which I didn't know very much about.

And so when you think about what I said the applications are –

risk management, derivatives pricing, asset allocation – there are

experts in all those areas in the department. So it was a great con-

nection for me to come here. The first time I came to Stern was as

a visiting professor for a semester, and then I went back to San

Diego. And then I decided to come permanently.

When you're studying financial markets, you can't do any better

than to be in New York. They're all around here. One of the great

things is teaching MBA students who have this great expertise in

whatever their job training was. And it's fascinating to teach

people who know the innermost details of some of these markets.

That wasn’t the case in San Diego. So it's been a lot of fun for me

being here. �

Sternbusiness 25

There was a paper published in '87 by French, Schwert and

Stambaugh, which applied these methods and some alternative

methods to financial data with lots of implications. This was pub-

lished in the finance community. And all of a sudden, there was a

whole lot of new interest in this model. I can't say that I had any

idea that it would have this kind of audience, because I didn't real-

ly recognize that finance was a natural place for it. So I guess I was

just lucky.

Question: Can you talk a little bit about the time you came up

with ARCH? What was the process like just before the model

cohered?

Engle: Yeah, I'd like to do that, actually, because it's sort of fun to

try to reconstruct. I think there were three inputs to this model that

were really important. One was I was interested in this macroeco-

nomic problem. I was concerned

about rational expectations and

all these kinds of things. And I

thought maybe uncertainty

was the missing item that

would make the macro

models work. I knew

what I wanted the model to

do, but I didn't know how to

do it.

The second input was I had been

doing a lot of work on a way of

writing probability density func-

tion of a variable, in terms of its

past. If we’re talking about ran-

dom events, what’s the distri-

bution of the random outcomes

tomorrow, conditional on what we know today? And this turns out

to be a very powerful way of thinking about dynamic processes.

Whenever you're trying to forecast something, one of the hard

parts is figuring out where you are today. So a conditional forecast

is a really important thing. And so this is an idea that had made a

lot of progress in macroeconomic forecasting, when the big mod-

els had been beaten by simple time series models, because they

took better account of the conditional forecasts.

Then there was a third input. Before I left San Diego, I was doing

something on the computer, and Clive Granger came into my

office, and he said that he was interested in a new test statistic,

which was to square the residuals from some kind of a regression

model, and look at the auto correlation of these square residuals. And

he had proposed this as a test statistic for a bilinear model. Bilinear

Robert Engle......1942 Born in Syracuse, N.Y.

1964 Graduates Williams College, physics major.

1966 Masters in physics, Cornell University.

1969 Ph.D. in Economics, Cornell University.

1969 Joins Massachusetts Institute of

Technology economics department.

1975 Moves to University of California at San Diego.

1982 Published first major article on ARCH.

2000 Joins NYU Stern.

2003 Shares Nobel Prize in Economics with Clive Granger.

Vijay Vaitheeswaran: The question we're here to talk about,

corporate social responsibility, cuts to the heart of some of the big

ethical questions of our day. What are the limits of corporate

responsibility? Is a corporation a moral actor?

Mindy Luber: What encompasses corporate responsibility?

To some, it’s worker rights and worker safety. To others, it's peo-

ple in the community. To others, it's the environment. Today, I

want to consider the issue of climate change. It is essentially a

business issue that we cannot continue to ignore. I would go

so far as to say that we are in breach of our fiduciary duty as

business leaders if we are not looking at an issue that has

multi-billion dollar implications. The key to the long-term health

and prosperity of any company and of the planet will depend on

the integration of sustainability issues into the core strategy of a

company. Climate change is a significant threat to the world's

economies. And responsible corporate behavior on climate

change builds shareholder value.

Bruce Buchanan: My mission here is to talk about how we

define corporate social responsibility in the classroom. Adam

Smith said, “By pursuing his own self-interest, he frequently pro-

motes that of society more effectually than when he really intends

to promote it.” Private selfishness equals public virtue. When it

comes to social responsibility, if the market works perfectly, there

is no need for social responsibility. We come into issues of social

responsibility when we have market imperfections, for example

pollution not being properly priced.

Political rights in our country are things like the right to a clean envi-

ronment, as enforced by the EPA, or the right to reasonably safe

products as enforced by products liability law. If someone has a

right, we all must respect that right and the political entity must

enforce it. But there is a distinction between a political right that's

enforced, and a more vague human right that is not. And it's in

human rights, where the corporation is operating without a strong

context of law and government around it, that corporate responsi-

bility is most called for. A company has a duty to not pollute the envi-

ronment in the U.S., and if it does pollute the environment, it will be

fined. What if that company is operating in a country without that

kind of law?

Paul Tebo: At DuPont, we don't use the words "corporate social

responsibility". We use the words "sustainable growth." Both con-

cepts talk about economics, environment, and social responsibility.

Many years ago, President Jimmy Carter was interested in elimi-

nating Guinea Worm Disease in Africa, which at the time either

severely affected or killed 3.5 million people. The worm gets into the

water system. He asked DuPont if we would create some nylon that

could be made into fabric that you could take into the remote places

in Africa and filter the water. And today there are less than 70,000

cases of the disease. Is that corporate social responsibility, or sus-

tainable growth? This gives me more of a feel of corporate social

responsibility. We made lots of money on nylon, but this was basi-

cally something that we decided to donate.

Compare that to a product called Tyvek. Today, we can take 25 per-

26 Sternbusiness

RESPONSIBLE PARTIESNYU Stern has long been committed to exploring the connection between business practices and issuesrelating to the environment and social welfare. In October 2003, as part of a joint venture with Resourcesfor the Future, a Washington-based think tank devoted to environmental, energy, and natural resourcesissues, NYU Stern convened a lively panel discussion that explored a range of topics centering on thetheme of corporate responsibility. The panel included: Bruce Buchanan, the C.W. Nichols Professor ofBusiness Ethics at NYU Stern; Mindy Luber, executive director of the Coalition for EnvironmentallyResponsible Economies (CERE); Paul Portney, president of Resources for the Future; and Dr. Paul Tebo,vice-president of health, safety and environment at DuPont Corp. It was moderated by Vijay Vaitheeswaran,the global environment and energy correspondent for The Economist.

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cent of the material to make Tyvek from waste milk jugs, water jugs,

things that are thrown away. We got 100 percent of the U.S. Postal

Service’s business at a price premium, because they like the recy-

cled content. Next we found you could wrap houses in Tyvek. Turns

out for every unit of energy put into making Tyvek, the average

homeowner saves 1000 units of energy in the normal lifetime of a

house. Tyvek is also used to protect people. A lot of Tyvek garments

came to Ground Zero here in New York City. We sent Tyvek gar-

ments to China to help eliminate SARS, so it's got a very strong

social responsibility component.

