Insider Trading and Investors: Avoiding the Stigma of Misconduct

Wall Street Journal reports that the hedge fund SAC Capital Advisors LP is losing investors at a rapid pace, with 1.7 billion dollar (one quarter of the total outside investments) at risk of being withdrawn. In a regular mutual fund, such a wave of withdrawals would have been disastrous because funds lose money when selling large amounts of stock in a short period of time. SAC can handle the situation because it has rules limiting withdrawal speed (normal for hedge funds) plus it is backed by 9 billion dollar of money invested by its fund manager and employees. So this is a serious situation but not a meltdown.

How did it happen? The fund got caught up in an insider trading investigation involving 6 of its former employees. The investigation may lead to civil charges, possibly leading to payouts to the government. The firm has said it cooperates with the investigation and will arrange any payouts so that its outside investors are not affected. Clearly this is not enough reassurance for all the investors, and now some are escaping and others are on the fence.

It is common that investors flee funds that have scandals. Often the scandals involve misconduct that is costly for investors, such as when funds make deals that favor some investors over others. But this scandal comes with a twist: insider trading is an illegal use of information, and it can be very profitable. If the insider trading occurred on investments held by this hedge fund, it would have been profitable for the clients who are now escaping. Indeed, SAC Capital has had very high performance.

Do the investors understand this? Absolutely. Investors in hedge funds are themselves fund management firms who know the rules very well, and also know how various kinds of misconduct would affect their balance sheets. So the investors are not worried that they have been robbed, but they are concerned with preserving their own reputation.

How reputations are brought down by misconduct, and can be recovered afterwards is a topic of research that interests me and coauthors Takako Fujiwara-Greve and Stefan Jonsson. In a paper in Administrative Science Quarterly, we found that reputation loss extends beyond the firm that actually was responsible for misconduct. A scandal in the large Swedish insurance firm Skandia led to investors escaping from mutual funds owned by other insurance firms, as if all investments connected with insurance had somehow become tainted. Also, other large firms saw investors escape from their mutual funds, as if all investments connected with large firms had somehow become tainted.

In ongoing work, we are exploring how reputations can be regained. The answer seems to be, slowly. In fact, the movement of investors out of and into the Skandia funds after the scandal is most consistent with a model of current investors leaving when the scandal hits, and never coming back, while new investors who were not paying attention to Skandia (because they were not its customers) gradually trickle back.

So what does this mean for SAC? It needs to be patient because the outside investors are not likely to come back very soon, as we found for Skandia. Their decision to withdraw makes perfect sense because reputation losses do spread beyond the original firm, as we found for Skandia. The outside investors can find another place to put their money. But I am personally curious about whether any of the money now being withdrawn is profits from the inside trading that triggered the withdrawal.

Fujiwara-Greve, Takako, Greve, Henrich R. and Jonsson, Stefan, Asymmetry of Reputation Loss and Recovery under Endogenous Relationships: Theory and Evidence (August 23, 2012).

Jonsson, Stefan, Henrich R. Greve, and Takako Fujiwara-Greve. 2009. “Undeserved Loss: Legitimacy loss by innocent organizations in response to reported corporate deviance.” Administrative Science Quarterly, 54 (June): 195-228.

Strasburg, Jenny, and Juliet Chung. 2013. Investors Exit Fund Dogged by Probe. Wall Street Journal, February 15, 2013.

Here is an earlier blog post involving insider trading and Rajat Gupta of Galleon.

Etihad’s Jet Air Investment: The Great Alliance Game

Jet Airways of India has increased its revenue and turned to positive profits this quarter. This is in part because of the troubles of competitor Kingfisher Airlines, but it is also helped by cost reductions, especially in fuel. The good news is very timely because Jet Airways is in talks to sell a 24% ownership stake to Etihad Airways, the United Arab Emirates airlines. Although Etihad is already likely to pay well for the strategic value of the Jet Airways investment, the profits will make the price even higher.

