Corporate Governance Paradigm in Crisis

The March 2010 edition of Corporate Governance: An International Review (CGIR), one of our favorite “stakeholders,” contains three articles that struck me as particularly significant.

Corporate-Governance Ratings and Company Performance: A Cross-European Study by Annelies Renders, Ann Gaeremynck, and Piet Sercu finds a significant positive relationship between corporate-governance ratings and performance across 14 developed economies in Europe from 1999-2003. The strength of this relationship seems to depend on the quality of the institutional environment, the correlation being weaker in countries with higher corporate governance ratings and stronger in countries with weaker shareowner protection laws. The authors find that improvements in corporate-governance ratings over time result in decreasing marginal benefits in terms of performance.

Second, the editorial by William Q. Judge, Editor in Chief, is significant in announcing a new type of article, which CGIR intends to publish. Noting the thesis of Thomas S. Kuhn’s The Structure of Scientific Revolutions, that paradigms do not get replaced until a credible alternative arrives that more effectively describes and explains unsolved puzzles, CGIR now invites “Perspectives” to “challenge the existing paradigm in which corporate governance research operates, point to anomalies that are not being solved, and suggest an alternative world-view that may better solve the problems before us.” The first such offering is included in the issue and is prominent governance consultant John Carver.

A Case for Global Governance Theory: Practitioners Avoid It, Academics Narrow It, the World Needs It includes the following opening observation:  “A credible theory of corporate governance will not arise by studying what is.”

I assume it is his long-time consulting practice that taught him it is better to start with what we need from corporate boards, rather than what they already do. “Therefore, it is not descriptive theory we need for governance but prescriptive theory.”

Once we have determined the needs of governance, those need can serve as the measure to judge the appropriateness of “accounting standards, structural considerations, reporting methods, techniques of delegation, officers’ roles, the choice of topics for board involvement, even statutes and codes.”

Clarifying what boards are for must not be based on the needs of CEOs (as is all too common today). Because boards’ prime fiduciary obligation is to owners, their organizational authority comes from owners, and their relationship to management is one of greater authority, boards are organs of ownership, not of organs of management.

Carver’s theory, like his practice, builds on the central position of the board. If we examine the board’s central purpose, we are only distracted from our theory building by recounting how boards have been used. We must start from the barest necessity.

The board represents owners in the governance of the enterprise… The board is owner-representative before it is the CEO’s superior and, in fact, before it makes a decision to have a CEO to begin with… It is the board’s necessary function, then, to define and demand what owners want the organization to accomplish and what risks it may take… Construed in line with this raison d’être, the board should be the most vigorous shareholder activist in sight.

Starting from this basic foundation, Carver argues that many other things follow:

Carver’s theory has been elaborated into what he calls his “Policy Governance” model, which

positions governance as an owner-representative function rather than a management function; provides for resolute board action despite diversity of views among owners and even among directors; balances overcontrol and undercontrol through a policy design that enables boards to control what they need to control and safely leave to the CEO what they do not need to control; avoids both rubber stamping and micromanaging; optimizes the values of CEO empowerment and board control; moves directors from advising on management’s job to defining management’s job; forces the practice of group authority by allowing no way to elude it; ensures that committees are aligned with dominant board accountability; positions the topmost of a two-tier board arrangement as the owner-representative (“governing” board), and illuminates any practice or structure that detracts from total board allegiance to agency responsibility (such as executive/inside directors and chair-CEO duality).

While he doesn’t claim his model to be the only governance theory possible, he does argue forcefully that a globally-applicable theory would facilitate progress by introducing a common language, enhancing public perception of corporate boards as accountable stewards, clarifying the distinction between governance and management, guiding productive research, clarifying roles, and aiding investor confidence.

Kuhn posited that “normal science” is predicated on the assumption that scientists know what the world is like. Anomalies are discounted until extraordinary investigations lead the profession to new paradigms, incompatible with time-honored theories. Scientist reject the old paradigm only when the new has more explanatory power.

Unlike the natural sciences, where paradigms are used to explain and predict, corporate governance is socially constructed. Paradigms in our discipline are normative models, used to to discipline and guide. The major stumbling block to shifting paradigms is recognizing the element of choice. We aren’t stuck with what we have. We can choose to move to a whole new paradigm, if it offers a better foundation for building the kind of world we want.

Personally, I doubt if the current crisis will push us into a new corporate governance paradigm. However,  it may accelerate explorations of what such a paradigm might look like. I’m delighted to learn that  Corporate Governance: An International Review will facilitate such discussion.