At DuPont, we also have a goal of

zero for injury, illnesses, incidence,

waste and emissions. Our global air

carcinogens are down 92 percent

over the last decade; global air tox-

ins are down 75 percent. In the early 90s, we set an energy goal

and we ended up keeping energy flat during the decade of the 90s,

while we grew 30 percent. That goal saved us about two billion dol-

lars in energy costs. Working on energy and keeping it flat while you

grow is a terrifically good strategy.

Paul Portney: If corporate social responsibility is to mean any-

thing, it has to mean the practice of companies going above and

beyond what they're required to do by law and regulation in areas

such as the environment, worker safety, and even on social issues.

I don't see a company as particularly responsible if what it does is

obey all of the applicable laws and regulations, anymore than I think

I deserve an award or feel that I'm a socially responsible person if I

pay my income taxes and don't drive faster than the speed limit.

I am troubled by the notion of corporate social responsibility

because it carries with it the unstated implication that the normal

activities in which corporations are engaged are somehow not use-

ful or perhaps even not responsible. And yet, I want to remind

everybody what happens in the normal process of corporate busi-

ness. First, in the United States today, corporate employment is

somewhere in the range of 70 to 80 million people. These people28 Sternbusiness

RESPONSIBLE PARTIES

are provided viable incomes and enjoy the benefits

of health coverage as a condition of their employ-

ment. Second, through their issuance of corporate

debt, corporations provide an outlet for savings, and

thus encourage our thrift. Finally, through the equity

markets, corporations reward risk taking. These are

all very responsible activities.

I believe we hear so much about corporate social responsibility

because we in society are reluctant to tax ourselves to support activ-

ities that are the legitimate domain of the public sector. All we've

done is move those costs around either to the customers, to the

employees, who will earn less than they would have otherwise, or to

the shareholders – instead of to the people that would pay the taxes

if these were public sector expenditures.

Vaitheeswaran: What is the dif-

ference in cost between cutting the

first 50 percent of a pollutant and

the last five percent of a pollutant?

Is zero pollutants the right target

for society or for a company?

Portney: It may make sense to reduce some things to zero, if

it's trivially inexpensive to make that final reduction. I guess my

economics training makes me suspect that in very few cases

could you justify going all the way to zero, because the more you

reduce the pollutant or the more you try to conserve the

resources that you use, the more difficult it becomes to reduce

pollution further. And the more you push these activities, the

more expensive each subsequent reduction in emissions

becomes.

Tebo: Making things go to zero is very, very important. Waste is a

defect in your process, it's a basic cost problem.

Luber: I think we could come to a reasonable agreement on emis-

sions, for example. Zero emission vehicles are not necessarily the

answer. But smart vehicles with slightly better vehicle mileage per

gallon is what I think we need as a society. They would create less

greenhouse gases, less air pollutants. But we've got to have an

economic system where it makes sense from a business perspec-

tive, not only from a corporate and environmental and social per-

spective, to build vehicles that are more environmentally efficient.

“When it comes to social responsibility, if the market works

perfectly, there is no need for social responsibility.”

ble parties and still meet all the other myriad stakeholder

demands?

Luber: Limits are legitimate. There are all sorts of people with all

kinds of demands. What we want to see at the end of the day is a

decrease in carbon emissions, because otherwise, we can't sustain

our planet, and there will be negative financial implications for our

economy, and for every industry. What we need to do is stop the

battling and come up with some realistic plans. Some regulation is

coming. Some number of utility executives said “Let's just get it

done now so we eliminate the risk.”

Eventually it's about us collectively

educating Wall Street.

Audience question: What is the

role of consumer responsibility in this

equation?

Tebo: American consumers, in my opinion, have shown no inter-

est in the environment, period. They drive huge cars with ‘Save the

Polar Bear’ plates. I'm a firm believer that you can't depend on the

consumer to make changes.

Portney: I actually like the idea of involving consumers more. If

consumers know where their energy is coming from, and if they

have a strong preference for green electricity then they're going to

put pressure on American Electric Power by buying electricity from

its competitors. I think the information provision and consumer

action should be a big part of the arsenal that we use for environ-

mental improvement.

Audience question: Is there something different in the model in

Europe that leads to a greater interest in talking about climate

change and global warming and corporate responsibility?

Luber: Europe is way ahead of us on almost everything, thanks

to the European reinsurers. They added up the numbers and they

said, the risk from climate change, if companies don't act, is in the

hundreds of billions of dollars. Also their use of smaller cars is about

a certain psychology and philosophy that has existed for decades.

What is it going to take here? Leadership is about making sure that

we don't see thousands of cases of asthma going up in every city

because of more pollution and more particulate matter, because

somebody didn't want to put scrubbers on their plants. �

There is no logic in the fact that we ought to be making more

Hummers, rather than making more hybrids.

Audience question: Should companies block or encourage

legislation that would benefit the society but hurt their bottom line?

Portney: We ought to be institutions that don't have an ax to grind

on either side of an issue, but try to do independent analysis and

share it with everybody, so that there is factual and high quality

analysis.

Tebo: I want to talk about leadership.

We waste so much energy in this

country, it's awful. We need an energy

goal. In my mind, that goal is not go

find more energy, but to use the ener-

gy we have more effectively. By 2025,

we should be completely independent

of foreign sources of energy. And by the way, I would not suggest we

go find more oil to do it.

Portney: My goal is that we price things correctly. The price of ener-

gy should reflect the full cost of production, not just the cost of explor-

ing for it and getting it to the United States and refining it, and selling

it in gas stations, but also the environmental cost, difficult though it

may be to estimate, and of import dependence from foreign countries.

Vaitheeswaran: Are you putting yourself at a competitive disad-

vantage by using clean processes?

Tebo: Most of our older factories are here in the U.S. And so as we

go overseas, we can design almost at zero waste and emissions

from the beginning. Most of our better operations tend to be outside

the U.S. We built a facility outside of Shanghai and chose to put a

waste treatment plant in when it wasn't required. The government

looked at the other companies around and said they need to put

waste treatment plants in also. The real problem is in the U.S. A lot

of the facilities here are old. It's much more expensive when you put

it on at the end, than if you figure out a way not to have it in the

beginning.

Audience question: The thing we struggle with the most in this

somewhat baffling world of corporate social responsibility is how do

we balance competing interests? How can we be socially responsi-

“American consumers, in my opinion, have shown no interest

in the environment, period. They drive huge cars with

‘Save the Polar Bear’ plates.”

Panelists for the Resources for the Future event from the left: Dr. Paul Tebo, Vice President of Health, Safety and Environment at DuPont Corp.; Paul Portney,President of Resources for the Future; Mindy Luber, Executive Director of theCoalition for Environmentally Responsible Economics (CERE); Vijay Vaitheeswaran,the Global Environment and Energy Correspondent for The Economist; and BruceBuchanan, the C.W. Nichols Professor of Business Ethics at NYU Stern.