So what does Etihad want with an ownership stake in a large Indian airline? Etihad is known among passengers for its high service level and convenient routes linking Asia, Europe, and the USA through its hub in Abu Dhabi. In the industry it is known for its rapid expansion: it is only 10 years old and operates 63 aircraft, most of them widebody jets for long distance routes. It has also started to move from regular codeshare alliances to taking ownership stakes in alliance partners such as Air Berlin and Aer Lingus.

Alliances are a common strategy in the airline industry because they can connect carriers with route networks that complement each other, increasing the convenience and value for their passengers. As an airline executive you would always look for alliances to strengthen your product. The trick is to find partners who have a route network that does not compete with yours, and that connects you to places that you cannot reach on your own. But that also means that you should be willing to drop one alliance and replace it with another if you get a better opportunity, so airline alliances are not necessarily stable.

So do firms really drop alliances when a better opportunity comes along? I do not follow the airline industry, but along with colleagues Hitoshi Mitsuhashi and Joel Baum I recently published a paper in Organization Science on when liner shipping firms left their alliances. What did we find? Shipping firms managed their alliances with an eye to the quality of the match, where complementarity in markets was the key dimension. This is just as you would expect from a transportation industry. And they did not just leave bad matches: they also left good matches when they were able to spot a better opportunity. If you are an executive in a firm dependent on alliances, the implication is clear. Having a good match does not mean you have a stable alliance: it depends on whether your partner can find someone better than you.

Back to Etihad. Why would they invest in an alliance partner rather than just make a regular alliance? Well, if you think that the alliance is valuable but you think that the partner might fly off with some other firm when the opportunity presents itself, an investment is a way to cement the relation. It can also be a way to reassure the partner that you are not going to leave the alliance. In alliances between firms, the stakes are so high that promises are not enough: money on the table is the way to make a commitment. So, what Etihad is doing is expensive, but it is a

good strategy if the alliance is important enough. By the way, Etihad means “union.” I am sure they are telling that to their potential alliance partners.

Chowdhury,A. 2013. Jet Air Swings to Profit as Etihad Deal Draws Closer. Wall Street Journal, February 1 2013.

Greve, Henrich R., Hitoshi Mitsuhashi, and Joel A. C.Baum. 2013. "Greener pastures: Outside options and strategic alliancewithdrawal." Organization Science 24(1):79-98.

Community Imprinting: Why do some Communities Work better than others?

It is possible to find a list of the best and worst-run cities in the US on the following blog:

http://247wallst.com/2013/01/15/the-best-and-worst-run-cities-in-america/#ixzz2IWFW3Xys

The best run city is Plano, Texas, followed by Madison, Wisconsin; the worst was San Bernardino, California, followed by Miami, Florida. How was the list made? To quote, “we looked at factors like the city’s credit rating, poverty, education, crime, unemployment, and regional GDP.” That seems a bit unfair. Poverty, unemployment, and regional GDP are outcomes of the local economy, which may be influenced by city government but is surely not run by it. None of these cities have a centrally planned economy.

But if it is not a list of the best and worst run cities in the US, it might be one of the best and worst functioning cities, by those criteria at least. That's interesting to know, especially if you are planning to move to any of these cities. But then it would also be interesting to learn how stable the ranking is, because looking at the list the year you move would make no sense if it was reshuffled every year. And also, the list of criteria could be expanded if we wanted to know where to move: What about schools, voluntary associations, and cultural life?

As it turns out, communities are stable in how well they function, so looking at the list for one year helps a lot. Communities also have stable differences in voluntary and mutual associations. And remarkably, these features seem to be stable not just from one year to the next, but from one generation to the next. Yes, I wrote generation, meaning 30 years. In a recent paper in American Journal of Sociology, Hayagreeva Rao and I look at some of the past work on community stability in governance and community life. We also report our own research on how communities have stable differences in the founding of mutual organizations. We took data from Norway, where mutual insurance firms and savings banks were founded in many communities in the 19^th century. Retail cooperatives (coops) were founded in many communities in the 20^th century. We found that even as we controlled for every other difference between communities that we could measure, it was still true that pioneer communities in banks and insurance mutuals were also pioneers in coops.

