Are corporate governance principles based on a flawed theory? Q&A with professor Loizos Heracleous

During the last few years, many large firms have been busy re-designing their governance structures and processes. The finance crisis, in particular, led to strong pressure from investor groups, industry associations and governments to implement reforms.

What, exactly, is “corporate governance”?

It is basically about specifying the roles and relationships between a company’s management, its board, its shareholders and other stakeholders.

If you have read my book, you will recall that I describe why a “governance model” should be defined for every major unit in an organization, but traditionally, the term “corporate governance” refers to the design of the key roles and decision bodies at the top of the organization only.

Here’s a quick drawing that illustrates some of the elements in a corporate governance structure:

As a more specific example, consider the Basel Commitee on Banking Supervision. It develops recommendations that in many cases are made into law in the 60 member countries.

The committee started by issuing recommendations about how banks should handle credit risks. But more recently, it has broadened its scope, by developing recommendations for how to improve corporate governance in banks.

In a document published in 2010, it explains how to define the role and composition of the boards of banks. It also proposes that every bank should have an independent risk management function, including a chief risk officer.

Similar guidelines have been developed for companies in many other industries.

In many cases, they make a great deal of intuitive sense. Few people would argue against the need for transparency and accountability in the way large corporations are governed.

But one key question remains….do these principles actually work? More precisely, do organizations that implement “good corporate governance” actually achieve better performance?

The rather embarassing answer is that we don’t really know. There is currently little evidence to suggests that modern corporate governance improves performance. One study concluded, for example:

“there is no evidence of substantive, systemic relationships between corporate financial performance and board leadership structure.”

To learn a bit more about this issue, I contacted one of the leading experts in the field, Loizos Heracleous, and asked him to explain what is going on here. Loizos is currently professor at Warwick Business School in the UK.

Here’s a summary of our conversation:

Q: Why isn’t there a stronger relationship between corporate governance and corporate performance?

A: What is needed for good performance is good strategic decisions. This is a necessary but not a sufficient condition for high performance.

For sound strategic decisions to be taken, there needs to be robust debate, questioning of assumptions, and engagement of contrary opinions.

There also needs to be proper monitoring of the results of such decisions so that the organization as a system, and its board, can learn and improve. This is why independence of the parties involved, transparency and accountability are important and are sound principles on which to organize boards.

The problem is that current governance rules are mostly geared towards protecting shareholders rather than achieving good strategic decisions.

Current corporate goverance principles are actually at odds with how one would define the responsibility of the board from a legal perspective. If we take seriously what the law suggests, directors are not accountable to shareholders but to the corporation as an independent legal person. Although shareholders own shares and voting rights, they don’t own a listed corporation in a legal sense.

The corporation has to take heed of the interests of a variety of stakeholders (including shareholders), and strategic decisions must balance these interests.

Q: Can you mention some specific examples of corporate governance principles that you consider to be problematical?

A: Two well known guidelines are to separate the role of CEO and Chair, and to have more independent directors on the board. These guidelines may make sense in many cases. But we need to recognize that there are arguments for and against such rules.

For example, separating CEO and Chair positions can increase the independence and scrutiny levels of the board. But it might also slow down decision making, encourage the CEO to share less or massaged information with board members. It can also make discussions at board level more adversarial than constructive.

Similarly, having more independent directors on the board may bring new perspectives and strengthen the monitoring function. But it may also reduce in-depth knowledge of the company’s specific industry at board level (since senior people from competing firms in the same industry would not likely be given a board seat).

This may lead lead to decisions that might look good in theory but would run into problems that could have been identified if more people with in-depth knowledge of the industry were present.

Clearly, the other extreme of having only executives at board level (as in many companies in Japan) is unhealthy as it effectively suppresses outside or competing perspectives from entering the discussion.

Different governance systems have tried to address this issue in different ways; for example in the US boards are mostly composed of non-executive directors, in the UK around half/half, in Germanic countries there are two groups, the executive and the supervisory, non-executive group which contains union representatives.

Q: Some might argue that the motivation behind “corporate governance” was not to raise performance in the first place, but rather to minimize the risk of failure, fraud, corruption, and so on. What would be your response to that?

A: Perhaps that’s true in terms of intention. Whether this was accomplished is an empirical question. Certainly many of the largest corporate fraud cases involved boards which ticked most boxes on the criteria of good governance.

Having said that, effective control systems are crucial for corporations, not just to minimize fraud and corruption, but as feedback systems for evaluating investments and strategic decisions.

But to reduce the role of the board however to a policeman would be unfortunate, since an effective board staffed with the right people can deliver much more value to a corporation.

Q. To what extent are the findings in your research acknowledged among those who create guidelines and advocate the adoption of different governance principles?

A: To a small or negligible extent.

One reason is that policy-makers may not be aware of research findings, another reason is that they may be wedded to a traditional view which supports these recommendations, and unwilling to entertain contrary hypotheses.

* * *

My own take on this is as follows.

There is a need for some clear rules and principles in this area. The key challenge seems to be that current governance principles are based on the “sharedholder value” model, which builds on some questionable assumptions, as Loizos describes in an article in Harvard Business Review.

In addition, as Loizos explains, the rules are fairly simple but their effects are more complicated. There are often unintended consequences of implementing a new rule or establishing a new role or structure.

This basically reminds us that corporate governance principles must be defined and implemented with a bit of understanding of organizational behavior. Organizations are complex beings.

Related posts:

Metaphors we live by….in designing organizations

Five questions you should ask before switching to a new organizational model