Ideas to Apply Corporate Governance

Two levels of analysis: the internal concerns of corporate agency and the emergent effects on social welfare, are required while understanding ethical behaviour in the context of corporate governance:

Corporate agency’s premise is that employees, managers, and directors (i.e., agents) should behave in the best interests of owners or shareholders (i.e., principals).

Social welfare is based on the premise that companies should engage in fair dealing with all of their stakeholders—including customers, employees, suppliers, and communities, as well as shareholders—in accordance with the expectations of the larger society in which they operate.

“Shareholder value” is an economic imperative. The business judgment rule allows boards and managers to easily get away with pet projects, the avoidance of difficult decisions, or the excuse that “as long as the music is playing (for our industry), we have to dance”. But every time a corporation gives up ground in the capital markets through value-compromising behavior, it comes one step closer to losing its viability as a stand-alone entity, and its ability to afford the maintenance of its stakeholder ecosystem. (It will be interesting to see if “B-corps” will be able to survive in the current capital markets, or if they will have to derive capital exclusively from endowments, as non-profits are supported, or if some hybrid capital/endowment market will evolve to accommodate them.)

The single most important job of the board is getting the right CEO. A close corollary is its willingness to get rid of the wrong CEO. Boards have to force themselves to do this work conscientiously because it can be personally uncomfortable, especially if the CEO does not want to spend time on it. Boards are also reluctant to force changes, since CEO transitions generally create a dip in the stock price; but if done it right, the company will quickly end up further ahead than where it would otherwise be.

External shareholders are inherently, significantly constrained regarding what they can know. These constraints make it easier for management and the board, and in fact make it compelling, to practice “short-termism”, e.g., via earning management. But companies have considerable leeway in choosing whether or not to play that game.

When it comes to executive compensation, “How” is much more important than “How much”. Incessant criticism of CEO pay has driven most boards to focus on compensation cost to the point of ignoring incentive effects. Overpaying the CEO could result in the waste of millions of dollars to a large company, and should be avoided. However, for a similarly sized company, the difference between mediocre incentives and good incentives can easily be worth hundreds of millions of dollars.

Good boards provide a balance of advisory support as well as monitoring oversight. Much of the corporate governance discussion for the last two decades has (appropriately) focused on the need for better monitoring, but research indicates the pendulum may have swung too far, with the advisory roles of boards getting short shrift. When these two roles come into conflict, as they invariably must, the board’s job is to resolve that conflict as best as possible in favor of shareholder interests.

Overconfidence and hindsight bias are enemies of effective governance. Companies benefit from constantly questioning what they are doing right and what they can do better, rather than assume that everything is fine when times are good, or that sweeping changes are necessary when times get rough. (It’s tough for a public company to avoid these reactions since these biases are at least as strong among the investor community.)