Corporate Governance Based on Self-Interest as an Axiom - Corporate Governance and Business Ethics

Corporate governance can be defined as “the determination of the broad uses to which organizational resources will be deployed and the resolution of conflicts among the myriad participants in organizations” This definition raises two major questions (e.g., Steinmann 1969; Steinmann and Gerum 1992). First, whose interests should guide the companies’ strategies and policies (question of legitimacy)? Second, how should formal decision-making procedures be designed in order to serve these interests (question of organization)?

The dominant paradigm in the corporate governance literature is based on institutional economics, in particular property rights and agency theory (e.g. Jensen and Meckling 1976). This paradigm considers the first question as resolved. Companies are viewed as a “nexus of contracts” between different resource owners who cooperate in order to generate quasi-rents. Quasi-rents are the difference between the value of a resource used in combination with other resources and its value in a market transaction (e.g., Zingales 1998). Except for shareholders, all other parties are assumed to protect their claims ex ante by means of clearly defined contracts. Shareholders, however, are considered as residual claimants. They specialize in monitoring the other cooperation partners (Alchian and Demsetz 1972) and in diversifying their risks (Jensen and Meckling 1976). In return, they receive a claim on the residual surplus of the company after all contractual obligations with other stakeholders have been fulfilled. Since all contracts are clear and complete, there are no conflicts of interest between shareholders and other stakeholders. The only conflicts of interest remain between shareholders and self-interested managers. These conflicts of interest become particularly salient when ownership is separated from control (Berle and Means 1932) in companies with widely dispersed share ownership. In this perspective, the legitimate guiding interest of a company’s strategy and policies is shareholder value. The question is merely how to incentives a company’s management to focus on the maximization of shareholder wealth.

The question of organization arises from the principal-agent-relationship between shareholders and managers. While shareholders are the principals, managers fill the role of agents who have no or little residual claims. Because of information asymmetries, managers have the possibility to expropriate outside investors. Therefore, corporate governance institutions need to be designed in a way that protects outside investors against expropriation.

Based on the assumption of self-interest as an axiom, a number of disciplining institutions are suggested to protect shareholders against expropriation. These institutions are both inside and outside the firm, such as the board of directors, the market for corporate control, the market for managers, and the audit firm (e.g., Kräkel 1999; Witt 2003). The board of directors is proposed to represent the interests of shareholders, thereby reducing the problem of rational apathy by minority shareholders (Berle and Means 1932) who have an incentive to free-ride rather than control the management’s activities. The control of management is considered to be particularly effective if the directors on the board are independent of management. Both the pay of board members and the pay of managers are suggested to be tied to the company’s performance in order to ensure an alignment of their interests and the interests of shareholders.

These suggestions have largely been followed in practice. The Sarbanes-Oxley Act, for example, is founded on the ideas of agency theory. It reinforces monitoring and sanctioning of management and can be described as “corporate governance for crooks” (Osterloh and Frey 2004). Agency theory has had a particularly strong influence on management compensation. Two decades ago, the high proportion of fixed compensation for managers, which resembled the salaries of bureaucrats (Jensen and Murphy 1990), was deplored. Only a few years later, the fixed compensation for US managers amounted to just 25% of their total income (Murphy 1999), largely due to stock options. At the same time, the difference between the average incomes of employees and top managers in S&P 500 companies has risen sharply (cf. Klinger et al. 2002). However, these developments did not lead to a strong relationship between managerial pay and companies’ performance (e.g., Barkema and Gomez-Mejia 1998; Bebchuk and Fried 2004) that can be attributed to above-average managerial performance (Hall and Murphy 2003). Less than 5% of managerial income can be explained by performance factors (Tosi et al. 2000). Not only is the impact of variable managerial pay on companies’ performance ambiguous, but variable pay may also cause distortions. Among the companies that were convicted for fraud by the Security and Exchange Commission (SEC), the median value of variable income related to shares and stock options was twice as high as in non-fraud companies (Johnson et al. 2009). Moreover, the number of restatements of US corporations is highly correlated with the proportion of stock options relative to the total income of top managers.