This is important because it suggests community imprinting: some communities end up with more community organizations than others.  Because those organizations are made to improve the community, this is obviously helpful for the residents. Imprinting may also occur for commercial organizations - we did not show that, but work like that of Pino Audia and coauthors suggests this effect. It means that we could be on our way to explaining some of the differences between the social, economic, and governance performance of nearby communities. What is the underlying mechanism? We think that community organizations create networks of trained activists who can use their skills to create other organizations. We also think that they leave a culture of community entrepreneurship. Now that we know about community imprinting – and it seems important, for how well communities work and where you should locate – we can look more closely at how it happens. That could be the next topic of research.

Audia, Pino G. , John H. Freeman and Paul Davidson Reynolds. 2006. Organizational Foundings in Community Context: Instruments Manufacturers and Their Interrelationship with Other Organizations. Administrative Science Quarterly, 51 (Sep), pp. 381-419. 

Greve,Henrich R. and Hayagreeva Rao. 2012. “Echoes of the Past: Organizational Foundings as Sources of an Institutional Legacy of Mutualism.” American Journal of Sociology, 118 (3): 635-675.

Why Entrepreneurs Fail: On Average Correct, but Overconfident most of the Time

Autobiographies by successful entrepreneurs often depict their business success as being "against all odds," accomplished only through extraordinary effort and sometimes also luck at critical junctures. They are right. Successfully starting an entrepreneurial venture is against the odds, as least as far as we can tell from the statistics that are available. Although the numbers differ by nation, the 50-5 rule that more than 50% of all new ventures are gone in 5 years is pretty good (perhaps a bit optimistic). A venture that closes within its first five years has probably lost money. On the upside, the ventures that make it past the 5-year mark are highly likely to survive the next five year.

These statistics have made people wonder whether entrepreneurs are overly confident, given the poor odds of success. In a new article in Organization Science, Robin Hogarth and Natalia Karelaia show that entrepreneurs are indeed overly confident, but this is – or could be – a result of them being right on average. This statement is not as paradoxical as it seems. The point is that even when our judgments are right on average, as they often are, they are not exactly right.  There is some error, plus or minus. I may assess my chances of success at some task as too high at one time, and too low at another, but in the long run it averages out. You and I make look at the same task at the same time and make too high and too low judgments of success, but on average we may be right.  (We are not always right on average, but for the sake of argument, let's assume we are.)

Now suppose the task in question was to start a new venture. You and I would only do this if we thought our chances of success were good. On average we are right. But that means that if we are both looking at the same opportunity at once, the one who is more confident of success will move. If I am looking at the same opportunity more than once, I will move when I am more confident of success. Suppose the value of the venture is exactly zero, or even negative. Because we only enter when we are confident of success, those who become entrepreneurs will on average be overconfident of success even if all potential entrepreneurs are – all the time – on average correct.

It is a neat model that helps us understand overconfidence in entrepreneurs. It also happens to be a rediscovery. In a 1984 article in Administrative Science Quarterly, J. Richard Harrison and James G. March made a model of decision makers that are on average correct about the value of different alternatives before making a choice. They take the highest-value alternative. as we all do. But if there is some error in their judgments, even if the error is unbiased, the act of choosing the alternative with the highest value will usually make them disappointed in their choice, because the alternative that seems to have highest value is also the one most likely to be overestimated. This is the same insight as Hogarth and Karelaia, except it is more general: instead of choosing between doing nothing and entering a business, the Harrison and March model is a choice between a number of different alternatives.

Rediscovery or not, it is important to be aware of this trap. The way we make choices sets us up for disappointments, even when we are on average right. So entrepreneurs can be on average right, but also too confident of entering new businesses. And scientists can be on average right, but also too confident of having new findings. 

Harrison, J.R., J.G. March. 1984. Decision making and postdecision surprises. Administrative Science Quarterly 29(March) 26-42.

