Corporate governance “covers all the mechanisms that govern the managers’ behavior and delineates their discretionary latitude.”5 The need for such mechanisms stems from the separation of ownership of the firm by shareholders and control of the firm by man-agement. However, it runs more deeply than this, and ultimately resides in the concern that any manager may make decisions and take actions that are in his or her own interest with no regard for the interests of others.
Many mechanisms contribute to corporate governance, including firm-specific pro-cesses of checks and balances, and ultimately the board of directors; external mechanisms such as regulatory constraints; and the market itself which exerts pressures on firms to achieve their potential—underperforming firms become takeover targets. The serious-ness and importance of corporate governance mechanisms became all too apparent amid one corporate crisis after another that revealed the shortcomings of those mechanisms.
In early 2004 Economist.com stated that “a new mood of austerity appears to reign in America’s boardrooms. The Sarbanes-Oxley Act of 2002, the most radical reform of cor-porate governance since the Great Depression of the 1930s, imposed tough new rules on companies—and harsh new penalties on wrongdoers. After a tumultuous few years in which a series of corporate America’s best-known names admitted to wrongdoing of one sort or another—the roll-call includes Enron, WorldCom, Qwest, Adelphia, Rite Aid, Tyco and Xerox—the focus shifted to Wall Street’s banks and fund managers, giving industrial companies some breathing space.”6
Enron’s collapse was dramatic, and a prime example of corporate governance failure.
Once the darling of Wall Street, in 2001 Fortune stated that
Right now, the title of “It Stock” belongs to Enron, the Houston energy giant. While tech stocks were bombing at the box office last year, fans could not get enough of Enron, whose shares returned 89%. By almost every measure, the company turned in a virtuoso performance: Earnings increased 25%, and revenues more than doubled, to over $100 billion. Not surprisingly, the critics are gushing. But for all the attention that is lavished on Enron, the company remains largely impenetrable to outsiders, as even some of its admirers are quick to admit. To skeptics, the lack of clarity raises a red flag about Enron’s pricey stock.7
The red flag loomed larger as analysts began to uncover what lay behind the Enron numbers. By mid-August, 2001 the stock had fallen from $80 at the beginning of the year to the low $40s and CEO Jeff Skilling announced that he was leaving Enron.
Skilling was replaced by Ken Lay, who had been Enron’s former CEO, and who had a high level of credibility on Wall Street. Lay assured the public that there were no
“accounting issues, trading issues, or reserve issues at Enron.”8 However, this was not the case. In an October press release Enron announced a $618 million loss. It had also written down shareholders’ equity by $1.2 billion. On December 2, 2001 Enron filed for bankruptcy. Enron’s auditor, Arthur Andersen, was drawn into the scandal and subse-quently collapsed.
John Zimmerman of USA Today summarized the key learnings from the Enron debacle.
Reviewing the entire nasty scene reveals at least three conclusions. First the break-downs were internal and caused by ignored or flawed ethics and beliefs at the highest personal and corporate levels. Second, many parties beyond senior executives and their greed contributed to the mess. Boards of directors failed their governance and, in some instances, they shared in the gains; the giant accounting firm Arthur Andersen forgot what auditing and fiscal responsibility was all about and was found guilty;
middle managers down through the financial and legal departments knew something serious was amiss, but remained silent; Wall Street became enamored with growth and stock value regardless of reality; and banks provided unlimited capital with little due diligence or even concern for repayment potential. Third, most of the corrective action is external [which] can be helpful, but ethical behavior can’t be legislated. It has to come from within.9
Boards of directors have been a prime target for reform. Although the board of directors must ensure that the strategic direction of the organization is in the best interest of the corporation and in particular the shareholders, there have been many criticisms about its effectiveness in achieving this mandate. One of the primary criti-cisms is that the board tends to be dominated by internal management, or friends of management, rather than individuals who operate at arms-length. On the other hand, individuals with an arms-length relationship may not have sufficient understanding of the business to intervene in discussions of strategic direction. There have been numer-ous prescriptions to remedy the situation. A set of prescriptions revolve around the structure of the board: separating the roles of CEO and chairman of the board, and appointing more outside directors and directors with greater diversity to increase the representativeness of the board and enhance its objectivity. Another mechanism has been to manage executive compensation to better align the interests of management with those of shareholders through stock option plans.
Although these mechanisms have focused on tightening control over wayward man-agers whose management preferences may be out of line with what is in the best interest
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of the corporation, John Pound argues that these mechanisms “do not address the funda-mental problems in corporate governance, which stem not from power imbalances but from failures in the corporate decision making process. . . .The goal should be to prevent significant mistakes in corporate strategy and to ensure that the mistakes that do occur can be corrected easily.”10 Pound argues that most performance crises are not because of incompetence or wayward managers, but because of failures of judgment. This is a criti-cal point. Although there are blatant breaches of ethics, many unethicriti-cal decisions are revealed more clearly with hindsight. In the midst of conversations and ultimately deci-sions, the ethical dilemmas may not be so apparent. In a recent study entitled “Leadership on Trial” it was deficiency in leadership character—wisdom, courage, justice, temperance, humanity, and transcendence—that was identified time and again by senior leaders as a major factor11 contributing to the economic crisis. In Chapter 9 we outline a number of cognitive biases that lead to these failures of judgment. However, it is important to note that boards of directors are not immune to these biases.
In addition to the cognitive biases that managers face, boards also suffer from several other decision-making shortcomings. They often lack the expertise to question manage-ment, and when a director does have the expertise, he or she often feels like a lone wolf in questioning the direction posed by management. Furthermore, board members lack the time and information resources to collect evidence that would counter that presented by management. As a result, it is extremely difficult for board members to counter errors of judgment by management.
Pound offers five recommendations: 1) Board members must be expert; 2) Board meeting procedures should focus on debating new decisions, strategies, and policies, not just on reviewing past performance; 3) Directors need better access to information; 4) Directors should be required to devote a substantial portion of their professional time to the corporation; and 5) Board members must have the right incentives.
Ensuring strong corporate governance is essential to restoring confidence and trust in a capitalist system. “Trust reduces monitoring and transaction costs in com-panies and in the wider economy. At the most basic level . . . ethics are a low-cost substitute for internal control and external regulation.”12 Furthermore, evidence shows that the best companies worry about governance and integrity. In a Financial Times survey, the top 20 most respected companies (global operators with distinctive brands, strong leadership internally and in the market place, long-term track record of growth, financial performance, and delivering shareholder value) were also the top 20 demonstrating the most integrity.13 In addition, “a study of 725 U.S. large capi-talization domestic equity funds found that portfolios heavily weighted in companies with above-average corporate governance scores reported better performance over three and five year periods.”14
There has been a wave of reform in corporate governance since Enron. A major study undertaken in 2002 revealed significant reforms in the boardrooms of Canada’s public companies including an increase in corporate governance committees, formal systems for
director recruitment, voluntary publication of corporate governance issues including how much a company’s auditors are paid for non-audit work, the number of board meetings held, and the attendance records of directors. The study also found increasing indepen-dence of key board committees (e.g. no management on the audit committee), but a sur-prising decline in overall board independence. This may be due to a tighter definition of independence.15
The foregoing has focused on the tension in balancing interests of customers, employ-ees, and shareholders. In a general sense, we can extend the list to include suppliers and other partners associated with the business. However, there is considerable pressure to expand the domain of stakeholders to include society at large. To understand this perspec-tive we examine corporate social responsibility (CSR).