Sternbusiness 29

Management gurus and chief executive officers devote lots ofrhetoric and resources to espousing the virtues ofcommunication. But at too many corporations, employeevoices remain stifled amid a climate that discourages the openexchange of views. Turning up the volume, and unleashing thediversity of thoughts and experiences that can contribute toperformance, may require radical change of hearts and minds.

30 Sternbusiness

magine an organizationwhere the CEO has noclothes. The CEO’s lack ofclothes is apparent to allwho set eyes upon him. Yetemployees don’t say a word.

Some employees even complimentand praise the CEO’s attire. TheCEO takes pride and comfort in thefact that subordinates recognize hisfine taste in clothing, and easily dis-misses the few trouble-makers whoeye him strangely in the elevator.

And yet these employees are notblind. Behind the safety of closeddoors and in veiled whispers, theytalk of their leader’s lack of clothing.They all clearly know that the CEOis not wearing clothes but only thefoolish or naïve dare to speak of it inpublic.

While seemingly fanciful, ourmock fairy tale captures an impor-tant phenomenon of organizationallife, – namely that, in many organi-zations, employees know the truth

about certain issues and problemsfacing the organization yet they donot dare to speak that truth to theirsuperiors. Employees tend to believethat they would face negative reper-cussions for speaking up, and thatspeaking up would not make a dif-ference. An Industry Week survey of845 line managers from diverse

organizations found that only 29percent of first-level supervisorsthought that their organizationencouraged employees to expressopinions openly. In our own inter-views with working MBA students,we have found that most (85 per-cent) have been in situations where

they have felt unable to speak upabout a concern at work, and thatmany feel this way frequently intheir organizations.

This phenomenon – which wedub “organizational silence” – is apotentially dangerous impedimentto organizational learning andchange. It can hamper the develop-ment of truly pluralistic organiza-tions – ones that value and allow forthe expression of multiple perspec-tives and opinions. But to date,there has been little systematic aca-demic exploration of why “organi-zational silence” is pervasive, or ofthe consequences of widespreadsilence – even in an era in whichmanagement universally extols thevirtues of greater communication.In our recent work, we have soughtto understand both the conse-quences and the causes of silence inorganizations, especially when thatsilence is widespread.

Sternbusiness 31

By Elizabeth Wolfe Morrison and Frances J. Milliken

SOUNDS OF SILENCE

I“There has been little sys-tematic academic explo-

ration of why ‘organizationalsilence’ is pervasive. . .even in an era in which

managements universallyextol the virtues of greater

communication.”

ILLU

STR

ATIO

NS

BY

KE

N O

RV

IDA

S

32 Sternbusiness

Implications of SilenceFigure 1 provides an overview of

the effects of silence. Extensive research on group deci-

sion making has shown that decisionquality is enhanced when multipleperspectives and alternatives are con-sidered. Further, it has been arguedthat innovation requires a contextwhere employees feel free to deviate –to offer totally novel perspectives orideas or to question current beliefsand practices. Together, these researchstreams suggest that organizationalsilence will compromise the effective-ness of organizational decision-mak-ing and learning by restricting thevariance in informational input avail-able to decision makers. In addition,without dissenting viewpoints, there isless likely to be the type of criticalanalysis necessary for effective deci-sion-making, which may similarlyundermine organizational learning.

Organizational silence is also likelyto compromise effective organization-al learning and development by block-ing negative feedback, or informationthat suggests that current practices arenot working as intended. Without neg-ative feedback, errors tend to persist

and may even magnify. To make mat-ters worse, top management may notrecognize that they lack importantinformation, and may interpret silenceas signaling consensus and success.Even if management directly asksemployees for feedback, employeesmay be careful to filter out negativeinformation.

Effects on EmployeesIndividuals have a strong need for

control over their immediate environ-ment and over decisions that affectthem. Being able to express opinionsand concerns gives people a sense ofcontrol, and feeling that one is unableto express opinions and concernsmakes people feel that they lack con-trol. And a perceived lack of controlhas several detrimental effects,including reduced motivation, physi-cal and psychological withdrawal,turnover, and even sabotage. Thus,when employees feel that they cannotspeak up about problems or concerns,there can be serious negative effectson morale and performance.

Organizational silence is also likelyto give rise to cognitive dissonance, anaversive state that arises when there is

a discrepancy between one’s beliefsand one’s behavior. Consider a sales-person who is confronted daily withevidence that customers are not satis-fied with a product, but feels unableto raise this information to his superi-ors without repercussions. In casessuch as this, the individual may existin a state of prolonged dissonance –knowing that there is a problem butacting as if there is not. This disso-nance can create high levels of anxi-ety and stress, both of which canundermine performance and con-tribute to turnover.

The above dynamics are particu-larly troubling because they may dis-proportionately affect those who dif-fer from the majority. Not only willsuch employees feel greater pressureto remain silent (because they aremore likely to see the world different-ly), but they may be more likely toexperience the negative effects ofsilence.

Origins of Silence To investigate the origins of orga-

nizational silence, our objective wasnot to explain why a particularemployee will choose to speak up or

SOUNDS OF SILENCE

F I G U R E 1 E F F E C T S O F O R G A N I Z AT I O N A L S I L E N C E

Lack of critical analysis of ideas and alternatives

Lack of variance ininformational input Less effective

organizationaldecision making

Poor error detection

and correction

Less effective organizational

learning

Low internal motivation Withdrawal

TurnoverSabotage

Anxiety & Stress

Lack of negativeinternal feedback

Employees’ perceived

lack of control

Employees’ cognitive

dissonance

OrganizationalSilence

Sternbusiness 33

not to speak up, but rather, to explainwhy the dominant response withinmany organizations may be foremployees (en masse) to remain silentabout important issues or problemsthey encounter on the job.

Figure 2 provides an overview ofsome of the managerial and organi-zational conditions that we believeare likely to promote silence inorganizations.

Fundamentally, we believe thatorganizational silence owes its originsto two major factors. The first is topmanagers’ fear of receiving negativefeedback, especially from subordi-nates. People often feel threatened bynegative feedback, and as a result, tryto avoid it. As well, when they doreceive negative feedback, they oftentry to ignore the message, dismiss it asinaccurate, or attack the credibility ofthe source. Because managers mayfeel a particularly strong need to avoidembarrassment, and feelings of vul-nerability or incompetence, they maytend to avoid information that sug-gests weakness or errors, or that chal-lenges current courses of action. Andit has been shown that when negativefeedback comes from below rather

than from above – from subordinatesrather than bosses – it is seen as lessaccurate and legitimate, and as morethreatening to one’s power and credi-bility. Thus, a fear of, or resistance to,“bad news” or negative feedback canset into motion a set of organizationalstructures and practices that impedethe upward communication of infor-mation.

