This article was originally published on Ciennce.
Something smells fishy about corporate governance today. Scandals, breach of trust, CEO hubris and apathy of corporate watchdogs make investors increasingly uncertain about how their capital is used by corporations. The big divide between shareholder activists and corporate executives has turned into a vicious circle where failures are being patched with increased control and regulation, fragilizing the system leading to unintended consequences and a need for even stricter control.
Stock Option Programs
One example of such is the popularity of stock option programs adopted by public companies in 1990’s. Subsequent research showed that executives possessed a great influence on their compensation plans manipulating information disclosure, accounting information or simply by pressuring their boards to increase their compensation packages. This was followed by strengthening the control over executives through imposition of audit and remuneration committees, increasing requirements for directors’ independence, reporting procedures and information disclosure. Executives’ risk taking offset by increased control was then needed to be stimulated by even stronger incentives.
While the delegation of decision-making authority to corporate executives is one of the primary benefits of a corporation, it also constitutes its major risk. While managers need autonomy and authority to run their corporations on behalf of the shareholders, the latter need to assure that this discretion is not misused by corporate executives. In Sweden, a number of high-profile corporate scandals involving the CEOs of large corporations such as Scandia, and now recently Swedbank, have shown that executives may use their authority to pursue their own goals at the expense of the shareholders lavishing themselves with excessive compensation packages and other perquisites. These examples of corporate failures demonstrated that present system of corporate governance is not always optimal when it comes to the creation of wealth for the shareholders and society in general.
Redesigning the system
Given the amount of capital invested in the listed corporation including not only private investments, but also pension and government funds, the current system of how corporations should be governed needs to be redesigned.
Coming back to the basic tenet of why we have a separation between those who supply the capital and those who decide on how it should be used, is the efficiency associated with delegation. Corporations funded by a large number of shareholders cannot be directed by the owners of the capital because of two key reasons: the competence and the engagement.
Recruited top executives who managed to advance in their careers to upper echelons through hard competition possess experience, skills and knowledge to lead their organizations, which capital providers may not necessarily have. Secondly, managers’ careers, reputation and income depend on the success of their decision-making, while shareholders who are not satisfied with quarterly results may simply divest from the corporation.
Today this advantage of having division of labor seems to be somewhat forgotten. While the public debate blames managers for behaving opportunistically, the policy makers tighten control over corporate executives, pressuring to maximize short-term results, even at the expense of the long-term opportunities. The question that rises up is whether increased control can make managers work harder to develop their organizations.
To create an optimal model of corporate governance one needs to take into consideration both the costs and then benefits of delegation. In my recent study titled “Costs and Benefits of Delegation: Managerial Discretion as a Bridge between the Fields of Strategy and Corporate Governance” (2016) I bring forward the question of effective delegation. On one hand, limiting managerial authority and autonomy can decrease opportunism. On the other hand, it may also result in inability of managers to capture profitable strategic opportunities and develop their firms.
Consideration of these trade-offs illuminates the balance between restraining and enabling managers in their decision-making. This balance will depend on the situation in which the decision is taken. Namely, considering the trade-offs between enabling and constraining managers corporations may undertake different approaches to corporate governance. When the stakes are high and the loss of shareholder capital is significant, corporate governance may undertake a more conservative approach, encouraging managers to focus on the preservation of capital and limiting their authority.
On the other hand, when the potential benefits are attractive corporate governance should encourage managers to strive for value creation. This implies that depending on the nature of business the company operates in, each firm will require a unique combination of controlling and enabling mechanisms of corporate governance. The benefits of this approach lies in the recognition of the main advantage of corporate form of organizing business activity – effective delegation. While focusing solely on controlling managers can assure that shareholders’ funds would not be misused, it also deprives corporations from realizing their full potential of growth and strategic development.
Reference: Yuliya Ponomareva (2016). Costs and Benefits of Delegation: Managerial Discretion as a Bridge between Strategic Management and Corporate Governance Linnaeus University Press Other: 978-91-88357-09-0
Image credit: Katja Hasselkus.
Find more about the author, Yuliya Ponomareva