by David F. Larcker
Stanford Graduate School of Business
Brian Tayan and I recently co-authored a book, titled Corporate Governance Matters, which takes an organizational perspective, rather than a legal perspective, on the important topic of modern corporate governance. Our purpose is to examine the choices that organizations can make in designing governance systems and the impact those choices have on executive decision-making and the organization’s performance. The book relies on an extensive body of professional and scholarly research, and aims to correct misconceptions and cut through the considerable rhetoric surrounding corporate governance. We hope the book provides a framework that enables practitioners to make sound decisions that are well supported by careful research.
Our book covers a wide range of topics regarding corporate governance. These include a discussion of the environment in which the organization competes to understand how various forces influence the mechanisms it adopts to discourage self-interested behavior by management. In addition, we spend considerable time examining the board of directors, including the structure, processes, and operations of the board, along with the board’s functional responsibilities, such as oversight and risk management, succession planning, compensation, accounting and audits, and the consideration of mergers and acquisitions. We also examine the role of the institutional investor to understand how diverse shareholder groups and third-party proxy advisory firms influence governance choices. The book also includes an assessment of commercial and academic governance ratings systems.
Many of the conclusions of the book are phrased in the negative. While the lack of positive correlations may disappoint some, this has important implications for the current debate on governance and your evaluation of the types of governance systems that organizations might require. Some of the central lessons we draw in the book including the following:
Testing Remains Insufficient
First, the lack of positive correlations suggests that most of the best practices—either those recommended by blue-ribbon commissions and high-profile experts or those required by regulators—have likely not been tested, or important influencers have not properly understood the results of those tests. We saw this clearly in the passage of both Sarbanes-Oxley and the Dodd-Frank Act, in which considerable disconfirming evidence was not considered when restrictions were placed on nonaudit services provided by the auditor and greater shareholder democracy was required.
Instead, we share the sentiments of Myron Steel, Chief Justice of the Delaware Supreme Court, who recently wrote:
Until I personally see empirical data that supports in a particular business sector, or for a particular corporation, that separating the chairman and CEO, majority voting, elimination of staggered boards, proxy access with limits, holding periods, and percentage of shares—until something demonstrates that one or more of those will effectively alter the quality of corporate governance in a given situation, then it’s difficult to say that all, much less each, of these proposed changes are truly reform. Reform implies to me something better than you have now. Prove it, establish it, and then it may well be accepted by all of us.
This standard should be a precondition to all governance changes, both those mandated by law and those voluntarily adopted. Governance changes are costly, and failed governance changes even more so. They are costly to the firm in terms of reduced decision-making quality and inefficient capital allocation, and they are costly to society in terms of reduced economic growth and value destruction for both shareholders and stakeholders. We believe that careful theoretical and empirical work can go a long way toward better understanding what works and does not work so that changes can be made in a cost-effective manner. There is no question to us that “governance matters.” The fundamental challenge is to understand when and how it matters.
The Current Focus Is Misdirected
Second, the lack of positive correlation signals that much of the discussion focuses on the wrong issues, such as independent chairman, staggered boards, risk committees, and director stock ownership guidelines. As such, efforts to improve governance systems (and the regulations that tend to come with them) are likely misdirected. Instead of focusing on features of governance, more attention should be paid to the functions of governance, such as the process for identifying qualified directors and executives, strategy development, business model analysis and testing, and risk management. To illustrate this point, consider the following sets of questions:
- Does the company have a CEO succession plan in place?
- Is the CEO succession plan operational? Have qualified internal and external candidates been identified? Does the company engage in ongoing talent development to support long-term succession needs?
- Is risk management a responsibility of the full board of directors, the audit committee, or a dedicated risk committee?
- Do the board and management understand how the various operational and financial activities of the firm work together to achieve the corporate strategy? Have they determined what events might cause one or more of these activities to fail? Have these risks been properly mitigated?
- What is the total compensation paid to the CEO? How does this compare to the compensation paid to other named executive officers?
- How is the compensation package expected to attract, retain, and motivate qualified executive talent? Does it provide appropriate incentive to achieve the goals set forth in the business model? What is the relationship between large changes in the company stock price and the overall wealth of the CEO? Does this properly encourage and long-term performance without excessive risk?