A second important factor that webelieve to be at the root of organiza-tional silence is a set of unstatedbeliefs that managers often implicitlyhold about employees and about thenature of management. One suchbelief is that employees are self-inter-ested and untrustworthy. Recentworks have emphasized that an eco-nomic paradigm currently dominatesthe thinking of many managers. Thisparadigm assumes that individualsare self-interested and effort-averseand can be expected to act in ways tomaximize their individual utilitiesrather than the organization’s per-formance. A related belief is that topmanagement, not those below, alwaysknows best about issues of organiza-tional importance. A third erroneousbelief that tends to be held by man-

agers in organizations characterizedby silence is that unity, agreementand consensus are signs of organiza-tional health, while disagreement anddissent should be avoided.

Fears and SilenceThese managerial fears and beliefs

can contribute to silence in manyways. If the unstated belief among topmanagement is that employees areopportunistic and not knowledgeableabout what’s best for the organiza-tion, then they will tend to excludethem from decision-making processesand not solicit much employee feed-back. Procedures such as systematicsurveying or polling will be rarebecause there will be a tendency tobelieve that little of value will belearned from them, and because neg-ative upward feedback would be seenas a challenge to management’s con-trol. Excluding employees from deci-sion-making processes and not askingfor feedback is also a way to avoiddissent and “bad news.”

Managers also tend to enact theirimplicit beliefs and their fear of feed-back in their day-to-day behaviortoward employees. For example, if

F I G U R E 2 D Y N A M I C S G I V I N G R I S E T O O R G A N I Z AT I O N A L S I L E N C E

Top ManagementTeam Characteristics• Stable membership• Demographic

dissimilarity fromlower level employees

• High power distance

Implicit Managerial Beliefs• High Belief that employees are self interested• High Belief that management knows best• High Belief that unity is good and dissent is bad

Managers’ Fear OfNegative Feedback

Organizational andEnvironmental Characteristics• Low-cost strategy• Low-resource environment• Vertical differentiation• External hiring of senior mgrs.

Organizational Structures& Policies• Centralization of decision

making• Lack of formal upward

feedback mechanismsClimate ofSilence:Shared beliefthat speaking upis dangerousand/or futile

OrganizationalSilence

Managerial Practices• Tendency to reject or respond

negatively to dissent ornegative feedback

• Lack of informal solicitationof negative feedback

CollectiveSensemaking

Factors AffectingEmployee Interaction• Similarity among employees• Workforce stability• Workflow interdependence

employees express concerns about aproposed organizational change, man-agers may assume that the employeesare resisting the change because it ispersonally threatening to them orbecause they do not understand it, notbecause they are truly concerned thatthe change might be bad for theorganization. Managers may also con-vey, consciously or unconsciously,annoyance or even hostility towardmessengers of unwanted news, andare unlikely to engage in much infor-mal feedback seeking from subordi-nates. When they do seek feedback,managers will tend to approach thosewho are likely to share their perspec-tives and who are thus unlikely to pro-vide negative feedback.

These practices and behaviors notonly inhibit upward information flow,but they actually create a “self-fulfill-ing prophesy.” If an organization’stop-level managers believe thatemployees are self-interested anduntrustworthy, they’re likely to act inways that implicitly and explicitlydiscourage upward communication.Well-meaning employees, who feelshut out of decision making processesand unable to express their views, mayrespond by becoming less committedto the organization and less trusting.Managers’ pessimistic beliefs canthereby become reality.

Incubating SilenceAlthough silence-fostering beliefs

are not prevalent in all organizations,the works of several scholars suggestthat they exist to some extent in mostorganizations. Several factors mayaffect the degree to which such beliefsare held, and the likelihood that con-ditions will be ripe for organizationalsilence.

Silence-fostering beliefs may bemore likely to become entrenchedwhen the composition of the top man-agement team is stable over time. Thelonger top managers have beentogether, the more deeply-held theirshared assumptions will tend to beand the less likely they will be to ques-

tion those assumptions. The similarity or dissimilarity of

the demographic profile (e.g., gender,race, ethnicity, age) of the top man-agement team in comparison to that ofemployees lower in the organizationalhierarchy may also influence theprevalence of silence. Research ondiversity has shown that people aremore likely to trust people who aresimilar to themselves. Hence, man-agers may be more uncertain abouthow to interpret “bad news” when itcomes from someone who they do notknow well or who is not similar tothemselves, and may be more likely toview it with suspicion.

The cultural background of the topmanagement team may affect thebeliefs that its members hold aboutemployees. For example, if the topmanagement team comprises individ-uals with cultural backgroundsreflecting high-power distance, thesemanagers may be especially likely tofeel threatened by the communicationof negative feedback by subordinates.High-power distance cultures are onesin which there is a strong acceptanceof, and respect for, authority and hier-archy, and where employees do notgenerally question or challenge theirbosses.

Organizational and environmentalvariables are also likely to affectwhether collective silence develops.When there is heavy strategic empha-

sis on control, management may viewnegative feedback as more threateningand dissent as more destructive. Thislogic would suggest that a contextconducive to silence is more likely toemerge in organizations pursuing alow-cost strategy, and also withinhighly competitive environmentscharacterized by a diminishingresource base.

High levels of vertical differentia-tion, or the existence of a lot of levels inthe organizational hierarchy, are alsolikely to reinforce silence. Within tallorganizational structures, top manage-ment will probably be less likely tointeract with, relate to, and hencetrust, lower level employees. In addi-tion, firms that bring in top managersfrom the outside instead of promotingfrom within may be more likely to cre-ate a gap between top managementand the rest of the organization.

Maintaining Silence To fully understand how organiza-

tional structures and practices lead toa climate of organizational silence, orin other words, to shared perceptionsthat speaking up is dangerous and/orfutile, we build on theories of socialinformation processing and symbolicinteractionism. These perspectivessuggest that climate originates from aprocess of collective sensemaking,whereby employees, together, try toderive meaning about their workplace.

34 Sternbusiness

“Within organizations plagued by silence, problems mayaccumulate to the point that they can longer be hidden

from important stakeholders such as owners.”

SOUNDS OF SILENCE

We believe, therefore, that a climate ofsilence is rooted not only in objectivefeatures of the workplace, but also insocial interactions that contribute tosensemaking processes. When organi-zational decision-making is highlycentralized and there are few channelsfor upward communication, workersare likely to collectively conclude thatmanagement does not think employeeopinions are important. And whenmanagement responds to employees’opinions with resistance or denial,employees are most likely to convergeon an interpretation that speaking upis risky or not worth the effort.

Common perceptions and attitudesare most likely to develop and becomereinforced to the extent that membersof a social unit have opportunities tointeract and communicate with oneanother. As a result, several factorsthat facilitate contact and communi-cation – and hence the development ofcommon perceptions – can increasethe likelihood of a strong climate ofsilence developing. One of these fac-tors is similarity, since individuals aremore likely to interact with those whoare like themselves. Shared percep-tions are also more likely to developwithin organizations with relativelystable membership. Workflow interde-pendence also contributes to the col-lective sensemaking process. Whenemployees must coordinate theiractivities with one another, there isgreater necessity for communicationand thus, a greater opportunity forthem to share their perceptions andexperiences.

