Making Sense of Nonsense: Enhancing Corporate Governance Through Compliance

by Peita Lin

“It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.” — Adam Smith

While not the first to make such an assertion, much of modern capitalism works under the assumption that the inherent vices that drive human behaviour, namely self-interest and the inordinate accumulation of wealth are thought to be in aggregate beneficial for society. As a certain fictional investor once so eloquently remarked ‘greed, for a lack of better word, is good’.

We’re all utility maximisers and corporate executives, as the fittest specimens of this criterion, serve to remind the rest of us why we’re not making seven digit salaries. The greedy tendencies that drives and motivates their success are often at times to the detriment of others; and therein lies the fundamental problem underpinning much of corporate governance. We expect them, the executives and managers, to act ruthlessly in competition but fairly in the allocation of accrued benefits to us, the faceless shareholders. The technical term is ‘agency conflict’ and a great deal of time has been spent detailing and proposing solutions to this problem with varying degrees of success. A quick definition for the uninformed: the separation between ownership and control in an incorporated firm creates tensions between the interests of the principal and agent thereby creating a position of moral hazard.

A natural reaction to all of this is to suggest vague and vacuous calls for more regulation once failings in governance become evident as is the case in financial sectors over much of recent history. We began the last decade with Sarbanes-Oxley and ended with Dodd-Frank. The stylized fact here is that booms and their subsequent busts tend to be followed by public outcry and a mad scramble by authorities to regulate. Greed induced risk taking is fine until things go awry, after which all matters of governance issues are raised, fingers are pointed and previously sturdy business practices are scrutinised by experts in hindsight.

Questions remain over the efficacy of these regulatory mandates. While it’s obvious why lenient measures fail, a scorched earth ‘one-size-fits-all’ policy typical of the U.S seems too callous an approach, particularly to the failing firms and fearful investors in times of economic disarray. We can only hope that emergency measures serve as a band aid fix rather than red tape. Furthermore, consideration needs to be made with respect to the diversity of ownership structures that have been widely noted empirically in the corporate governance literature of late. The nature of the agency conflicts, contestability of control and ability for shareholders to voice concerns are likely to differ between firms.

Like the first law of thermodynamics, power is neither created nor destroyed, it’s simply taken by force or transferred. Where power flows, newly empowered agents find new ways to leverage their agendas. Thus explicit rules that disturb the status quo of stakeholders within a company will in most cases only displace the current agency problems with a set of new ones which may not be readily apparent.

UK’s Walker report (2009) which operates under a ‘comply or explain’ principle considers these issues but it’s not without flaws. It begins with the assertion that current gains in governance are to be had in compliance rather than mandates. The idea is to reduce the number of situations where one would suffer from the temptation to act irresponsibly and suggests improvements in board composition, director quality and reassessments of remuneration policy as the way to go. Problems arise however in that these recommendations are based on governance related factors with little or no empirical evidence. Too often are things taken at face value and passed off with legitimacy. For example many governance factors are of dubious significance due to statistical biases caused by endogeneity and measurement error. Performance indexes fare no better and are by and large constructed in an ad-hoc and arbitrary manner.

The comply or explain approach also suffers in that shareholders only demand explanations if a firm fails to perform. This promotes inappropriate risk taking and indeed much of corporate culture is geared this way. The prevalence of lucrative short term bonuses and absence of shared downside risk for executives are a root cause of risk-seeking misbehaviour, although deferrals of short term bonuses and increased punishment as a deterrence mechanism may help address these concerns.

But these are all really just first-world problems in light of other forms of misbehaviour. Consider the canonical homicide problem. I’m sure many people would have brilliant explanations under the UK method but the point rests in that harsh punishment as a deterrence mechanism works well in attenuating degenerate behaviours. If these greedy corporate types are so keen on risk, let them have their risk; lets up the stakes and introduce harsher criminal charges for excess negligence and corporate fraud.

Peita Lin is an Honours student at Queensland University of Technology.

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