Hogarth, R.H. and N. Karelaia. 2012. Entrepreneurial Success and Failure: Confidence and Fallible Judgment. Organization Science November/December 23:1733-1747.

On a Tax Scandal in Greece, and How to Get a Diverse and Free Press

Along with its bond payment troubles, austerity measures, unemployment, and protests, Greece is experiencing a scandal over possibly undeclared income and unpaid taxes among its elite. The story is interesting and confusing, and it involves the press as a key actor.

Some facts (omitting lots of details) are: In 2010 France handed over to Greece’s finance ministry a list of Swiss accounts held by Greek citizens. Italy and Spain also received similar lists. Because the money could be undeclared income hidden from tax authorities, France, Italy, and Spain started investigating whether the owners of the accounts could show that they had paid tax on it. Greece’s list held 2,062 names. The head of the Greece’s tax police testified that he received 10 names to investigate. The rest of the names were not acted on, but the successor of the finance minister allegedly received a list of 2,059 names. No further action was taken, until the press started applying pressure. The existence of the list was published. Then, and this is important, the small magazine Hot Doc published the names of the individuals on the list.

What happened? First, the journalist behind Hot Doc, Kostas Vaxevanis, was arrested for violating privacy laws. He was found not guilty and released. Second, many members of the business and political elite of Greece have been shown or alleged to be on the list. The most recent revelation involves the difference between the 2,062 names held by the first finance minister and the 2,059 (allegedly) passed on to the second: the three missing names are relatives of the first finance minister. So the scandal rolls on, and is likely to strengthen the anti-austerity protestors, as well as the tax police’s ability to pursue tax cheats with political connections.

We have come to think of the press in many different ways: idealist journalists pursued by the government, big corporations who restructure everything from newsroom to printing operations, and paparazzi photographers who ambush celebrities’ private occasions and parts. But what is the origin of all this diversity? To answer that question, it is necessary to go back to the beginning of publishing, as Heather Haveman, Jacob Habinek, and Leo Goodman have done in a recent article in Administrative Science Quarterly. They looked at the background of the people starting magazines in the US in the 18^th and 19^th century (magazines are a good site to investigate because they are easier to start than newspapers, and are still - like Hot Doc - an influential part of the press).

What did they find? As in many industries, many early founders of magazines were from a related industry, in this case printers or other publishing professionals. But the origin of the press as an outlet for opinion as much as a profit-making enterprise was clear from the background of other early founders. They were intellectuals and professionals, a social background that also matched many of the writers, who were hobbyist writers expressing opinion in essays or writing poetry and prose. They used professional writers for getting content, but very few magazine founders were professional writers.

Did the magazine industry become more professional? In content and presentation it no doubt did. But in ownership the opposite happened. The proportion of industry professionals among founders declined dramatically, and the proportion of individuals in other professions (priests and doctors) as well as writers increased. But more remarkably, they came from much more modest means. Whereas the typical early magazine founder was highly educated and often wealthy and well-known before starting the magazine, the later founders were more likely to be common people – and this is even though access to education improved between the 18th and 19th century. Haveman and coauthors conclude that the elite background of the early magazine founders helped making magazine founding easier, paving the way for the later ones with fewer resources. It likely also helped usher in some of the protections that the US press currently enjoys, but did not have when the magazine industry started. As a result, the press became a place with broad diversity in founder background and magazine mission.

In the US, as in many other places, the press isn’t just seen as being a complex mixture of idealists, profit makers, and celebrity hunters – it really is all of those things. And the current state of the press is a direct result of its origins.

Haveman, Heather A., Habinek, Jacob,and Goodman, Leo A. 2012. How Entrepreneurship Evolves: The Founders of New Magazines in America, 1741–1860. Administrative Science Quarterly,57(4): 585-624.

Pangalos, Philip and Nektaria Stamouli. 2012.Scandal Deepens Over Greece's 'Lagarde List.' Wall Street Journal, December 292012.

