Boards and Investors Collaborate to Defeat Good Governance - NSFM participant 'thought' piece by Andrew Clearfield

"Given the near universal desire for charismatic leadership and the ideological obsession with shareholder value maximization, we shouldn’t be too surprised that the normal corporate governance structures and processes (e.g., Board oversight of CEO, Investor oversight of Board) have been pretty ineffective in containing executive failure. Arguably, they have encouraged it." —Raj Thamotheram

I would go further and say that the infernal nexus between shareholders' desire (longing, yearning, lust?) for charismatic leadership, which is to say, in most cases for corporate politicians or self-promoters skilled in cultivating the media, and boards' obsession that they must never disappoint the shareholders with a negative quarterly comparison (the practical meaning of "shareholder value") means that both sides are determined to subvert whatever protections are embodied in good governance practice, UNTIL AND UNLESS THE COMPANY BEGINS TO SERIOUSLY UNDERPERFORM. This tendency is going to be exacerbated by the very human fact that CEOs are naturally going to attempt to influence the process in their own favor, by making sure that directors are chosen who are pliable, like-minded, and do not keep them from having their own way.

If this be the case—and there is more than ample evidence that it is—then voluntary enforcement of governance best practice by shareholders will never work. It is not in the nature of investors as a group to risk-adjust any positive returns. There are only two practical solutions I can see to this: heavy regulation, or significant penalties for the failure to exercise proper prudential supervision.

Heavy regulation is intrusive, expensive, stifles initiative (of the beneficial, as well as the malevolent kind), and is ultimately ineffective, because there are always circumstances the regulators have not envisioned, unintended consequences always abound, and because as soon as the regulations are passed, there will be legions of clever people lying awake nights trying to think of ways to circumvent them. This leaves only the post-hoc remedy of significant penalties for malfeasance or negligence.

The problem here is that business judgment is always involved. Calculated risk-taking is the essence of economics; it is not easy to draw a bright line between a reasonable decision which happened to come out badly, and a reckless or knowingly bad decision made by directors or managers who should have known better, or who were taking advantage of a situation solely for their own benefit. Accordingly, absent fraud, it is frequently impractical to impose sanctions for what could be an honest mistake or a forgivable lapse in judgment.

Still, even the mere existence of a downside for egregious violations of governance rules which lead to major economic loss could serve as some sort of deterrent against willful violations of those rules. Here is probably not the place for a detailed discussion of what sanctions there could be and under what circumstances they could be imposed, but in general, I think that in order to work at all, these would have to be imposed on some level upon major investors (i.e., those with large stakes) as well as upon directors, and that on the directors' part there would accordingly have to be significant benefits to make up for the increased liability they would be incurring, as well as for the much greater time commitment they would have to make to exercise such diligence as would be necessary.

I would like to hear suggestions from other NSFM participants on any particular measures they might think would reasonably increase both director and shareholder responsibility for a failure to supervise obvious mis-governance which results in significant loss.


Andrew Clearfield, President, Investment Initiatives: Corporate Governance Engagements for the Long-Term Investor

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