Since the dawn of the corporation (and even before, whenever investors and management were not identical, such a ship owners and ship captains), the “agency problem” has plagued business (Wright & Mukherji, 1999). The agency problem essentially boils down to this: when a group of investors essentially turns their business over to someone else (professional managers) to run the business, the interests of the owners and managers can diverge. We saw extravagant examples of this in the late 90s/early oughts when senior management in companies like WorldCom and Global Crossing used corporate treasuries as their own personal piggy banks. A less egregious example of this behavior is empire building (e.g., unnecessary/non-accretive M&A activities, outsized pay packages, and sinecures and senior positions for long-time associates (Robert A G Monks, 2002)).
When global corporation are so badly run that they result in scandal and massive loss of equity value, bad corporate governance is nearly always one of the culprits (Locke & Spender, 2011). Bad corporate governance can be broken down into two categories: inept governance and badly structured governance. Inept governance is usually set up in a way that should provide value for the stockholders, but because of the power of the CEO and/or other senior managers, the directors owe their seats to senior management so any kind of aggressive investigation or oversight is unlikely. These directors know that if they contradict management’s plans or look too closely at them, they are unlikely to be re-nominated the next time they come up for election.
Structural issues that lead to agency problems/opportunistic behavior are the lack of appropriate committees and/or inappropriate appointments to those committees. For example, the head of the audit committee should be someone with a background in finance, but in several of the most flagrant cases, the audit committee was composed of people with no finance background at all. Likewise, the remuneration committee should be composed or led by someone with an HR background. Otherwise, compensation consultants recommended by the CEO engage in a race to the top and result in frankly outrageous pay packages that appear to incentivize performance but, according to several studies, pay out no matter whether the company does well or poorly (Robert A. G. Monks, 2005).
So whether it’s by ineptitude or poor structure, poor governance has predictable results according to agency theory. When added to the diffuse nature of share ownership and the difficulty in changing the board or having any activist say in the running of a corporation, the problem of managerialism, disconnected agency, and opportunism gets worse and worse.
I was re-watching “The Smartest Guys In the Room” (about the Enron debacle) recently and I was amazed by how much intentional (motivated) ignorance there was on the part of the Board of Directors regarding the operations of Fastow’s finance department. Not only was he obviously breaking many conflict-of-interest laws, but also many commonly accepted accounting practices. The fact that even Arthur Andersen was complicit is mindboggling.
The behavioral economists and ethicists call this “motivated reasoning” and it’s one of the primary problems with most boards and board committees today. They all have motivations (keeping their profitable board seats) to look the other way and not exercise their fiduciary duty. It’s not till shareholders and institutional investors start holding them accountable will they lose the motivation to look the other way. And then maybe the particle, now watched, will start behaving differently.
Will it ever be possible to have good corporate governance under the current structure of shareholder capitalism? Again, following Monks (2008), there are a number of factors that make it unlikely that managerialism (the primacy of management over shareholders) will be displaced anytime soon:
- Shareholder diffusion: the fact that shares are widely dispersed means that no shareholder has enough power to insist on governance change or insist on creation of greater shareholder value.
- Management control of board selection process: In most companies, the directors are recommended by the management. This means that the directors owe their jobs to the CEO.
- The lack of rights of shareholders to recall or replace shareholders. The management had most of the rights to elect boards and are protected from takeovers that might benefit the shareholders.
- Motivated reasoning: Until there is some countervailing motivation or structures are built into the board to hold board members accountable, wishful thinking is likely to keep boards docile and dependent.
Until these structural flaws are dealt with, it seems that management will continue to run companies with very little interference or oversight from the Boards of Directors.
References
Katz, C. M., Choate, D. E., Ready, J. R., Nuňo, L., Kurtenbach, C. M., Kevin, S., … Nuňo, L. (2014). Evaluating the impact of officer-worn body cameras in the Phoenix Police Department. , (December), 1–43.
Locke, R., & Spender, J.-C. (2011). Confronting Managerialism: How the Business Elite and Their Schools Threw Our Lives Out of Balance (Economic Controversies). London: Zed Books.
Monks, R. A. G. (2002). Creating Value Through Corporate Governance. Corporate Governance, 10(3), 116–123.
Monks, R. A. G. (2005). Corporate Governance – USA – Fall 2004 Reform – The Wrong Way and the Right Way. Corporate Governance, 13(2), 108–113. doi:10.1111/j.1467-8683.2005.00409.x
Wright, P., & Mukherji, A. (1999). Inside the firm : Socioeconomic versus agency perspectives on firm competitiveness. Science, 28, 295–307.
Capital and Conscience 