Post of Posts: One Year of Organizational Musings

I was planning to write a blog entry today, but I lost the spark. I have seen too much news about the tragic school shooting in Newtown, CT, and it is hard to write about the latest news and research in management with that fresh in the mind. Instead, let me just give a list of the top blog posts of last year. The end of the year is a time for reruns anyway, and this happens to be the 50^th blog post for me, so I have some reason for looking back.

The all time hit is my little note in honor of Judea Pearl's book on causality, and its link to how organizations learn, but not always correctly.

Also popular was the post on how the black turtlenecks of Steve Jobs became dark shirts in his successor Tim Cook; a nice case of symbolic management.

People were interested in some posts on careers, including the post on the cost differences between transferring, promoting and hiring people and the post on how leader networks are shaped by their employment histories.

Posts on organizational misbehavior also drew reader attention, including the posts on insider trading and on avoiding responsibility for the Costa Cruises accident.

The most-commented post was on how network theory could inform policy makers about the effects of drone attacks in Afghanistan and elsewhere.

The post with the most recommendations was on risk-taking effects of deadlines in American Football.  

Of course, rankings like these will always be unfair for the newer posts that have not had as much time to accumulate hits. I am guessing the ranking will be different a year from now, but this is what it looks like now. 

There will of course be more posts on this blog later! 

Your CEO’s Child: How it Affects your Wages

We can all recall or imagine the scene seen in many firms, large or small: Somebody has a child, and the employees are gathering to celebrate the happy occasion. Let's make the scene more concrete by saying that the person celebrating the birth of a child is the CEO (chief executive officer), who happens to be a man. Now, if workers are celebrating a CEO becoming a father, there might be some tensions in the room. Some are especially eager to congratulate, thinking of it as good career management. Or maybe they are just especially happy for him, but their coworkers suspect them of doing career management. Things are never completely easy around CEOs.

If they had known about the research by Michael Dahl, Cristian L. Dezso, and David Gaddis Ross in Administrative Science Quarterly, there would have been even more tensions in the room. Chances are that these employees are about to get robbed. Dahl and coauthors looked at the effects of the CEO fathering a child on employee pay, because it would be a way to explore an interesting tension. On one hand, becoming a father might change his values to be more helpful to others. Some CEOs are thought to be short on those values, so a child might help. On the other hand, becoming a father might instead make the CEO think more of providing for his family, and so use more company resources on own rewards rather than employee pay. Either effect would be stronger for the first child. Either effect could happen unconsciously, but given CEO power over pay could be really consequential for the employee.

But now I have teased you long enough with the remark that the employees were about to get robbed, followed by a story of fatherhood and values. What were the findings? Employee pay changed following fatherhood – it fell. That’s right, the finding was not that the growth in employee pay was reduced. It was a drop in employee pay. The effect was larger for a first child. But, there is more. For employee pay, it is especially bad if the CEO has a first-born son, and it is especially bad if the employee is also male. It is less bad if the CEO has a first-born daughter, and it actually good for pay if the employee is female.

Got that? So the first child does change CEO values. Later ones do too, but not as much. The CEO becomes more helpful if that child is a daughter, and seems to especially appreciate female employees more. But at the same time, the conservation of resources for the family happens too. The CEO conservation of resources hits male employees especially hard, and especially if the child is also male. If you described these findings to me, but replaced CEO with “dominant gorilla,” employee with “gorilla tribe member,” and pay with "food" I would totally believe them, but these are humans working in formal organizations. This is pretty amazing.

Europeans might note that this is just an indication of how US CEOs can do anything they like to their employees, unlike in Europe where rules and unionization prevents such mischief. Sorry, but Dahl and coauthors used Danish data, so all this happened under a set of labor rules made to prevent pay cuts for no good reason.

So what should you do if you are attending a party celebrating the birth of your CEO's child? Have some extra cake; you might be paying for it later.

Dahl, M. S., Dezső, C. L., & Ross, D. G. 2012. Fatherhood and Managerial Style: How a Male CEO’s Children Affect the Wages of His Employees. Administrative Science Quarterly, 57(4): 669-693.