The Recurrent Crisis in Corporate Governance

With fits and starts, the current governance crisis has been 30 years in the making. The decline in performance of the over-diversified, overstaffed corporation in the 1980s was marked, and blamed on management that was essentially ungoverned. A round of firings of management followed, accompanied by the creation of independent, active boards of directors. Governance reform was thought to be evolving in the late 1990s as the American corporation forged ahead in efficiency and earnings performance with strong response in stock price appreciation. No more was the imperial Chief Executive Officer (CEO) to be criticized for ignoring the rightful returns of investors; but the scandals of Enron and others, and the bursting of the bubble in stock prices of Internet, telecom and energy company shares, has caused those of us involved with the corporate enterprise to take another look. While we thought governance had reached an enviable pinnacle of excellence, at least in form, we came to realize that it had not, in substance. Substantive governance simply had not followed structural reforms.

In the space of less than twelve months in 2001–2, more than a quarter of the largest corporations in the American economy experienced downturns in current sales revenues or prospects for future revenues that caused their common share prices to fall from the $50 range to $1 or less. The levelling of gross domestic product, termed a recession by media alarmists, played a major role in this collapse, but the failure of Internet services, information technology, and telecommunications to grow as rapidly as had been forecast played an even greater role. The most spectacular declines were in equipment companies for these industries where more than $1.5 trillion of investor share value disappeared.

Any discussion of faults in governance has to begin with an explanation of the corporation’s ultimate purpose: that is, the criteria by which the corporation’s performance and success are to be measured. Throughout its development the corporation has had one stated objective: ‘the conduct of business activities with a view toward enhancing corporate profit and shareholder gain’.¹ While some have argued that employees, suppliers and communities deserve at least some of the residual, or ‘profit’, this has generally been rejected as being in conflict with the conceptual model and state law and judicial decisions.

The ‘effectiveness’ of boards has been the subject of numerous investigations by analysts and financial experts. They have not resulted in a consensus position. The studies have centred on major events such as corporate takeovers, restructurings, or replacements of the CEO. A substantial body of work has developed regarding the relationship of these events, and how they were addressed in the context of corporate governance. But this body of work has been too narrowly focused for any general findings on the governance performance relationship. The initial difficulty in generating conclusive empirical results stems from the failure to develop a proxy for board ‘independence’. Most studies have relied on some measure of board composition, such as the number of outside versus inside directors, to indicate ‘independence’.¹ However, on their face, these surrogates are not associated with reform practices and shed little light on the conduct of an independent board.

In 1997, we conducted a study of 154 US companies in which we found a positive correlation between US corporations with active and independent boards of directors and Economic Value Added (EVA™).¹ This study has since then been noted as one of the few to look at board independence from a behavioural rather than structural perspective.’² In that study and in this further work, of the same kind, we choose to use a methodology based on the logical foundations that led Darwin to his conclusions.³ We have observed that certain changes in board

The last half of the 1990s was a period in which the economy expanded at a rate in excess of long term growth rates, due principally to investments in technical change resulting from new Internet and communications products. The promise of these products had beneficial effects across industry and trade, so that there was a balloon-like increase in share prices through much of the economy. By 2000 share price increases had, according to many financial analysts, developed into an authentic ‘bubble’; but this was not long lasting, and inventory accumulation and other over investments brought the economy down by the end of 2001.

The faults in governance and ensuing corporate performance in two different eras, the 1980’s conglomeration and the 1990 stock price localations provide the basis for proposals that we believe will enable boards to monitor management more effectively in market downturns as well as upturns. We propose steps that will change lack of access to knowledge to ‘knew and acted’ on that knowledge.