Jun 14, 2012 at 5:08am

The Capitalist firm is based upon some people giving some of their money to other people so that they (the ones who receive the funds) can use it to make money for the owners of the funds. Without this process firms cannot grow.

This process is inherently risky. Shareholders must be confident that their assets will be well and accountably managed and that managers will not use guile and deceit to appropriate the shareholders’ funds for themselves or use them incompetently or hazardously. Governance structures are intended to reduce the risk of these possibilities.

Corporate Governance is the system by which companies are directed and controlled. Boards of directors are responsible for the governance of their companies. The responsibilities of the board include setting the company’s strategic aims, providing the leadership to put them into effect, supervising the management of the business and reporting to shareholders on their stewardship. The board’s actions are subject to laws, regulation and the shareholders in general meeting. (Cadbury, 1992, p. 25)

Governance is good for shareholders and good for business. It supplies a positive discipline on directors’ behaviour, reducing the possibility of biased, complacent risk-taking. McKinsey (2000) found that investors would pay more for the shares in well-governed companies, especially when the firm is located in a part of the world when financial standards are not seen to be high. Investors said that they took governance structures and processes into account when making investment decisions.

Governance structures are necessary because managers occasionally fail in their stewardship of investors’ funds.

During the 20th century governance structures and processes have changed following a series of corporate collapses and governance scandals in the US in the late twenties, again in the early 2000s and (the Sarbanes-Oxley Act of 2002). The Cadbury (UK) report of 1992 was a response to the corporate collapses of the late 1980s.

France had the Vienot report, (1995), South Africa the King report (1995). All these reports were concerned with the potential (and in many cases, actual) abuse of corporate power at the expense of the shareholder.

Why do corporate leaders and their boards fail to execute their proper stewardship of investors’ funds?

Governance failures are not simply the result of individual executive sinfulness or greed, they are not exceptional, accidental, a deviation from the norm but in some ways may display an excessive and distorted compliance with prevailing values and systemic tendencies - with prevailing conceptions of leadership and prevailing executive compensation regimes which stress the unique heroic qualities of leaders and reward them with unbelievable compensation packages.

When governance failure results from incompetence this can arise not because of individual failings but either because boards do the wrong things (because at the time these are regarded as virtuous), or because they do things wrong - because they fall victim to systemic weaknesses of board dynamics.

Boards do the wrong thing if they commit the firm to the pursuit of a flawed strategy. The better they are at pursuing this flawed strategy the worse, ultimately, will be the consequences for the investors. Executive commitment to shareholder value is an example of a flawed strategy.

The recent near collapse of General Motors and the relatively poor performance of many US/UK firms has been attributed to the short-termism and obsessive cost cutting and decline in investment that are associated with an emphasis on maximising shareholder value.

But boards also make poor business decisions through trying to do the right things but failing to do so – because boards are congenitally prone to develop processes, habits and routine which greatly assist efficiency but also lead to decision-making dangers. These possibilities arise from the normal functioning of the organisation and the board.

The conventional view sees management and decision-making as rational, systematic, evidence-based objective.
But this is not how decisions are made in reality. The complexity of organisations and individuals’ cognitive limitations mean that decision-makers are unable to realise the rational approach to decision-making. Key issues may be unclear, ambiguous or contested; data about options may be incomplete, misrepresented and key success criteria may be disputed or uncertain. The full range of possible options is not considered (indeed some options are not even defined as options) while historic and current options are given special emphasis and importance. Also executives try to avoid uncertainty by avoiding the pressure to anticipate events in the distant future and instead emphasise short-term reactions to short-run feedback. They solve pressing problems rather than develop long-term strategies.

Organisations are structures of power and power impacts on decision-making. Power-holders (executives) may behave in ways which are supportive of their sectional interests - define issues in the light of their interests and priorities or try to block the initiatives of others as part of sectional rivalries. They may manipulate or block or create information; build alliances to further their interests. And if other groups are behaving in the same way decisions may be made not on the basis of reason but through bargaining, negotiation and compromise which generates less than optimum outcomes.

Over time senior teams develop ways of thinking, decision-making procedures, shared assumptions and values which greatly help (and speed up) decision-making. But these ‘recipes’ paradoxically can also limit thinking and open-ness: it becomes hard for executives to step outside these, especially when they seem to be working. They develop unrealistic optimism; explain away any contrary data by attributing the data to exceptions. Ways of thinking, search techniques, and modes of analysis develop over time which become constraining under new circumstances: past successes and cognitive rigidity encourage intellectual conservatism, and team solidarity makes this conservatism and consensus difficult – even dangerous – to breach.

Boards are groups. Groups are prone to tendencies which distort decision-making and may result in over-optimistic and unrealistic behaviour. Group decision-making tends towards conformity: they put their members under pressure to adjust their views to the group norm. Group decision-making also tends towards increased riskiness. These risks are exacerbated in groups where there are differences in power and status where junior members may defer to or excessively ‘respect’ the views (or perceived views) of senior team members. These conditions can discourage confrontation, encourage acquiescence because in the face of a lead from a respected superior, junior members may be over-impressed and easily persuaded. These tendencies are exacerbated in organisations (or countries) where there is a strong culture of respect towards authority, or towards interdependence rather than independence.

‘Groupthink’ is the possibility that ‘members of any small cohesive group tend to maintain esprit de corps by unconsciously developing a number of shared illusions and related norms that interfere with critical thinking and reality testing’ (Janis, 1972, p. 36)

If governance is to be improved it’s necessary to understand why executives risk shareholders’ funds. And while some of the explanation for poor stewardship results from greed or criminality much results from normal (if dysfunctional) processes of team dynamics, and much is a result of the prevalence of pervasive and distorted conceptions of the nature of corporate leadership (and associated reward packages) and conceptions of proper organisational purpose prevalent in the West.


By Graeme Salaman