The sensemaking process that wehave described has a strong tendencyto give rise to biased and often inaccu-rate perceptions. Employees makesense of managerial actions based onlimited, and often distorted, informa-tion, much of it second-hand.Employees can also form exaggeratedperceptions of the riskiness and futili-ty of speaking up. For example, if amember of the organization voicesdissent, and soon thereafter fails toreceive an expected promotion, some

employees may reach the conclusionthat the promotion was lost becausethis person expressed an unpopularopinion. As this information passesthrough the grapevine, the widespreadperception that those who expressnegative views are punished may soonarise. Similarly, if a few employeesoffer input on a particular policychange and that input is ignored, theymay conclude that all input is ignoredeven if this is not the case.

Breaking the SilenceA troubling aspect of the dynamics

that create and maintain silence isthat they are hidden from view andoften unrecognized. Management maysee that employees are not engaged,but may assume that it is because theyare self-interested or not motivated.In addition, within organizationsplagued by silence, problems mayaccumulate to the point that they canno longer be hidden from importantstakeholders such as owners or credi-tors. At this point, these constituenciesmay conclude that the organizationsuffers from “poor management” andtop managers may lose their jobs. Yetthe reasons for the organization’sproblems may be misunderstood.

So how can employees and man-agers break the climate of silence? Itmay not be easy. The behavioral cyclesthat maintain organizational silencewill be hard to break in part becausethey are not subject to direct observa-tion or discussion. What’s more, oncepeople start distrusting a system, it isextremely hard to restore their faith.Even if management eventually real-izes that it needs accurate internalfeedback and tries to elicit it, employ-ees may tend to be cynical about thischange.

Yet we do believe that silence canbe prevented, and that organizationscan break down walls of silence thathave developed over time. In terms ofprevention, managers must work hardto counteract the natural human ten-dency to avoid negative feedback.They must not only seek out honest

feedback, on a regular basis, theymust also be careful to not “shoot themessenger” when they receive badnews. Managers must also work hardto build an open and trusting climatewithin their organizations, one inwhich employees know that theirinput is valued and that it is safe tospeak up. If employees sense thatthose above them do not want to hearabout potential problems and issues ofconcern, they will not talk aboutthem. Managers must recognize thisdynamic and convince employees thatthey do want input.

Moving from an entrenched cli-mate of silence to a climate of opencommunication will be more difficult,but not impossible. One way to createsuch a change is to bring in new topmanagers. This will not only enablethe organization to break from itspast, but will signal to employees thatthere is a commitment to changing thestatus quo. It will also be importantfor managers to send consistent mes-sages indicating that they want to hearemployee’s concerns, and that thereare no negative repercussions foremployees who talk about organiza-tional problems. These messagesmust, of course, be backed up byaction.

To prevent silence from character-izing their organizations, leadersshould not only permit, but reward,employees who come forward withsensitive or risky information, andshould create formal mechanismsthrough which employees can speakup anonymously if they wish to do so.Not doing so means risking the dis-covery that the story of the CEO’s newclothes is more than a fairy tale.

ELIZABETH WOLFE MORRISON is aprofessor of management and chair ofthe Management and OrganizationsDepartment. FRANCES J . MILLIKEN is a professorof management and coordinator of thedoctoral program in Management andOrganizations at NYU Stern. A longerversion of this article appeared in theAcademy of Management Review, Vol 25.

Sternbusiness 35

36 Sternbusiness

P O C K E T P

ILLUSTRATION BY THEO RUDNAK

Sternbusiness 37

R O T E C T O RLast fall, former Securities and Exchange Commission Chairman Arthur

Levitt, Jr., was named the inaugural Citigroup Distinguished Fellow in

Leadership and Ethics for the 2003-2004 academic year. The new Citigroup

Leadership and Ethics Program, run in coordination with NYU Stern’s existing

Markets, Ethics and Law Program, represents an extension of Stern’s long-

standing commitment to the practice of professionally responsible business.

Mr. Levitt, who headed the SEC from July 1993 to February 2001, is the

longest-serving chairman in the SEC’s history.Throughout his tenure, he over-

saw the introduction of a host of initiatives designed to educate, empower,

and protect America's 50 million investors. These included: the launch of the

EDGAR system; regulations that strengthened auditor independence; requir-

ing companies to release important information to all investors at the same

time; and mandating the use of “plain English” in public communications. A

graduate of Williams College, Mr. Levitt worked in the brokerage industry for

16 years. From 1978 to 1989 he was the Chairman of the American Stock

Exchange. Mr. Levitt currently is a senior adviser to The Carlyle Group, a glob-

al private equity investment firm, and serves on the board of Bloomberg L.P.

His memoir, Take on the Street: How to Fight for Your Financial Future, was

published in 2002.

In December, Mr. Levitt prepared remarks for the “Integrity of Financial

Markets” conference held at NYU Stern. Excerpts from these remarks follow.

I must admit to having a degree ofskepticism toward the entire endeavorof teaching ethics. I believe that ethicscan’t be taught in one conference, oneweekend, or one semester. A sense ofwhat is right and wrong comes fromone’s upbringing and the cues we takefrom society at large.

But that doesn’t absolve us of theresponsibility of trying to shape ethi-cal business leaders. Rather, it placesupon us a larger burden. We mustourselves teach ethics everyday – byhow we run our companies and howwe choose to conduct ourselves in thepublic arena. In just my one semesterof teaching here at Stern I’ve learnedthat young people interested in busi-ness aren’t just searching for the pathto success, they’re also searching forrole models. And so we need to movetoward the day when there is a criticalmass of ethical, public-spirited busi-ness leaders dedicated to the commongood, when ethical behavior is seen asstandard operating procedure.

Unfortunately, this leadership wasmissing over the past decade and ahalf. The bull market built up wealthjust as quickly as it tore down ethicalstandards. The symptoms first arosein the executive suites – and came toour attention two years ago this weekwith the bankruptcy filing of Enron.What was uncovered at Enron,WorldCom, and the rest brought tothe public’s attention the sad truththat CEO’s were managing the num-bers, not necessarily managing theircompanies.

Auditors were complicit.Accounting standards – especially asthey relate to the expensing of stockoptions – were a catalyst. Corporateboards were catatonic. This erosion oftrust and independence infectedinvestment banking and stockresearch as well. And with the recentrevelations about the mutual fundindustry, even more individualinvestors realized that they had beentaken along for a ride.

Leadership DeficitBetter regulations and more effec-

tive oversight were not the only things

gone under, and unemployment wassurging. Sound familiar? I mentionthis to highlight the optimism of the‘90’s – the 1890’s. The President whosaid this wasn’t Bill Clinton, butBenjamin Harrison.

