Harmony or Dissonance? The Good Governance Ideas of Academics and Worldly Players

There are numerous players who have ideas about what are good or best corporate governance practices, but different players have different themes. My article, Harmony or Dissonance? The Good Governance Ideas of Academics and Worldly Players, originally delivered as a special lecture and recently published in The Business Lawyer, asks questions concerning ideas about what constitutes good corporate governance that are espoused by different players.

The article dwells briefly on seven categories of players: (1) academics, such as financial economists and law professors who resort heavily to empirical studies; and more worldly players such as (2) legislators, (3) governance rating firms, (4) large institutional investors, (5) corporate directors, (6) law firms that represent corporate clients on the defensive, and (7) courts. Are there discernible trends and patterns in the views espoused by these different categories of actors, despite all the differences among individual actors within each category? I believe there are such patterns, and offer some initial thoughts about the characteristic themes and different patterns of ideas about good corporate governance that we observe among the different categories of players. I then hypothesize about the reasons for these differences. My approach focuses on the motives and incentives driving the different players and how they take shape in the occupational situations inhabited by the players.

At the end I reflect on what a benign policy maker interested in increasing overall social welfare might do with these observations. To put what is perhaps the most basic question in general terms: What should good policymakers do to affect the allocation of power and influence among the seven categories of players, and/or the normative weight assigned in practice to their good corporate governance themes?

My own first instinct is to give priority to empirically based academic research as the gold standard for assessing what the law should regard as good governance. There are virtues to this approach. It seems likely to lead to practices that are more rational and beneficial to investors, and less likely than other methods to lead to rules that impose serious deadweight costs on companies and investors, or to generate rules that are actually counterproductive while ignoring what really matters. But I concede that there are significant problems with exclusive, or even dominant, reliance on the empirical-study approach.

There are at least three major categories of such problems. The first one is incomplete data and issue coverage. It is often extremely difficult to get the full scope and quality of data relevant to justify a particular rule. Identifying, then trying to measure, all relevant benefits and costs of rules or norms can be very hard and elusive. A second large problem for the benign policymaker is that empirical studies evolve and sometimes conflict, or at least appear to conflict. It is therefore hard to know when and whether particular reported empirical results are a good basis for adopting, not adopting, or repealing rules about good corporate governance practices. The third problem is that there can be real changes in the typical consequences of rules. The real consequences to shareholder value (or to other policy goals, like systemic risk reduction) of corporate governance rules can change over time, going from none to good or to bad, or vice versa. The possibilities of relevant change are open-ended and hard to identify and assess in advance. What, then, should the truly thoughtful benign policymaker do?

A policymaker asked to think about elevating the influence of some players proposing good governance practices, while curbing or eliminating that of others, may first wish to reflect on the fact that the different categories of players have differing risk and benefit profiles for shareholders and society. For example, the governance practices strongly indicated by serious empirical studies seem more likely to have real and major benefits for shareholders, but relying only on such studies creates a serious “incompleteness risk”—there may well be other valuable governance practices. By contrast, the constantly evolving and much more comprehensive governance practices recommended by rating agencies may present significant additional benefits, but with a modest risk of simply amounting to a deadweight “fashion tax” on investors. (The benefit/risk profiles of the seven types of players are elaborated in the article.)

By analogy to standard portfolio theory for investors, this complex reality suggests that allowing and even encouraging a diversity of players may lead to a greater “risk-adjusted return” to society for the whole evolving mix of good governance practices. But the analogy still leaves unsolved a very big practical policy problem. How much power or influence should be permitted or supplied to each category of player?

One tack might be called the evidence-plus-judgment approach, coupled with an ex ante commitment to monitor and revise rules and norms if appropriate (“EJMR”). That is, policymakers (legislatures, agencies, and, in some respects, courts) would commit themselves to the following norms: do take available empirical evidence very seriously and do not ignore it when setting priorities; but also use judgment based on experience and sensible-seeming policy arguments; think proactively about how the results of rules can be monitored and measured over time and modified if appropriate; and charge a relevant power holder, such as a regulatory agency, with the duty of carrying out such monitoring, review, and revisions. As should be apparent, this approach aims to diversify risk. The problems with empirical research are different from those of experience-based reasoning, arguments, and judgments; so are the benefits. This multiple-inputs approach reflects a kind of portfolio theory; it may lead to higher expected governance benefits per unit of risk (of mistake, collateral damage, and lost opportunities).

Admittedly, the EJMR approach is incomplete. The portfolio theory analogy suggests a good general reason for an approach that includes “judgment,” but the approach doesn’t offer a compelling theory about how we should go about identifying and eliciting “good judgment” in policy making. In practice, that elusive virtue may make all the difference.

The full paper is available for download here.