Corporate Governance and Behavioural Ethics

There are two ideas that underlie most theories about corporate governance, and those reflect the assumptions of the classical economic theory of homo economicus, or economic man (or, more politically correctly, economic person). Economic man encapsulates two assumptions about human behaviour, i.e., that human beings always act in ways that are both rational and self-interested. While these assumptions are the bedrock of most classical and liberal economics, they have only recently begun to be tested empirically in the fields of behavioral economics and behavioral ethics. As I wrote in my 2011 article in Compliance and Ethics Professional, the empirical examination of rational self-interest has exposed some substantial faults in these assumptions. What has not yet happened, as far as I can see, is for these insights about human behaviour to be propogated to the study of corporate governance.

There are two primary theories of corporate governance, the shareholder/agency theory and the stakeholder theory. Each makes different moral assumptions about the purpose of the corporation and the ethical and practical responsibilities of the senior-most decision makers in the corporate structure, the board of directors. The agency theory is more representative of the Friedmanite view that the sole responsibility of the corporation is to maximise legal returns to shareholders. Stakeholder theory holds that society gives the corporation its license to operate and therefore there are other groups, or stakeholders, to whom are owed consideration in addition to shareholders. Examples of these stakeholders are customers, workers, suppliers, communities, and society at large as representative of common/societal goods, such as the environment.

What both both these theories have in common, however, is that they both view the actors within the corporate system as self-interested and rational. In fact, agency theory is a direct expression of the assumption of selfishness. It suggests that because management and ownership are separated, the agent (the manager) will be motivated to behave in his or her best interest, not in the best interest of the principle (the shareholders/owners). Without the assumption of selfishness, the principle/agent problem disappears (or is at least diluted). This in turn calls into question many of the incentives used to align shareholder interests with those of the management (stock options, restricted stock, and contingent bonus plans). Much of the research done into employee motivation suggests that, beyond a certain minimal level, compensation is one of the least effective motivators of employee performance. This thus provides an ex post facto indictment of the belief in the centrality of selfishness for corporate governance.

While stakeholder theory demotes the importance of self-consideration, it places a greater emphasis on rationality. In fact, it requires an assumption quite the reverse of selfishness, in that assumes that managers and/or corporate boards can place their own self-interest in abeyance and, without bias, consider the interest of other actors. Prominent researchers (Kahneman, Tenbrunesel, Messick) have empirically demonstrated several varieties of self-interested decision-making bias. Perhaps even more consequentially, these biases are usually unconscious and/or self-deceptive, so the decision-maker doesn’t know he or she acting in a self-interested way, even when the entire project of stakeholder consideration is to combat narrow self-interest.

The practical implication of the outdated assumptions of both agency and stakeholder theories is that there can be a substantial mismatch between the intentions of corporate board, the decisions that boards make, and subsequent behaviour of management. At the very least, new systems of remuneration and incentives need to be developed to align corporate direction with management activity. Additionally, when incorporating a stakeholder approach to corporate governance, it is important to verify the interests of other stakeholders with those stakeholders themselves as self-interest biases can yield incorrect assessments in this regard. There are considerable opportunities in both academic and practitioner realms for the development of new, comprehensive theories of corporate governance and practical frameworks to control for bias and diverse motivations.

Timelines, Risk, and Right: The ethical danger of short-term rewards

An editorial in yesterday’s New York Times addresses a deservedly sensitive issue in the world of business ethics: compensation. Of specific interest to me, this editorial homes in on most important question: the relationship between risk and reward with regard to pay. While the Times editorial focuses primarily on the legislative approach to this problem (which is some time in the future) the more basic ethical/decision-making issue is how well we judge risk in the short term vs. the long term and how we are likely to behave when we are rewarded for one kind of risk when the ethical thing to do is focus on the other. In short, are these traders going to make better or worse ethical decisions when they are rewarded for short-term risk taking?

First, the practical considerations. It’s been widely and accurately claimed that much of the market behaviour that led to the debt-based asset bubble was driven by short-term rewards. In fact, if you examine the mortgage value chain, each of the players received rewards and passed the longer-term risk on to the next player. The borrower passed it to the broker, the broker to the bank, the bank to the investment bankers, the investment bankers to the investors. Ultimately, when the risk aggregated with the investors in the longer-term, the system melted down and the effect has been, in large part, the global financial crises.

What the current bankers and traders are doing is much the same. They are paid quarterly or annually for returns on their investments from that period. The previous quarter or year’s transactions aren’t tracked from a compensation perspective. Since most people, lacking a compelling reason, practical, ethical, or otherwise, will act in a way that rewards them, the bankers and traders will continue to focus on short-term gains.

This wouldn’t be a problem if these short-term gains added up to long-terms gains but frequently they don’t. The bailout of the financial system, which has cost the taxpayers of the United States more than a trillion dollars, is the paradigm case of this. What ends up happening, therefore, is that the short-term rewards are expressed privately in the huge (by any measure) bonuses in the financial services industry while the long-term risks are socialized and/or passed on to the investors. Thus we, as an investor nation, end up paying twice: once for the bailout, and again as our 401ks bite the dust. The traders and bankers only get paid.

And herein lies the fundamental ethical question. Is it right to transfer risk from the people who stand to gain from it to people who can only lose? In other words, it’s a question of upside, downside, and time horizon. What the current system does is reward the long-term upside rewards to those who only have short-term risk, the traders and investment bankers. It also places this downside risk mostly with the long-term investors/tax-payers. So, contrary to the mythology of free-market fundamentalists, the risk-takers aren’t truly rewarded, and those who are rewarded aren’t truly taking on risk. I think this could be unpacked much further, but I think what I’m trying to say is clear: by transferring downside risk from those who get for it (Wall Street) to others (investors and taxpayers), the system encourages the traders to act unethically because it rewards them for doing so. Because people are so bad at estimating long-term risk, they end up acting unethically without even knowing it.

I know that there’s a lot more to be explored here. In fact, probably a book’s worth. For example, what about the upside rewards for investors? If the traders are acting in a way that they are supposed to (at least institutionally), how can they be said to be acting unethically. These questions can be answered but they’re out of scope here. The point I’m trying to make is that the system is currently broken, from the perspective of risk, reward, and ethics. The Times is therefore right in thinking it needs to be reformed, probably through legislation and regulation. But it’s also important to understand how it’s broken in order to fix it correctly and this is what I don’t see much discussed in the current debate. I hope my little blog post adds something positive to the discussion.