Then, as now, faced with an eco-nomic downturn and the reality thatthe economy and society had to beretooled for a rapidly changing time,many business leaders formed power-ful lobbies to resist change. They tookthe attitude famously summed up byrailroad baron William HenryVanderbilt: “The public be damned!”But others recognized that making themarket work in an industrial agewould require new rules and safe-guards. And so people like MarkHanna, a prominent Republican andindustrialist, and Edward Filene, thedepartment store magnate, formedgroups like the National Bureau ofEconomic Research and theCooperative League to research, craft,and lobby for reforms. As JeffreyGarten explains in his excellent newbook, The Politics of Fortune, theircommitment to the national interesthelped this country through the diffi-cult transition from an agriculturaleconomy to an industrial one; from anisolated nation to a world player.

Corporate leaders played a similarrole during a similarly chaotic timeimmediately after World War II. Atthe urging of the Secretary ofCommerce, a bi-partisan group ofcorporate executives formed theCommittee on Economic Developmentto offer non-ideological guidance onhow the U.S. could make the transi-tion to a peacetime economy. TheCED offered invaluable advice on avariety of economic topics – from tax-ation to monetary policy, from urbanrenewal to government administra-tion. When President Truman formeda committee to draft a plan to rebuildEurope, five of the nine on the com-mittee were CED trustees.

Today, as we navigate the properrelationships between the public andprivate sectors in creating a worldthat is safe from terrorism and suitedfor market prosperity, the input of

that were missing. Something else wasmissing as well: the leadership of thebusiness community. During the1990’s, very few people were willing tostand up and point out the madness ofday-trading and the virtues of diversi-fied investing for the long-term. Veryfew people questioned quarterly earn-ings that always beat expectations ormutual fund advertisements thatboasted of returns that defied gravity.

We lacked the kind of leadershipthat instinctively puts the public inter-est above corporate interest or careeradvantage and works constructivelywith policymakers. There are todayfew business leaders recognized asbeing spokesmen or spokeswomen fora set of realistic, intelligent public-spirited values.

I’ve been in and around the mar-kets for 40 years. And I can’t think ofa time since when our business com-munity and market institutions havebeen viewed with such disdain by thegeneral public. In a recent poll on theethical standards of various profes-sions, only about 15 percent said thatstockbrokers and business executiveshad “high” or “very high” ethicalstandards. The good news is thatstockbrokers and business executivesranked ahead of insurance salesmenand car salesmen. The bad news isthat they still ranked at the bottom ofthe pack – just behind United StatesSenators.

It wasn’t always like this. In thepast, business leaders not only ledtheir companies, they helped usthrough difficult economic transitions.At the end of the century and the endof his term in office, a Presidentproudly boasted to Congress: “Therehas never been a time in our historywhen work was so abundant, or whenwages were as high.” By the end of theyear, however, a financial panic tookplace, thousands of businesses had

38 Sternbusiness

“Young people interested in business aren’t just

searching for the path to success, they’re also

searching for role models.”

POCKET PROTECTOR

responsible business leaders is onceagain needed. Yet, by and large, theleadership is not there. That is not tosay that there are not those engaged inpublic policy or politics. But busi-ness’s interaction in public affairs ismostly of a certain, selfish kind.During my time at the SEC, I encoun-tered a staggering number of industrylobbyists whose sole purpose was tostop any minor change that they sawas a threat to their own specific inter-est. They had no thought at all as tohow the changes they were stoppingor supporting would undermine thevery market from which they wereable to reap such prosperity.

Instead, we need public-mindedleadership that offers to our electedofficials insight into how best to setthe rules for fair and vigorous compe-titions in a global economy, and thatis unafraid to expose and condemnthose actions that undermine marketcapitalism itself.

Such leadership is needed nowmore than ever in the mutual fundindustry. Today, 95 million investorscount on mutual funds for their retire-ments, college tuitions, and life sav-ings. If we do not clean up this indus-try, we stand to lose a whole genera-tion of investors.

For some time, mutual fund com-panies have abused their place ofprivilege in the investing world. Theindustry often misleads investors intobuying funds based on past perform-ance. Fees – along with the effect ofannual expenses, sales loads, andtrading costs – are hidden. Funddirectors, as a whole, are stretched toothin and show little interest in exercis-ing vigorous oversight. The cumula-tive effect of this lack of accountabili-ty and transparency has manifesteditself in late-trading and other prefer-ential treatment for hedge funds andother large investors.

Reform From WithinSuch dealings, at best, turn indi-

vidual investors into second-class citi-zens, and, at worst, into sheep to befleeced. The time has come for a realclean-up, not cosmetic policy changes

A New EthicWhen I was coming up, people like

Irving Shapiro of Dupont, JohnWhitehead of Goldman Sachs, andWalter Wriston of Citibank set thestandard and fostered an ethic ofaccountability and service. But duringthe 80’s and 90’s, the image of asuperstar CEO changed. Gracing thecovers of Fortune and BusinessWeekwere impatient, tough, bottom-lineoriented corporate rock stars whocould acquire a huge company at thestroke of a pen, fire 20,000 employeeswith another, and several years latersell the enterprise for much less thanshareholders paid for it.

The market now demands some-thing else: business leadership thatwill be at the vanguard in the move-ment to restore public confidence. Thetimes call for sensitive, caring,thoughtful, and committed personali-ties – working in public-private part-nerships to support the fabric of oursociety, rather than simply boostingtheir own bottom lines.

The public is not asking for busi-ness to stop caring about business. It’sasking for something as old asAmerica itself: “self-interest rightlyunderstood.” This new ethic will betaught in places like Stern. But thereal lessons must be taught by thosemanaging our companies, and build-ing small businesses all over thecountry.

Business leaders must lift theirsights above business, and spend partof each week on whatever kind of pub-lic-spirited purpose it might be –whether it’s conservation, foreignaffairs, or health care reform. Theymust rediscover the habits of involve-ment and social leadership of an earli-er era and through their actions, showa younger generation that publicspiritedness is not just good publicrelations; it’s good business. That willgo farther and be more effective inrestoring public confidence in the mar-kets and in the private sector, in liftingour stock markets, and in strengthen-ing our economy than virtually anylaw we can pass, investigation we canlead, or regulation we can write. �

or image campaigns. Some of thesechanges will require governmentalaction. But true reform won’t occur –and investor trust won’t be regained –unless mutual fund companies showpublic-spirited leadership. Today,mutual fund companies can erect bar-riers to market-timing by requiringsignificant redemption fees for thosewho want to flip their funds’ shares.Today, mutual fund companies canshake up their boards by appointingand empowering independent direc-tors. Today, mutual fund companiescan put an end to broker incentivesthat damage investor interests, such asrevenue-sharing and sales contests.And today, fund companies can endmisleading performance advertising.