In each of these, the first question asks about a governance feature, the second about a governance function. A focus on the latter will almost certainly yield significantly more benefit to the organization and its stakeholders.
A mistake that many experts make is to assume that the presence of the feature necessarily implies that the function is performed properly. That is, if a succession plan is in place, the assumption is that it is a good one; if there is a risk committee, the company takes risk management seriously; if compensation is not excessive, it encourages performance. We have seen clear evidence that this is not always the case. If experts and proxy advisory firms are to add any value, they should shift from a service that verifies that features are in place, to one that evaluates the success of various functions. This no doubt would require a substantial increase in analytical skills and processes, but it is a shift that markets would likely value.
Important Variables Are Clearly Missing
Third, the lack of positive correlation suggests that important variables that impact governance quality have been inappropriately omitted or underemphasized in the discipline. After all, governance is an organizational discipline. As such, the analysis should incorporate organizational issues—such as personal and interpersonal dynamics, and models of behavior, leadership, cooperation, and decision making. Without offering a comprehensive list, we believe the following elements are central to understanding how a governance system should be structured and when and where it is likely to fail:
- Organizational design — Is the company decentralized or centralized in structure? Have internal processes been rigorously developed, or did they evolve from historical practice?
- Organizational culture — Does the culture encourage individual performance, or cooperation? How are successes and failures treated? Is risk-taking encouraged, tolerated, or discouraged?
- The personality of the CEO — Who is the CEO, and what motivates this individual? What is his or her leadership style? What are the individual’s ethical standards?
- The quality of the board — What are the qualifications of these individuals? Why and how were they selected? Are they engaged in their responsibility, or do they approach it with a compliance-based mindset? What is their character?
As evidence, we see some of these aspects in the literature, but often peripherally and without thorough consideration. For example, an analysis of the linguistic patterns of the CEO and CFO is shown to have some relation to the probability that the company will have to restate earnings in the future. Strong leadership, clear access to information, and parameters around corporate risk taking are important in ensuring that the company develops an appropriate risk culture. Directors with extensive personal and professional networks facilitate the flow of information between companies. This can lead to improved decision making by both allowing for the transfer of best practices and acting as a source of important business relationships.
We believe that these types of analyses should be pursued further and with greater rigor. Doing so will require tools and techniques across disciplines. It is a mistake to think that corporate governance can be adequately understood from a strict economic, legal, or behavioral (psychological and sociological) perspective. All of these views are necessary to understanding complex organizational systems.
Furthermore, this necessarily implies that the optimal governance system of an organization will be firm-specific and take into account its unique culture and attributes. Adopting “best practices” will likely fail because that approach attempts to reduce a complex human system into a standardized framework that does not do justice to the factors that make it successful in the first place. This explains why two companies can both succeed under very different governance structures.
Context Is Important
Finally, governance systems cannot be completely standardized because their design depends on the setting. For example, governance systems differ depending on whether you take a shareholder perspective or a stakeholder perspective of the firm, as well as the efficiency of local capital markets and labor markets. They also differ depending on your view of the prevalence of self-interest among executives.
Consider, for example, John Bogle, the founder of Vanguard, who has written about self-interested behavior among executives:
Self-interest got out of hand. It created a bottom-line society in which success is measured in monetary terms. Dollars became the coin of the new realm. Unchecked market forces overwhelmed traditional standards of professional conduct, developed over centuries. The result is a shift from moral absolutism to moral relativism. We’ve moved from a society in which “there are some things that one simply does not do” to one in which “if everyone else is doing it, I can, too.”
The extent to which you believe this is the norm in society will have a direct impact on the extent to which you believe control mechanisms should be in place to prevent the occurrence of self-interested behavior and the rigor of those controls. Nevertheless, in the end, a balance must be struck. Excessive controls will lead to economic loss by retarding the rate of corporate activity and decision making. Lenient controls will lead to economic loss through agency costs and managerial rent extraction.
As our book seeks to demonstrate, context is critical to designing an effective corporate governance system.