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Introduction to Corporate Governance: Organizational Choices and Their Consequences

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Corporate governance has become a well-discussed and controversial topic in both the popular and business press. The authors of Corporate Governance Matters discuss corporate governance definitions, standards, and best practices in this introduction to their book.
This chapter is from the book

Corporate governance has become a well-discussed and controversial topic in both the popular and business press. Newspapers produce detailed accounts of corporate fraud, accounting scandals, insider trading, excessive compensation, and other perceived organizational failures—many of which culminate in lawsuits, resignations, and bankruptcy. The stories have run the gamut from the shocking and instructive (epitomized by Enron and the elaborate use of special-purpose entities and aggressive accounting to distort its financial condition) to the shocking and outrageous (epitomized by Tyco partially funding a $2.1 million birthday party in 2002 for the wife of Chief Executive Officer [CEO] Dennis Kozlowski that included a vodka-dispensing replica of the statue David). Central to these stories is the assumption that somehow corporate governance is to blame—that is, the system of checks and balances meant to prevent abuse by executives failed (see the following sidebar).1

As the case of HealthSouth illustrates, the system of checks and balances meant to prevent abuse by senior executives does not always function properly. Unfortunately, governance failures are not isolated instances. In recent years, several corporations have collapsed in prominent fashion, including American International Group, Adelphia, Bear Stearns, Enron, Global Crossing, Lehman Brothers, Tyco, and WorldCom. This list does not even include the dozens of lesser-known companies that did not make the front page of the Wall Street Journal or Financial Times, but whose owners also suffered. Furthermore, this problem is not limited to U.S. corporations. Major international companies such as Ahold, Parmalat, Royal Dutch/Shell, Satyam, and Siemens were all plagued by scandal that involved a breakdown of management oversight. Foreign companies listed on U.S. exchanges are as likely to restate their financial results as domestic companies, indicating that governance is a global issue.

Self-Interested Executives

What is the root cause of these failures? Reports suggest that these companies suffered from a "breakdown in corporate governance." What does that mean? What is corporate governance, and what is it expected to prevent?

In theory, the need for corporate governance rests on the idea that when separation exists between the ownership of a company and its management, self-interested executives have the opportunity to take actions that benefit themselves, with shareholders and stakeholders bearing the cost of these actions.13 This scenario is typically referred to as the agency problem, with the costs resulting from this problem described as agency costs. Executives make investment, financing, and operating decisions that better themselves at the expense of other parties related to the firm.14 To lessen agency costs, some type of control or monitoring system is put in place in the organization. That system of checks and balances is called corporate governance.

Behavioral psychology and other social sciences have provided evidence that individuals are self-interested. In The Economic Approach to Human Behavior, Gary Becker (1976) applies a theory of "rational self-interest" to economics to explain human tendencies, including one to commit crime or fraud.15 He demonstrates that, in a wide variety of settings, individuals can take actions to benefit themselves without detection and, therefore, avoid the cost of punishment. Control mechanisms are put in place in society to deter such behavior by increasing the probability of detection and shifting the risk–reward balance so that the expected payoff from crime is decreased.

Before we rely on this theory too heavily, it is important to highlight that individuals are not always uniformly and completely self-interested. Many people exhibit self-restraint on moral grounds that have little to do with economic rewards. Not all employees who are unobserved in front of an open cash box will steal from it, and not all executives knowingly make decisions that better themselves at the expense of shareholders. This is known as moral salience, the knowledge that certain actions are inherently wrong even if they are undetected and left unpunished. Individuals exhibit varying degrees of moral salience, depending on their personality, religious convictions, and personal and financial circumstances. Moral salience also depends on the company involved, the country of business, and the cultural norms.16

The need for a governance control mechanism to discourage costly, self-interested behavior therefore depends on the size of the potential agency costs, the ability of the control mechanism to mitigate agency costs, and the cost of implementing the control mechanism (see the following sidebar).

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