We can be sure that the SEC in thecoming months will take action on allthese fronts. But imagine, for amoment, what would happen if theheads of the 10 or 15 largest mutualfund companies announced that theyhave agreed to undertake all of thesereforms on their own. It would bringabout reform without the heavy handof regulation. More importantly, itwould let investors know that thesecompanies take their obligation totheir shareholders seriously.

Of course, I have been around longenough to know that the odds of suchan announcement happening are long.Ultimately, we need a cultural changethat rejects excess and skirting therules – a culture in which directors andCEO’s all put pressure on each other touphold standards of acceptable behav-ior. We need private sector leaders atall levels to dedicate themselves to cre-ating a culture of accountability andfoster an ethic of service. We need tochange who our role models are.

Sternbusiness 39

“I’ve been in and aroundthe markets for 40 years.And I can’t think of a timesince when our businesscommunity and marketinstitutions have been

viewed with such disdainby the general public.”

Currency EventCurrency EventIn late 2003, the future of the European

Monetary Union seemed to be at a cross-

roads. The Stability and Growth Pact,

under which member nations agreed to

limit deficits, seemed all but dead.

Meanwhile, European leaders were strug-

gling to draft new agreements that would

allow the admission of up to ten new

members to the European Union. As ques-

tions surrounding the continent’s political

and economic integration swirled, a panel

sponsored by NYU Stern and Blackwell

Publishing, Inc. convened on December 5

to discuss the future of Europe.

Participants included: NYU Stern Dean

Thomas Cooley; Hervé Carré, who repre-

sents the European Commission in

Washington as Minister for Financial

Affairs; Francesco Giavazzi, professor of

Economics at Bocconi University in

Milan, and a former economic advisor to

the Prime Minister of Italy; and Mickey

Levy, chief economist at Bank of

America. It was moderated by Georges

de Ménil, NYU Stern Visiting Professor of

Economics from Ecole des Hautes Etudes

en Sciences Sociales, Paris.

40 Sternbusiness

Sternbusiness 41

42 Sternbusiness

them joining any time soon. Now, if they decide to stay out and theyhave weak fiscal discipline, then I could imagine that it might underminethe currency union. But it’s definitely a factor that in the long run has tobe thought about.

Francesco Giavazzi: I've been asked to talk about a more mun-dane problem: Fiscal policy and the stability pact. Do we need rules inthe monetary union? Yes, we need some rules. But the stability pactprovides the wrong incentives. It forces countries to focus attention onthe short run rather than on the long run. It encourages people to focuson this year’s budget, when an issue like pension reform – which theFrench government enacted in July – is much more significant fordeficits over the next ten years. In Germany, issues like pension reformand health reform are more important for the long run sustainability ofpublic finance then an effort to keep the deficit within three percent ofGross Domestic Product at a time when there are 4.5 million peopleunemployed.

What can be done? I think there are two ways out. My ideal would beto take the U.K. code of fiscal responsibility, put it in the constitution andgive the Commission the power to monitor fiscal policies based on that.But this solution is very unlikely. The second is to increase transparen-cy, and, hence, market pressure. Italy has, in a single year, shifted twopercent of public expenditures into a special purpose vehicle that underLuxembourg rules, is outside the government accounts. Had that notbeen done, Italy would be far above the three percent deficit-GDP limit.

Mickey Levy: If you look at Europe in recent decades, economic per-formance has been disappointing. Since the EMU was established, theeuro-zone growth has averaged nearly a percentage point below theUnited States. And it doesn't seem like the establishment of the EMU orthe euro has had any significant effect on overall economic perform-ance. It seems to me the underperformance is a direct function of mis-guided fiscal and regulatory policies. The ECB has pursued a consis-tent and successful low-inflation monetary policy. But when you look atthe excessive government spending, taxes, regulations that reducelabor supply and reduce the implementation of capital spending, there-in lies the problem.

Fiscal policy reform is constrained and distorted by the Stability andGrowth Pact, particularly its deficit to GDP limitation. It limits counter-cyclical fiscal policy and tax reform. It has led to budget gimmickry andit has not addressed the major problems of government spending andtaxes. I strongly believe the deficit to GDP ratio is an inadequate, limit-ed and potentially misleading representation of fiscal responsibility. Forexample, the deficit to GDP ratio in Germany is pretty close to that inthe United States. But in Germany, government spending exceeds 50percent of GDP. In the United States, it's about 33 to 35 percent.

To really address the problems of Europe, the pact needs to focus ongovernment spending and taxes as well as budgets. Firstly, I would putlimits on the ratios of government spending to GDP and of taxes toGDP. But I would phase them in over time. And to the extent that taxesare cut before spending, I would relax temporarily the deficit to GDPratio. That would make policy makers focus on the real issues that areinhibiting economic growth.

What’s more, the figures on national debt and cash-flow deficits don't

Hervé Carré: I think the challenges we face now are easier to facethan the ones we successfully faced in Europe ten years ago. Thereare many challenges. But I will just elaborate on three of them.

The first is economic policy coordination. In Europe, we have a singlemonetary policy, entrusted to a federal institution. And on the other hand,the responsibility for all other economic policies and budgets remainsdecentralized – although subject to common rules. This decentralizationprovides the necessary room to adapt to national economic structuresand to adjust to country-specific preferences. However, the growinginterdependence of member states, and the potential for spillover effectscalls for coordination of national economic policies.

The second is structural rigidities. Six million jobs were created in theEU between 1999 and 2001. But since then employment growth hasstopped. More structural reforms are needed in the labor market toraise employment and productivity, and ultimately to increase the stan-dard of living of European citizens. In 2002, GDP per capita in the EUwas only 71 percent of the level in the U.S. The employment rate is 86percent of the U.S. level. This means that in Europe we do not workenough. We also need structural reform that allows wages and pricesto adjust more quickly to changes in supply and demand.

The third challenge is enlargement. Ten new member states will join theEuropean Union soon next year. This will bring extraordinary benefits:The extension of the zone of peace, stability and prosperity in Europe;the addition of more than 100 million people in rapidly growingeconomies; and the strengthening of the EU’s role in world affairs. Butthe criteria for accession to the EU require these countries to be func-tioning market economies. And our institutional framework must con-tinue to guarantee an efficient management of economic policy.

Tom Cooley: I’ll focus on the countries that have opted to stay out-side the monetary union, like the U.K., Sweden and Denmark. And Ithought I would relate it to the debate a couple of years ago aboutwhether countries like Mexico and Brazil and Argentina should adoptthe U.S. dollar as their home currency.

It turns out there are incentives for countries that are not in a currencyunion to stay on the periphery. If Mexico could be reasonably disci-plined in its monetary policy, there were more gains to Mexico to stayout of the union, but to have a monetary policy that's sort of close towhat the U.S. policy is. And this same logic applies to the case of theU.K. and Sweden.