Many empirical studies have illustrated that top managers are able to manipulate the performance criteria according to which they are measured (Bebchuket al. 2001; Becht et al. 2002). An example for these manipulations is “earnings management”, that is, influencing the company’s profits by means of accrual and amortization (Healy and Wahlen 1999) or manipulating reference groups that are chosen to compare managerial income (Benz et al. 2002; Bertrand and Mullainathan 2001). These developments were reinforced by the use of compensation consultants and the disclosure of top management’s income that was required by the SEC Bizjak et al. 2008; Schiltknecht 2004). Even in agency theory, it has been acknowledged that variable pay has led to considerable abuse (e.g., Bebchuk and Fried 2004; 1uller and Jensen 2002; Hall and Murphy 2003; Hall 2003; Schiltknecht 2004). However, it is believed that the system of variable managerial pay can be improved to eliminate negative side-effects.

There are also other suggestions derived from the principal-agent approach that do not find convincing empirical corroboration. Ambiguous relationships have been found between stock-based compensation of board members and companies’ performance (Dalton et al. 2003) and between the proportion of independent board members and companies’ performance (Dalton et al. 1998; Hermalin and Weisbach 2003). Other studies have examined the market for corporate control. Management is assumed to be controlled efficiently if there are no obstacles to takeovers. Protections against takeovers, such as poison pills or staggered boards, are seen as detrimental since they allow inefficient management teams to stay in office. However, it has been shown in the US that poison pills did not systematically deter takeovers or cause a demise of the market for corporate control (Comment and Schwert 1995). In sum, while the principal-agent approach is very popular in theoretical debate and in practical application, it has not been an empirical success story (Daily et al. 2003). Therefore, it makes sense to consider alternative theoretical perspectives.

Many alternative theoretical perspectives question the assumption that, except for shareholders, all other stakeholders are able to protect their claims ex ante. A particularly influential alternative perspective is the theory of incomplete contracts. The theory of incomplete contracts (e.g., Tirole 2001; Zingales 1998) submits that not all future circumstances can be specified in contracts. Some stakeholders, in particular employees, carry out firm-specific investments in human capital that generate quasi-rents. These quasi-rents are lost when the cooperative relationship with other stakeholders is terminated. As a consequence of their firm-specific investments, the employees’ outside opportunities are worsened (Zingales 1998). Unless they are offered control rights after the conclusion of the contract, they are in a weak bargaining position and may face the risk of hold up. Employees anticipate this risk and therefore prefer to invest in general rather than firm-specific human capital. A lack of investment in firm-specific human capital has negative consequences for the company. As the knowledge-based theory of the firm emphasizes, one of the most relevant assets for a company’s sustained competitive advantage is firm-specific human capital, which needs to be generated, accumulated, transferred, and protected (e.g., Penrose 1959; Rumelt 1984; Mahoney and Pandian 1992; Grant 1996; Kogut and Zander 1996; Spender 1996; Teece et al. 1997; Foss and Foss 2000; Grandori and Kogut 2002).

The theory of incomplete contracts does not offer a universal suggestion concerning the distribution of control rights. While offering control rights to stakeholders induces their firm-specific investments, it may also raise coordination costs due to he heterogeneous interests of different stakeholders (Hansmann 1996; Tirole 2001). Corporate governance is proposed to be designed in a way that maximizes quasi-rents while minimizing the costs of inefficient ex post bargaining (Frick et al. 1999). Under certain circumstances, it might still be most efficient to offer the right of controlling a company to one single stakeholder group, such as shareholders. Although multiple stakeholders may have legitimate interests in guiding a company’s strategy and policies, this does not necessarily mean that these stakeholders should be involved in formal decision-making procedures.

While the theory of incomplete contracts has generated valuable insights, it still shares the axiomatic assumptions of the dominant paradigm concerning the self-interest of directors, managers, and employees. We suggest that a theory of corporate governance needs to be based on more refined motivational foundations. The new and fast-growing field of psychological economics (e.g., Fehr and Falk 2002; Frey and Benz 2004; Rabin 1998) is able to provide corporate governance theory with empirically founded psychological insights. Moreover, it contributes to bridging the gap between institutional economics and research on organizational behavior.

It may be argued that the simplistic institutional economic model of human psychology can still generate robust predictions and be scientifically valid (Friedman 1953). While this argument has been criticized at the epistemological level (e.g. Donaldson 1990), a brief analysis of the current financial crisis illustrates that a too simplistic model of human psychology carries the risk of suggesting control measures that produce self-interest as a self-fulfilling prophecy (Frey and Osterloh 2002; Ghoshal and Moran 1996).


All rights reserved © 2018 Wisdom IT Services India Pvt. Ltd DMCA.com Protection Status

Corporate Governance and Business Ethics Topics