It's clear that the U.K. has had a very different monetary policy than theEU in the last few years, and as a consequence has had a very differ-ent inflation rate, as has Sweden. If you conclude that Sweden and theU.K. are achieving growth rates that are closer to their potential growthrates over this period, then it's hard to see what the incentive would befor them to join. So the prediction would be that we're not going to see

“Ten new member states will join theEuropean Union soon next year.

This will bring extraordinary benefits: The extension of the zone of peace, stability, and prosperity in Europe.”

£CURRENCY EVENT

Sternbusiness 43

now is forecast for Europe. It took a fairly radical change in tax rates togenerate positive economic results and higher standards of living. Andso I'm not just pointing to Europe and saying you need a straitjacket, butyou need incentives to enact pro-growth changes.

Hervé Carré: For the Commission, the choice of taxation level andchoice of spending to GDP ratio, is a political choice. It's the expressionof a choice of society. It cannot be taken by bureaucrats. That's all. Notaxation without representation.

Audience question: I’m an economic consultant. As I recall thereis one success story within the European Union, and that's theNetherlands. They had a debt to GDP ratio which was more or lessaround 100 percent. And they managed to lower it very, very sig-nificantly.

Hervé Carré: Right. At the time of the Mastricht negotiation, the ratioto GDP in the Netherlands was close to 90. Now it's below 60 percent.But I think the best example of a very quick reduction of debt to GDPwas Ireland.

Georges de Ménil: Can the Irish miracle be a model for Europe, forthe Continent?

Mickey Levy: Ireland is a great story. They certainly didn't need anylimitations. But their growth, their economic performance was so bad,what did they do? They lead with tax cuts and a constraint on govern-ment and they created an environment that put incentives in place.What if one of the ascension nations recommends sharp tax cuts? Andthen that nation becomes a very attractive destination for capital andjobs, even though they violate every deficit to GDP concern in Europe?What happens then?

Georges de Ménil: Well, with that open and challenging provocativequestion, let me thank the panelists. �

capture the unfunded liability of thepensions. The long-run projectionsare very unfavorable. But withregard to the issue of debt, anddeficits, you have to ask the ques-tion, well, what are you deficitspending for?

Hervé Carré: I'd like to respond toMickey’s point. We were aware ofthe crude character of the three per-cent deficit to GDP ratio when weadopted it. And the level of debt isclearly the major problem in terms ofsustainability. On pension reform, Ifully agree. The Commission for fouryears has been recommending tomember states that they take nec-essary measures to change thepresent system. But here again it'sa political problem. Governmentspending is also a hot potato. All theministers from the Scandinaviancountries will tell you that they don't want to decrease the level of tax-ation, because their voters want to keep the social safety net. So it’seasier when you're an economist, than when you are a politician.

Tom Cooley: I think all this discussion is kind of missing the boat abit. It seems to me that the real compelling problem of Europe is thattheir productivity growth is so much lower than the U.S. And I think theanswer lies in structural reforms that will remove the conditions that

inhibit Europeans from taking risks and engaging in the kind of innova-tive activities that drive productivity growth elsewhere in the world.

Francesco Giavazzi: On productivity, one has to be very careful,because the level of productivity per hour worked is higher in mostEuropean countries. The productivity per person is lower because assuggested before, the amount of hours worked in Europe are 30 per-cent below hours worked in the U.S.

Mickey Levy: Well, the statement about productivity I think is wellstated. I think the problem in Europe is you've seen this sharp declinein aggregate hours worked per employee. And that's in part endoge-nously determined by misguided policies. I understand the difficulties inimplementing my proposal about the ration of deficits to GDP. But if youthink about targeting deficits as a percentage of GDP, it's just as silly.Go back to U.S. history in the 1970s. There was abysmal productivityand very high unit labor costs, and double digit inflation and interestrates. The fiscal and monetary policy makers lacked credibility. Thehighest marginal tax rates were 70 percent. And the forecast of poten-tial growth was less than two percent – less than what potential growth

“The stability pact provides the wrong incentives. It forces countries to

focus attention on the short run rather on the long run.”

Sir Nigel Wicks,Former Member ofthe EU Committee of“Wise Men” onEuropean SecuritiesRegulation, FormerPrincipal PrivateSecretary to PrimeMinister MargaretThatcher, andkeynote speaker atthe dinner followingthe EMU panel,speaking with Dean Cooley andHervé Carré.

working perfectly well.Ford stubbornly clung to the

Model T. But by early 1927, theChevrolet was outselling the

Model T. And so on May26, 1927, Henry Ford

watched the 15 mil-lionth Model T Ford rolloff the assembly line athis factory in HighlandPark, Michigan. Thenhe shut down the

plants and stoppedproducing Model Ts.

Nearly 20 years afterthe introduction of theModel T, Ford and hiscolleagues designed a

new car – the ModelA. They gave it a new

engine, a three-speed transmission,and hydraulic shock absorbers. InDecember 1927, Ford began toshow the new car, and withinweeks, 600,000 customers hadsigned up to buy one. By 1929, theModel A had recovered the groundit had lost to Chevrolet.

Today, of course, auto companiesspend untold billions annuallypitching hot new designs to car afi-cionados. Henry Ford managed in asimpler time. For nearly twodecades he was able to ring up mas-sive profits on a single car, whichcame in any color the customerwanted – provided it was black.

DANIEL GROSS is editor of STERNbusiness.

n today’s era of shortattention spans we’vebecome trained tolook for – and to buy

– the latest model. Whetherit’s the Zagat guide orBeaujolais nouveau, fash-ions from Milan or carsfrom Germany, savvyconsumers eagerly antici-pate the most recent ver-sion of a product theymay already own.

And while the rhythmsof model years and vin-tages seem ingrained in ourlives, it wasn’t always so.Indeed, one of the most impor-tant models ever made –the Ford Model T –endured for nearly two decadeswithout much change at all.

“I'm going to democratize theautomobile,” Henry Ford had saidin 1909, a year after he introducedthe Model T. “When I'm through,everybody will be able to affordone, and about everybody will haveone.”

Ford wasn’t too far off the mark.In 1921, the Model T – the firstmass-produced automobile – held60 percent of the new-car market.And by June 1924, some 10 millionTin Lizzies, as the sturdy coupeswere known, were roaming thenation’s roads. All of them wereblack, and all of them closelyresembled the original.

endpaper

I

44 Sternbusiness

The Latest Model By Daniel Gross

Ultimately, however, the Model Tbecame a victim of its own success.Having created a mass market forcars, Ford faced competition. Themost formidable rival was GeneralMotors. Under the leadership ofAlfred P. Sloan, Jr., GM gainedground on Ford by tapping into theAmerican consumer’s need for new-ness. With the Chevrolet, GM intro-duced important marketing wrinklesincluding the installment plan,trade-ins, and, most significantly,model years. By doing so, the com-pany gave status-conscious Americanconsumers – which is to say most ofthem – an incentive to purchase anew car when their old one was

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